COMMENTARY ON THE SCIENCE OF ORGANIZATION -AND BUSINESS DEVELOPMENT ROBERT J. FRANK, LL. B. \ OF THE CHICAGO BAR REVISED EDITION CHICAGO COMMERCIAL PUBLISHING COMPANY CHICAGO 1910 COPYRIGHT 1907 BY ROBERT J. FRANK COPYRIGHT 1909 BY ROBERT J. FRANK COPYRIGHT 1910 BY ROBERT J. FRANK PRESS OP CHICAGO LBGAL Naws Co., CHICAGO. A TREATISE ON THE LAW AND SCIENCE OF THE PROMOTION, ORGANIZATION, REORGANIZATION AND MANAGEMENT OF BUSINESS CORPORATIONS WITH SPECIAL REFERENCE TO APPROVED PLANS AND PROCEDURE FOR THE FINANCING OF MODERN BUSI- NESS ENTERPRISES OF THE UNIVERSITY OF "Science Is nothing but trained and organized Common Sense, differing from the latter only as a Veteran may from a raw recruit, and Its Methods differ from those of Common Sense, only as the guardsman's cut and thrust differ from the Manner in which a Savage Wields his Club." HDXLBY. AUTHOR'S NOTE. Almost immediately after the first edition of this book appeared, a money panic suddenly overwhelmed the country, the cause of which may be directly attributed to the faulty methods heretofore adopted in the organization, reorganization or financing of busi- ness enterprises, and incidentally many of the prin- ciples herein contended for have thereby been vindi- cated, and demonstrated to be sound and practical. In the present volume a number of minor corrections, some omissions, and numerous important additions have been made, so that the original purposes may now be considered as accomplished namely to present in a brief and concise form, a general statement of the important practical questions relating to business organization and the well-settled legal principles necessary for a proper application of the various plans and modes of procedure discussed. The generous reception the first edition enjoyed has encouraged the author in the belief that this volume has served a useful purpose. EGBERT J. FKANK. Chicago, October, 1909. CONTENTS INTRODUCTORY. CHAPTER I. ORGANIZATION. A Common Error. The Corporation and Its Advantages. How to Organize a Corporation. Where to Organize. CHAPTER II. CORPORATE FINANCING. Capital, Bonds and Stocks. Capitalization of Corporations. Raising of Additional Capital. Transferring of An Established Business to a Corporation. CHAPTER CORPORATE MANAGEMENT. Directors, Officers Their Duties and Liabilities. Stockholders' Rights and Liabilities. By-Laws and Their Uses. Corporate Records and Books of Account. Examination of Books and Records. 8 CONTENTS. CHAPTER IV. REORGANIZATION AND CONSOLIDATION OF ENTERPRISE& Reorganization Possible Advantages Therefrom. Consolidation of Enterprises. Stock-Jobbing. CHAPTER V. PROMOTION OF ENTERPRISES. Promoters. Promotion Contracts. Good Will Trademarks and Trade Names. Patents and Their Commercial Value. Mining Enterprises. APPENDIX. Containing General and Special Forms of Contracts, Reorganiza- tion and Installment Certificates, By-Laws, Resolutions, etc.; also a synopsis of the Corporation Laws of favorite States for incorpo- rating, rules for Listing Stocks and Bonds, forms of Option Con- tracts, table showing the Earnings of Stocks and Bonds, and other special matter relating to the above subjects. (See TABLE OF CONTENTS, PAGE 187.) INTRODUCTORY INTRODUCTORY Before the advent of the corporation, or before the almost universal adoption of that form of conducting business, those responsible for the success or failure of an enterprise were principally concerned about its details. Now such details are delegated to subordi- nates, and the actual head of the enterprise is more intimately concerned with its policy and its financial plans and general undertakings.^ It has been said that the type of man who has genius for acquiring exact technical knowledge is not ordinarily a successful executive, and the accuracy of this statement must, in a measure, be admitted; but it must also appear to those familiar with present con- ditions that the successful executive not only neces- sarily possesses an intimate general knowledge of the science pertaining to the particular enterprise under his control, but an equal general knowledge of the established rules concerning corporate organization and finance, and the elementary rights of stockholders, as well as the duties and responsibilities of corporate officers. It is clearly beyond the possibility or legitimate pur- 12 INTRODUCTORY. poses of any book to attempt to so qualify its readers as to enable them to dispense with the services of the legal profession; but it is possible to give such a general announcement of the law and approved procedure pertaining to corporate organization and financing and particularly the practical features relating thereto as will be of inestimable value to those charged with the responsibilities of such under- takings, and at the same time suggest to the practicing lawyer who has not specialized along those lines the important practical questions which inevitably arise for consideration in the course of such employment. Particularly is this true concerning the reorganiza- tion of a business enterprise where the adoption of corporate plans for its conduct is concerned. In- numerable questions there arise which ordinarily do not receive the attention they deserve on account of their far-reaching effect upon the success or failure of the enterprise, or upon the rights of the individuals interested therein. The contents of this volume may properly be termed a discussion of the middle ground between what has ordinarily heretofore been considered within the em- ployment and province of the lawyer who is called upon to create the corporate entity which is to con- duct a new enterprise, or to take over the property of or reorganize an old one and what might, with equal propriety, be considered within the province of INTRODUCTORY. 13 the promoter 01 the individuals interested in such undertaking. Every mistake in the organization of a business corporation discloses ample evidence of either lack of proper knowledge of the questions constituting the middle-ground referred to, or (what is equally as disastrous to the enterprise) the failure to put such knowledge into execution; and this might, and often does arise on account of the fact that the employment of or instructions given the corporation attorney have been limited to simply complying with the statutory formalities in the creation of the corporate entity. Strictly speaking, the lawyer's duty is discharged by simply complying with the instructions of his client, be they ever so faulty; and the client is rarely ever qualified to decide for himself the most important preliminary questions that arise when the first steps are to be taken in launching a modern business venture, namely : the creation of the corporation which is to own and conduct it. Its purpose, capitalization and financial plans, adequate protection for investors or the owners of property to be conveyed, and rules for internal conduct, etc., are each and all matters of first importance, either immediately or at some future period of development; and these and other questions of like significance are not met with inevery-day affairs of business life, and rarely in the general practice of the law. 14 INTKODUCTOBY. A careful examination of all the works on corpora- tion law now in existence fails to disclose any adequate discussion of the field alluded to above; and this, per- haps, on account of the difficulty attending such a venture, owing to the great variety of conditions which are encountered in actual practice, and the almost hopeless task of attempting to cover such field in any satisfactory manner. But it is believed that a brief and concise announcement of the general prin- ciples covering the practical questions referred to, (which have been established by precedent as practical) and an equally general discussion of the law relating thereto, must necessarily be of value, particularly to the student or executive who is desirous of acquiring a knowledge along such lines, and who is not inclined or able to devote the time necessary to an extended research, much less to acquire the experience neces- sary to apply such knowledge once it is obtained. It may appear to those who simply review the con- tents of this volume, or who are unfamiliar with its purpose, that the arrangement of the subjects are somewhat unsystematic, and that it discusses only legal questions generally. It is to be hoped, however, that, upon a more careful study of the volume as a ivhole, the connection and continuity will be disclosed, and the fact appreciated that a general, rather than a particular discussion of the subjects in hand is more to be desired as being of greater practical value, than an extended discussion of details involving cir- cumstances or conditions which may never be met in actual business life. INTEODUCTOKY. 15 The illustrations given in the Appendix are intended to supplement and explain certain important state- ments or plans referred to in the text, and at the same time serve as suggestions for adaptation by the Profession. In every work of this character many questions, often considered elementary, are necessarily discussed, for the reason that every book treating on any science must anticipate that such a work will more often fall into the hands of those unfamiliar with such questions than otherwise. The use of technical language has purposely been avoided, and no attempt has been made to substantiate any principle of law laid down by citations of adjudi- cated cases or authorities, but careful reference has been had to all the leading works on corporation law, and the laws of the various States, as well as to numer- ous adjudicated cases which were deemed necessary to insure the accuracy and reliability of the legal princi- ples herein stated. ORGANIZATION CHAPTEE I. ORGANIZATION. A COMMON ERBOB. THE CORPOBATION AND ITS ADVANTAGES. How TO OKGANIZE A COBPOBATION. WHEBE TO ORGANIZE. A com- Every business has peculiarities and mon Error, mysteries that cannot be solved by intu- ition, and the controlling elements that make for suc- cess (when recognized at all) are often the result of the accidental occurrence of circumstances rather than the result of any pre-conceived plan. But there are elements which lead to certain failure, and they may, in most cases, be "seen from afar" and avoided by seasonable consideration. More money has often been made or lost through the plans adopted for financing, organizing or re- organizing a business than in its operation ; at the same time mistakes in such plans often prevent well-merited success or occasion individual sacrifice. There is often a tendency in the selection and pro- motion of a new enterprise to look primarily, and almost exclusively, to the " opportunities " of the busi- 20 A COMMON ERROR. ness, and to disregard the equally important questions concerning the formation, or methods to be adopted for its successful conduct. Experience has demonstrated that a business oppor- tunity, otherwise promising, may be unsuccessful without a proper basis for operation, or executive ability behind it to organize the details and properly conduct such a business. To err in the inception of a business undertaking, in its organization, or in some apparently minor detail, may mean a handicap throughout; and the consequences of faulty formation, or errors of judg- ment are rarely discovered until experience has pointed them out, and frequently, after it is too late to remedy them. Then, it is but natural to refuse to see or admit such mistakes after they are once made, and to proceed upon a theory that has proven to be erroneous or without the promise of ultimate financial reward. Individually, serious losses of both money and property frequently occur through manipulations in the coalition or reorganization of business enterprises ; and opportunities for permanent and advantageous salaried connection with a consolidating organization are as often forfeited for lack of adequate protection for those entitled thereto. There are no undertakings in business affairs where so many opportunities for the exercise of skill and THE CORPORATION AND ITS ADVANTAGES. 21 experience are presented, and where the same are so essential to success, as in the construction of a new, or the re-adjustment of the affairs of an established business such as the devising of practical and advan- tageous plans for the securing of additional capital, or a regeneration of its vitality. The business with a proper foundation is at least one-third a success; the other two-thirds may usually be acquired by opportunity, and proper and adequate facilities. The Supreme Court of the United The Cor- poration and States has said that " Private corpora- its Advan- tions are but associations of individuals united for some common purpose, and permitted by the law to use a common name, and to change its members without dissolution of the association.'' And also, "A corporation is an arti- ficial person created by law as the representative of those persons, natural or artificial, who contribute to, or become holders of shares in the property entrusted to it for a common purpose. As it is the creature of positive law, its rights, powers and duties are prescribed by the law." The legitimate purposes of the corporation are to provide a modern system for the conduct of business, to 22 THE CORPOKATION AND ITS ADVANTAGES. enable two or more individuals to combine their capi- tal and efforts in the accomplishment of a common purpose, and also to obviate the risks and many other disadvantages of the obsolete co-partnership and pri- vate ownership of enterprises. The fact that great fortunes have been amassed and " trusts " created through this modern system simply demonstrates the weakness in the laws of the various States where such organizations have their existence and domicile, and should not militate against the plan itself. The legitimate advantages of incorporating a busi- ness are many and varied. It is impractical to attempt to enumerate all, or any considerable number of them. Among the most prominent, however, are the follow- ing: It exclusively perpetuates any trade name, and inci- dentally the good will attached thereto. It eliminates the dangers of personal liability be- yond the money originally invested which attaches to any business conducted by an individual or co-part- nership. It enables the organizer to engage in different pur- suits, to more successfully conduct an enterprise, or enlarge the same, with a limited amount of individual capital. Upon the death of a stockholder, or disagreement, THE COKPOBATION AND ITS ADVANTAGES. 23 or separation of the management, the business is not necessarily hampered or interrupted, and the transfer of the individual interest of any stockholder is sim- plified, and its value readily determined. The capital invested can be increased at any time to admit of expanding the business, or to enable compet- ing enterprises to join forces, without disadvantage to either. Employes or customers may be permitted to become interested in the enterprise without the danger of dis- solution or other possible objectionable entanglements which almost invariably occur through disagreement of co-partners. Any stockholder may pledge his individual stock to obtain individual accommodation without jeopardiz- ing the interests of the corporation, which cannot be done by a partner in a co-partnership; besides, the individual debts or personal entanglements of any stockholder will not interfere with the existence or standing of the corporation. Then, the advantages of the individual stockholder of raising funds upon his individual interest in an enterprise (stock) over that of any other form of per- sonal property is apparent. In the majority of cases a business may be sold out- right to a much better advantage by first incorporat- ing it. It is less difficult to find a number of persons 24 HOW TO OKGANIZE A COKPORATION. who would take stock in a company that owned an attractive business than to find an individual who could purchase the whole; and besides, the value of the Good Will can be, in this way, preserved and real- ized upon, and the price of the business fixed by the owner before it is offered for sale. Probably the most important of all the advantages are the opportunities which are possible to the re- sourceful individual, and which present themselves in almost every undertaking, and they depend entirely upon the skill, ability and experience of the organizer of the particular corporation. How to It is frequently difficult to appreciate organize a or remember that a corporation is an corporation, artificial being, and exists independently of the stockholders or persons interested in it. By comprehending and bearing this fact in mind, all ques- tions relating to a corporate existence are simplified. These artificial beings, "invisible and intangible, ' ' are created only by legislative enactment. Most of the States, however, have what is termed "General Acts," which means that the Legislatures of these States have prescribed methods of creating corporate bodies, and have delegated to a certain State official, HOW TO ORGANIZE A CORPORATION. 25 or officials, certain powers and duties which relieve the applicant for corporate license from the delays and other difficulties incident to direct application to the Legislature itself. Illinois, for instance, has such a " General Act," passed in 1872, and amended from time to time since its passage. In discussing and illustrating the mode of organizing a corporation, the " General Act" of Illinois will be here followed, and its provisions com- plied with. The first step in the organization of a business cor- poration is the determination by the parties to be interested therein upon some definite object to be accomplished; that involves the important question of business policy, which clients are usually expected to solve for themselves. For convenience, the advantages of incorporating have been treated under the preceding head ; for it is important to understand such advantages in connec- tion with the purposes in view. In fact, the contents of this book are especially intended to be helpful in determining these and other important practical ques- tions, and the principal purpose thereof is to supply such information as is otherwise inaccessible, and it will be necessary to refer to the various headings for a full explanation and discussion on the questions here suggested. 26 HOW TO ORGANIZE A CORPORATION. After the objects which it is desired to obtain have been agreed upon and formulated, the next step is to apply to the Secretary of State for a "license to open books of subscription to the capital stock, " etc., and for the appointment of commissioners to complete the organization. This application sets forth the corpor- ate name selected; the objects for which the cor- poration is to be formed; the amount of capital stock; the amount of each share; the number of shares; the location of the corporation, and its duration of cor- porate life. In selecting the corporate name, reference should be had to the business contemplated, if this is feasible, and the name should be as short and euphonious as possible. The retention of an established trade name is always desirable, and can usually be accomplished without difficulty. Care should be exercised in avoiding the selection of the name of a corporation in existence, either in the State where the charter is obtained, or elsewhere, for under the recent law of "Unfair Competition, " now recognized by all courts, it has been held that an in- junction would lie to restrain the use of a corporate name so similar to one already in existence that it would create confusion in trade, and otherwise be injurious to the business of the company having a prior corporate existence. HOW TO OKGANIZE A COEPOKATION. 27 The objects of the corporation are, perhaps, the most important rights to be protected in the formation of a corporation, for they frequently give the incor- porators many advantages in the development of the business. While it is always desirable to make the objects contemplated as broad as possible, this may be overdone, and under the present Illinois statutes it is necessary to limit the objects of the corporation; besides, the doing of business ultra vires (outside the scope of the objects set forth in the application) is unlawful, and may result in loss to the company and lead to other complications. Determining the amount of capital stock is treated under a separate heading.* The amount of the shares must not be less than $10, nor more than $100 in the State of Illinois. As to the duration of the existence of the corporation, this may be made the safeguard or otherwise of the rights of the parties; that is, if it is desired to con- duct the enterprise for a limited time, that fact can be set forth in the application, and, in consequence, the corporation's life will end upon the termination of the time limit thus set forth. This means that the affairs of the corporation must be wound up at that time, regardless of the wishes of the stockholders, and with- out any further action being taken by them. "Capitalization of Corporations," page 51. 28 HOW TO ORGANIZE A CORPORATION. On the other hand, if it is not desired to have a lim- ited undertaking, the duration of the corporation should be ninety-nine years (the tune limit in Illinois), for one of the chief assets of a business is its trade name, and this should be more valuable each succeed- ing year. Upon the receipt of the application, properly exe- cuted, the Secretary of State issues what is termed a "license to open books of subscription. " This instru- ment empowers the parties named therein to complete the organization that is, to have the stock subscribed for according to law, and to give notices, under the statute, to parties subscribing for such stock, of the holding of a meeting to elect directors, etc. The stat- utes provide that the notice for the holding of the first meeting must be mailed to all subscribers to the capital stock at least ten days prior to the meeting day, as determined by the commissioners and sub- scribers, and set forth in the notice referred to. There is now a custom among many incorporators of formally waiving the statutory notice above re- ferred to, and of holding the first meeting, to organize, immediately upon receipt of the license from the Secretary of State. The question of the legality of so doing was submitted to the Supreme Court of Illinois in 1906 and the court held that "the only persons interested in the result to be obtained by giving notice HOW TO ORGANIZE A CORPORATION. 29 of the object, time and place of a meeting of the sub- scribers to the Capital Stock of a corporation for the purposes specified in the statutes are the subscribers themselves, " and that, therefore, if all the subscribers join in such waiver of notice, and the meeting to organize is actually held in accordance with such waiver, the purpose of the statute has thereby been accomplished. In pursuing this method of completing the organiza- tion of a corporation, the waiver of notice should be entered in the Minute Book of the corporation, and bear the original signatures of all the subscribers. Under the present state of our "General Act" it makes it necessary for the commissioners named in the license referred to, to take over, as such commis- sioners and trustees, for the new corporation when formed, any property which it is contemplated shall be transferred to the new corporation, and this, of course, includes the payment of money, which, under the present act, is required to be done on or before the meeting called by the notice above described, to the extent of 50 percent of the capital stock ; that is, one- half of the capital stock must now be paid to the com- missioners in advance of complete organization of every business corporation. Great care must be exercised in the accepting of property in payment for capital stock by the commis- 30 HOW TO OBGANIZE A COBPOBATION. sioners in question, or they assume a liability which they may not contemplate, or intend to assume. In the Appendix will be found a copy of a resolu- tion which it is considered covers this question in a practical way,* and the subject of taking over assets other than cash in payment of stock in a new corpora- tion is treated at length hereinafter.! Appraisals of property to be taken in payment for stock are always advisable, if not necessary, both by the commissioners and directors when elected, and as to the valuation of such property, that is also treated hereinafter.! Separate minutes of the acceptance and appraisal of property by the commissioners should be entered in the Minute Book for their own protection, and as a basis for a resolution, by the directors, taking over the property from such commissioners, after the cor- poration is formed. Upon the meeting day of the subscribers to the capital stock, set forth in the notice referred to, the usual formalities should be observed in all particulars, in the holding of the first meeting and transaction of business thereat, and the minutes should be pre- served and recorded in the Minute Book of the cor- poration, and signed by the parties in interest, if they Appendix, page 209. t "Transferring of An Established Business to a Corporation," page 69. HOW TO ORGANIZE A CORPORATION. 31 are not too numerous; at any rate, they should be signed by the commissioners, and attested by the secre- tary. At this meeting, the subscribers to the capital stock elect the first Board of Directors, and this is important in relation to the future management and control of the corporation, for the ensuing year, at least ; for it must be borne in mind that the directors control the offices of the corporation, and not the stock- holders, and that the officers in turn transact the busi- ness of the corporation. The Statutes of Illinois relating to directors pro- vide that the number of directors shall be fixed at the first meeting of the subscribers, and their number depends wholly upon the will of the incorporators. Such subscribers may, if they see fit, by resolution, divide the Board of Directors into three classes; the term of office of the first class expiring on the date of the annual election of the company then next ensuing ; the second class one year thereafter, and the third class two years thereafter. Thus, at each annual elec- tion for directors after such classification, the stock- holders elect, for the term of three years, the number of directors constituting such class whose term then expires. In this way, one or more directors will hold office from the beginning of the organization for three years, others for two years, and still others for one 32 HOW TO ORGANIZE A CORPORATION. year, if for any reason this plan be advisable, as it frequently is in large corporations. The usual plan, however, is to elect the entire Board of Directors for a period of one year, particularly in small or close cor- porations. We now have (at least) three commissioners hold- ing the title to the property or funds of the corpora- tion in process of formation, which have been turned over to them in accordance with the law, and all neces- sary steps have thus far been taken, including the election of the first Board of Directors, and the record- ing of the minutes thereof in the Minute Book. A report in due form of these proceedings is now prepared and forwarded to the Secretary of State, and upon its receipt (if in all things it complies with the law and the original application) a certificate of complete organization is issued and forwarded to the commissioners, who should at once record the same in the office of the Eecorder of Deeds of the county where the principal office of the corporation is located; for this is a condition precedent to the corporate life of the company, or its right to transact any other busi- ness than that already explained. The next step is the adoption of a code of by-laws for the government of the company, and it is well to remember that the by-laws are the internal laws of the corporation, and as such should set forth the rules HOW TO OKGANIZB A COKPORATION. 33 necessary for the proper conduct of the business. This has been made the subject of separate discussion,* and, therefore, need not be further alluded to at this time. While it is impossible to prepare " stock by-laws" that will meet all the requirements of incorporators generally, still the form given in the Appendix heretof will be found to be adaptable, with minor changes, to the ordinary business corporation organized under the laws of Illinois. After the adoption of a set of by-laws for the gov- ernment of the corporation, the next step to be taken is the election of officers, and they will be such as the by-laws have provided for. The laws of Illinois require every business corporation to have a Presi- dent, a Secretary and a Treasurer; and leaves it dis- cretionary with the directors as to how many addi- tional offices they shall create. After the election of officers, if assets have been turned over to the commissioners, to be applied upon the payment of stock subscriptions, the Board of Directors then proceed to appraise and take over the same (if it be property), and to approve or disapprove of the action of the commissioners in this regard. There is no direction in the law for the carrying out of its provisions under which advance payments are * By-Laws and Their Uses," page 94. | Appendix, page 217. 34 HOW TO ORGANIZE A CORPORATION. required, except that they shall be paid. It is mani- fest, however, that inasmuch as the corporation contemplated is not yet in existence, the commissioners are the only proper persons to take title to property, or to receive advance payments on account of stock subscriptions ; and for that purpose, they stand in the relation of trustees for the new corporation when formed. The approved method of taking over property or advance payments made by the stockholders to the com- missioners, in advance of complete organization, is for the Board of Directors, by proper resolution, to ratify, confirm and adopt the acts of the commission- ers in this behalf, if such acts are in fact proper and deemed for the best interest of the corporation. A form of resolution applicable for this purpose may be found in the Appendix,* and will serve as a guide to what is usual under the circumstances here indi- cated. The rules relating to the valuation, appraisal and purchase of assets by a new corporation are further, and at length, discussed under the title, "Transfer- ring of An Established Business to a Corporation, "f After the foregoing steps have been taken, and the minutes of the various meetings written up in the Corporate Eecord Book, the ordinary business cor- * Appendix, page 209. tPage 69. HOW TO ORGANIZE A CORPORATION. 35 poration is in existence, fully organized and ready for the transaction of any business for which it was incorporated. The question of "how to create the corporate entity before the principal capital becomes interested " fre- quently arises. Particularly is this so where the incor- porators have a limited amount of capital, or the cor- poration is being created for the purpose of taking over a business already established, or for reorganiza- tion purposes, and the details of such undertaking have not been entirely settled. In such a case it is possible to accomplish the object, and fully comply with the law requiring 50 percent of the capital stock to be paid in before complete organization, etc., by first incorporating with a nominal capitalization, and afterward raising the capital stock to the amount originally contemplated or desired. The Corporation Laws of the various States differ somewhat materially in the manner and form of creat- ing a corporation, and it is beyond the scope of this book to undertake to discuss the details of the various acts; the formalities required for their compliance must necessarily be entrusted to those familiar with such laws as they exist at the time of organization; but the essential practical features of the organization of business corporations are much the same every- where, and they are discussed under the various head- ings herein. 36 WHERE TO OEGANIZE. where to Like most questions of procedure, this organize. is one depending largely upon the cir- cumstances of each individual case. There are no general rules which can be applied when the ultimate success of the enterprise is considered. So far as the most favorable laws are concerned, that is always subordinate to the more important questions of business policy. For instance, one State may offer inducements in the way of reduced incor- portion fees and enlarged privileges in short, a more favorable franchise; but when this is compared with the other objects sought to be accomplished, it is of little importance to the organizer. Many a corporation has been handicapped by mak- ing the fatal mistake in organizing under the laws of some foreign State. Usually companies with ulterior objects seek domicile in a State offering the greatest latitude for their purposes this fact being so noto- rious that it is prima facie a reflection upon legitimate undertakings to go away from "home" for the pur- pose of organization. However, this reflection may be removed by explanation, when the peculiar circum- stances of the particular case justify the selection of a foreign State for incorporation, as they frequently do. New Jersey, Maine and Delaware have gone a long way toward encouraging corporations to organize in WHEKE TO ORGANIZE. 37 their respective States; North and South Dakota and Arizona have attempted to do likewise, and the laws of all these States have their peculiar advantages, particularly over those of some of the other States where corporations would naturally desire to locate on account of the business advantages offered. It will be found that in the States where business is most centralized, and where the actual business of most business corporations is transacted, the laws are more or less stringent, and some are unreasonable and obsolete; but, in some of these last-mentioned States the intention at least is to protect stockholders and creditors, and for the legitimate, well-meaning enterprise it is often best to submit to these condi- tions and organize at home. Particularly is this true where outside capital is to be interested. Prospective investors, as a rule, invest their money under the advice of legal counsel, and local attorneys are naturally more familiar with the laws and decisions of the courts thereabout, in their own State, and can advise their clients more readily and securely; and in addition to this fact, the invest- ing clients themselves feel more secure in their rights when the corporation is organized under the local State laws. The State of West Virginia was the first to offer inducements to foreign corporations in the way of 38 WHEKE TO OKGANIZE. reduced incorporation fees and enlarged powers and limited liability. A large number of the modern com- bination organizations were attracted to that State on that account, but after organizing there, the Legis- lature changed the laws, and it was otherwise deemed necessary to leave the State and incorporate else- where, particularly in New Jersey. It must be borne in mind that in nearly all of the States the right to change the General Incorporation Act is reserved by the Legislature, and the advan- tages offered may be diminished or repealed at any time, and the privileges of the corporation curtailed. In addition to this possible objection, most States have recognized the fact that their local capital have sought other States for the purpose of organization only to evade the payment of the local incorporation fees, and to otherwise evade the provisions of the laws of the respective States where such corporations in fact intend to operate. To protect themselves, special acts have been passed by most of the States, similar to that now in force in Illinois, which defeats nearly all of the advantages heretofore obtained by organiz- ing in any of the foreign jurisdictions. The present act of Illinois relating to " Foreign Corporations " is given verbatim in the Appendix;* and most of the States have the same or a very simi- * Appendix, page 258. WHEBE TO OKGANIZE. 39 lar statute for the regulation of foreign corporations. For the convenience of prospective incorporators, a synopsis of the Corporation Laws of the States of New Jersey, Delaware, Maine and South Dakota will also be found in the Appendix,! which shows the spe- cial powers, statutory fees and other information desirable for a preliminary understanding and con- sideration of the questions to be taken into account when selecting a State in which to organize. The various statutes of those States deemed most favorable, and above referred to, have numerous minor provisions, presumably for the protection of stockholders and the public generally, which often serve to furnish dissatisfied stockholders with the means of annoying and otherwise interfering with the business of a corporation organized in a foreign juris- diction. It will be seen, by reference to these statutes, that the objects to be obtained, and suggested here, must be taken into consideration, first in this as well as in other questions relating to the organization of a busi- ness corporation ; and the important question to decide is always, What effect will the organization of the par- ticular corporation under the laws of a foreign State have upon its business success? t Appendix, page 247. 40 WHEKE TO ORGANIZE. Whenever the laws, conditions, purposes or plans justify the decision to incorporate in a state other than that in which the parties in interest reside, or where the principal operations are to be conducted, it is of first importance that a proper statutory agent or local representative be chosen to represent the new corpora- tion, both to bring it into existence, and thereafter in qualifying under the laws of the state relating to domicile, such as maintaining a statutory office, acting as local resident agent, director or officer as the laws may require for the acceptance of service of legal process, the keeping of certain corporate books or rec- ords, etc., all of which require reliable, competent and permanent attention in order that such new corpora- tion may not suffer loss through unknown, or unneces- sary litigation, statutory fines, etc. Similar important services are necessary when any corporation attempts to comply with the various ' 1 Foreign Corporation Acts" by establishing local branches in states foreign to that of their creation; and here as before the questions of reliability, experi- ence, facilities to serve, and permanency (rather than economy) should control in the selection of a repre- sentative for the conduct of such foreign affairs. CORPORATE FINANCING CHAPTEE II. CORPORATE FINANCING. CAPITAL, BONDS AND STOCKS. CAPITALIZATION OF COBPOBATIONS. RAISING OF ADDITIONAL CAPITAL. TRANSFERRING OF AN ESTABLISHED BUSINESS TO A COBPOBATION. Capital ^ ne questions of finance are among Bonds and the most difficult if not the most im- stocks. portant with which the organizer of a business corporation has to deal, and like other ques- tions of business policy, they are necessarily governed by the circumstances of the undertaking in hand. It is necessary for a correct understanding of the questions of corporate finance that the distinction be- tween the terms capital stock, shares of stock and capital be understood. At the same time, an under- standing of the nature and peculiar characteristics of stock as property is essential. The difference between the capital stock and capital of a corporation is, that the former constitutes the amount divided into shares or parts at which the in- corporators have limited the issuance of stock in other words, the amount upon which calls may be made (43) 44 CAPITAL, BONDS AND STOCKS. upon the stockholders and dividends paid; while the capital of a corporation is the proceeds of the sale of this capital stock, and, in addition thereto, all money or property of the corporation acquired from any and all lawful sources. The former amount remains the same until changed by consent of the State, while the latter may vary according to the success of the enter- prise. The term shares of stock means the several parts into which the capital stock is divided, e. g., if the cap- ital stock of a corporation is $100,000, and the denom- ination of the shares is fixed at $100 each, a share of stock represents one one-thousandth part of the prop- erty of the corporation. Then these shares of stock are represented by stock certificates, which may be made out to represent one, or any number of shares of the capital stock, according to the will of the makers of the certificate. The proceeds of the sale of the capital stock the capital belongs to the corporation, and the owners of such capital stock have no right to withdraw any part of such proceeds after it is once paid into the treasury; and this is the law, even if all the capital stock is owned and held by one individual. As here- tofore stated, the corporation is a legal entity a per- son in the eyes of the law and the stockholders, directors and officers combined do not constitute the CAPITAL, BONDS AND STOCKS. 45 corporation. A stockholder, by reason of his owning stock in a corporation, does not thereby acquire title or right to the profits or surplus of a corporation, until the same has been formally and legally " de- clared " by the Board of Directors and formally set apart for the stockholders ; at the same time, a stock- holder has no title or individual interest in, or rights to, the property of a corporation until a dissolution takes place. He cannot even acquire a good title to the property of a corporation by purchasing all of its stock and then abandoning the corporate existence. There are but two general classes of stock in a business corporation which need be here referred to, namely, common and preferred. Many American writers on Corporation Law give other classifications, such as "watered stock/' "deferred stock," "special stock" and "over-issued stock/' but they all fall within the above classification, or are of no importance in this connection, except to understand the meaning of the terms employed. "Watered stock " means simply stock that has been issued and not paid for, in money or money 's worth, to the extent of the face value of the stock issued; "deferred stock" is in reality a bond under another name; "over-issued stock" as its name implies is stock that is issued in excess of that authorized by law, or for which the corporation was originally cap- 46 CAPITAL,, BONDS AND STOCKS. italized; and the term " special stock" is a class of corporate property unknown in any other State but Massachusetts, where it is created and authorized by the laws of the State. Common stock is a general interest in common in the property of a corporation. It is, like all other stock, divided into parts or shares which represent a certain proportionate part of the whole. This class of stock confers equal rights and privileges among all its owners, such as the right to share in the profits of the business; to vote for directors; and upon a disso- lution of the corporation, to share equally with all other stockholders, in the division of the assets, etc. Preferred stock is a special interest and contract combined whereby the corporation agrees to pay its owners a certain specified dividend out of the net profits of the business in advance and in preference to the common stockholders. It may not be amiss to here refer to some of the important differences between preferred and common stock. The former provides for a guaranteed divi- dend out of the net profits, usually the customary rate of interest of the State where the corporation is or- ganized. Such dividends can be made cumulative or non-cumulative; that is, should the net profits for any one year be insufficient to pay the dividend named, any unpaid portion of such dividend shall be made 7 ur i ri UNIVERSITY OF CAPITAL, BONDS AND STOCKS. 47 up and paid out of the profits of any subsequent year, before dividends can be applied to the common stock, or any other class. Common stock has no guaranty of dividends, even if there should be net profits, but is entitled to all of the earnings of the company after the dividend is paid on the preferred stock; and unless the conditions of the preferred stock are such as to prevent, it will pro- rate with the common stock in all dividends that may be earned and declared, after the dividend has been paid on the preferred stock, and an equal amount paid to the holders of the common stock. The conditions upon which preferred stock is issued govern all the rights of its holders, and constitute a contract between the corporation and the holder; and in the absence of a condition to the contrary, preferred stockholders may vote and exercise all the rights of the holders of the common stock. Some of the State statutes do not provide for the issuing of preferred stock, but it has been repeatedly held that such stock may, nevertheless, be issued if it is provided for at the time of organization; and such preferred stock may also be issued at any time there- after, with the consent of the holders of all the com- mon stock of the corporation. A Stock Certificate is not necessary to the owner- ship of stock in a corporation. It is merely evidence 48 CAPITAL, BONDS AND STOCKS. of the ownership; the stock exists independently of the certificate itself. Shares of stock are a peculiar species of property. They are intangible, and resemble what is termed in law a chose in action that is, a right or claim which can be reduced to writing and enforced in a court of law. Shares of stock are, in the absence of a statute ex- pressly authorizing the same, not subject to levy and sale upon execution, like other personal property; however, most of the States have enacted laws whereby such levy may be made. It is necessary to get per- sonal service on the owner of stock, or to get physical possession of the certificate representing it; and it has been decided that attempting to levy on the stock of an individual through the corporation is ineffectual, which demonstrates the principle above stated that this species of property is somewhat peculiar, and differs from a claim for money or property, in that particular at least. Then, in addition, shares of stock possess many features of negotiability. For instance, by simply indorsing the certificate in blank, stock may be trans- ferred from one individual to another by delivery of the certificate, and the right to insert the name of any intermediate or ultimate owner, and to have the stock transferred to such owner upon the books of the com- CAPITAL, BONDS AND STOCKS. 49 pany, passes with the certificate indorsed in that way which enables the possessor of this species of property to readily use the same as security for financial accom- modation. Bonds are formal obligations executed by a corpora- tion and usually secured by trust deed upon the plant or assets of the company. They are ordinarily issued in denominations of a size that will enable the corpora- tion to negotiate a large loan among a number of investors, and to secure alike any number of holders of such obligations. The terms of payment and security of bonds are wholly dependent upon the will of the corporation creating them. The usual object of issuing this form of obligation is to obtain what is termed a "permanent loan, ' ' or financial accommodation for a long time, and upon a low rate of interest, in order that the same may be used for the advancement of the business, and to be repaid out of the profits of the enterprise. It is customary to make such obligations payable to the bearer ; and when this is done, they are suscept- ible of being transmitted from one person to another without formality of any kind. The law presumes ownership with their possession, when made in that way. The conditions of a trust deed made to secure such bonds, as well as the terms of the bonds themselves, 50 CAPITAL, BONDS AND STOCKS. may be made to facilitate or hinder their sale; conse- quently great care is necessary in the preparation of both. Bonds may be drawn so as to be convertible into stock, at the option of the holder, and in this way facilitate their sale, by enabling the owner to practi- cally invest in the enterprise, and in case of success, to convert his bond holdings into stock. And on the other hand, if the venture proves less profitable as an investment than the interest guaranteed by the bonds, the holder is secured, and can ultimately recover his investment, with interest. Bonds may also be issued in lieu of dividends. By so doing, the amount of the dividend may be retained in the business for development purposes, and the stockholders will have received what is equivalent to the dividend as well. The foregoing simply explains the latitude and some of the advantages afforded the creator of bonds and stocks. The terms that may be incorporated in stock certificates and industrial bonds are always a subject of contract between the corporation and the purchaser; such terms are limited only by general rules of law and business expediency. The term debenture is often used interchangeably with, or substituted for, the word bond. While the meaning of the term debenture is, strictly speaking, CAPITALIZATION OF CORPORATIONS. 51 the evidence of an existing debt, it may be a simple debt, and unsecured ; but common usage has established many qualifications to the word bond, and they are ap- proved in the world of finance, and their meaning and significance understood. capitaiiza- ^ ^ s comparatively a simple matter to tion of cor- determine the questions relating to capi- porations. talization where the number of parties in interest are few, or in a case where the business to be capitalized is what is termed a " close corpora- tion. " In such cases the objects to be accomplished are usually confined to the conduct of a single business venture for the benefit of a limited number of per- sons, and the questions that arise under other, and ordinary circumstances, are absent. It is, therefore, unnecessary to discuss the capitalization of such a corporation as is here alluded to, for it is presumed that no outside assistance or interest will be desired. It is where the rights of the parties are to be con- sidered at the time of organization in order that they may be protected under present conditions and future business developments, and that the needs of a business may be provided for at the time of organi- zation, as well as in the future that this subject re- quires special attention. 52 CAPITALIZATION OF COKPOKATIONS. A business with a good foundation and prospects may be greatly handicapped, and its opportunities for successful promotion be "killed," by over-capitaliza- tion. For example, A had a valuable patented device that was, in itself, the foundation for a success- ful business venture. He formed a corporation and capitalized it at $2,000,000, when as a matter of fact, $100,000 was all the working capital which was neces- sary for the successful conduct of the business. By manipulations, hereinafter more fully explained, the business was so arranged as to offer this stock at a ridiculous figure (below par, of course), with the result that after disposing of a certain amount of this stock enough to get the business thoroughly en- tangled, and to demonstrate that such a plan was not feasible, and that sufficient money could not be raised thereby to exploit the device and promote the busi- ness it became necessary to reorganize the company, and to re-capitalize it at a reasonable amount, before the business could be financed sufficiently to dem- onstrate the earning capacity of the device. Numerous other cases illustrating the principle above set forth could be given, but they are of such frequent occurrence as to be familiar to everyone who has had experience in business organization. At the same time, the capitalization of a business corporation at an amount less than the immediate or CAPITALIZATION OF CORPORATIONS. 53 future prospective requirements of the business will admit, may, and usually does, furnish an occasion for reorganization. What may be considered suffi- cient capital for present needs may prove wholly in- adequate after the business has been developed, and unless this contingency has been taken into account at the time of organization the providing of addi- tional capital is always a difficult question; for the rights of the stockholders will have accrued in the meantime, and their consent to such an object may be necessary and difficult to obtain. Under the laws of Illinois (and most other States) it is necessary to obtain the consent of stockholders owning two-thirds of the capital stock before an in- crease of the same can be legally accomplished; and unless the amount of capitalization at the time of organization is sufficient to provide for the future needs of a business the absence of this consent may defeat the raising of such needed capital, in that way. There is, of course, no arbitrary or settled rule for fixing the amount of capitalization of a business cor- poration, but the effectual and conservative rule usually adopted for the guidance of incorporators is that the demonstrated or reasonably prospective earn- ing capacity of a business should control in fixing the amount. If the question arises in the reorganization of a going business, its past record and reasonable 54 CAPITALIZATION OF COEPOBATIONS. future prospects based thereon, are legitimate sub- jects for consideration and guidance in fixing the capitalization. As an illustration : Where a business has shown a net profit of 15% on the capital employed, it would not be out of proportion to capitalize a cor- poration, which was to operate such a business in the future, at three times the amount formerly invested therein. On the other hand, if the proposition under consideration is a wholly new business venture, its present and conservatively estimated future prospects should form the basis of capitalization; and these prospects may be arrived at by various methods usually known to those experienced in the particular line of business under consideration. There are usually but two important considerations in fixing the capitalization of a corporation, and they are, first, to enable the company to obtain working capital; and second, to protect the rights of the pres- ent parties in interest. In accomplishing the former, due regard should be entertained for the opinions and judgment of those who may be invited to invest in the undertaking. The manner of capitalizing a corporation, that is in fixing the classification of stock to be issued whether preferred or common, or both is also im- portant, and this should be done at the time of organization, as far as possible, for reasons already alluded to. CAPITALIZATION OF CORPORATIONS. 55 In the reorganization of a corporation or business it is frequently desirable that the former owners of the business should continue to be interested in the enterprise, by accepting stocks or bonds, or both, in payment for their interest conveyed to the corpora- tion. This may be accomplished by issuing preferred stock to cover all the interest of such persons, or to issue bonds to cover the conservative value of the tangible property, and common stock in payment of the Good Will and other intangible assets conveyed. If, on the other hand, it is the desire of those interested to ultimately dispose of their holdings entirely (in other words, to incorporate for the purpose of dis- posing of their business), this may be accomplished through the bond issue, or by the issuing of preferred stock which is preferred as to the assets as well as to profits; for they are both more likely to find a ready sale than common stock, particularly while the enter- prise is in its infancy. The question of whether the interest conveyed shall be paid in preferred stock or bonds is simply one of expediency; in either event, the party interested is protected. The principal and controlling difference between preferred stock (such as is here suggested) and bonds secured by a trust deed on the plant of an established business, is that the bonds secure the holder ahead of subsequent creditors and guarantee 56 CAPITALIZATION OF CORPORATIONS. the payment of a certain rate of interest, while the preferred stock does not insure a dividend unless it is earned, and is not a lien on the assets; and with these differences, they may be considered as of equal value and security. If the business management and conditions justify the accepting of preferred stock of this character, it is frequently desirable to do so in preference to issuing bonds ; for with such preferred stock there is no indebtedness against the business to injure its credit and prospects, which would be the case if a bond issue was adopted. The capitalization of a new venture without a nucleus or established business as a basis, and where the organizers depend upon the sale of stock for work- ing capital, presents more difficulties. Ordinarily, there are a number of persons interested in such undertaking at the time of organization who propose to contribute a certain amount toward its promotion and establishment but expect to raise the majority of the capital by the sale of stock. Where such a condition exists, it is advisable to have both preferred and common stock, the proportion of which must depend upon the circumstances of the particular case in hand. An approved and dem- onstrated plan, however, is to have the stock divided equally; that is, one-half preferred and one-half com- mon, and to capitalize the corporation at an amount CAPITALIZATION OF CORPORATIONS. 57 sufficient to make the proceeds from the sale of the preferred stock furnish the immediate working capi- tal, and to leave the common stock for sale for future development purposes, after its earning capacity has been demonstrated; or if it is feasible to do so, have the preferred stock cumulative as to dividends, and preferred as to assets, and to sell as near as possible an equal proportion of each class of stock at the out- set. In this way, the investor is insured a dividend on one-half his investment, if the business earns enough to pay it ; and in the event of a dissolution or failure, he would be protected ahead of common stock- holders in the same proportion. Then enough of this preferred stock would be retained to aid the sale of the common stock, should the business require it. There are numbers of circumstances which permit of the issuing of all common stock, particularly among the smaller undertakings, and of course this is to be recommended whenever the conditions will justify such a course that is, when the capital necessary for the needs of the business can be as readily obtained in that way. After the amount and manner of capitalization of a business < corporation has been determined there still remain for consideration the terms and manner of payment of the stock sold or subscribed for. The statutes of most of the States provide for a 58 CAPITALIZATION OF CORPORATIONS. certain minimum amount with which a corporation may begin business, and this, of course, must be paid in at the time of organization. In the absence of a statute to the contrary, the payment for all stock in a corporation is a fit subject of contract (as between the subscriber and corporation), and in the absence of any contract such payment is subject to call of the Board of Directors. In a case where it is necessary to sell stock to be paid for in installments, or to sell stock in small blocks or installments, the approved method for accomplish- ing this purpose is to issue an "installment certifi- cate " or contract for the ultimate delivery of the reg- ular stock certificate upon complete payment, or when a certain number of shares shall have been paid for, etc. Where it is necessary to adopt such methods for the raising of capital, it is usually advisable to issue such contracts in lieu of stock, and to have their terms provide for the delivery of the regular stock certifi- cates upon a certain specified date, far enough in the future to insure the sale of all stock which it is con- templated will be sold, or which it is deemed necessary to sell, in that way. For, if the regular stock certifi- cates are delivered as the stock is sold, circmnstances may make it necessary or profitable for the purchasers to dispose of some or all of their stock before the com- pany's unissued stock is sold, and in this way create CAPITALIZATION OF CORPORATIONS. 59 a competition between such stockholders and the cor- poration, and, in consequence, demoralize the market and hinder the sale of the balance of the company's stock. Such a certificate as is here alluded to must be drawn with special reference to each particular state of facts. An approved general form illustrating the application of the plan here referred to will be found in the Appendix.* Eecurring to the subject of bonds : Their terms and conditions, and the terms and conditions of the trust deed made for their security, are matters of impor- tance from a practical standpoint, both to the corpora- tion issuing them and to the prospective purchaser in the open market. While it is necessary that these provisions should be all that is reasonably required for the protection of the investor, care should be exercised in making their terms to suit the convenience and possible contingen- cies of the business of the corporation; as an exam- ple, in the terms of their payment it may be provided that any of a certain series of bonds may be retired by the corporation upon giving reasonable notice to that effect upon any annual interest day, and by pay- ing a certain reasonable amount for the privilege, in the shape of advance interest. In addition, the de- Appendix, page 214. 60 RAISING OF ADDITIONAL CAPITAL. nomination and time of payment should be considered. If it is desired to sell such bonds in a private way, or in a locality wherein the persons interested are known, the making of small denominations may greatly facilitate their sale among small investors; and the time of payment should be placed at a conserv- ative distance in the future to insure the ability of the company to repay the principal when due. It is often advisable and necessary that the stocks and bonds of a corporation should be listed with the local Stock Exchange, in order that they may have a market among investors in securities, who naturally look to such a source for information concerning the value and regularity of the issue offered for sale. Such Exchanges have rules for the protection of their members and the public which must be complied with; a copy of that portion of the By-Laws of the Chicago Stock Exchange is given in the Appendix,* and the conditions there imposed are similar in all respects to those of such Exchanges in other cities. Raising If the corporation is legally formed of Additional w [th due consideration for its possible capital. future developments and financial needs, and the business has been legitimately and success- * Page 245. RAISING OF ADDITIONAL CAPITAL. 6.1 fully conducted, and its books and records accurately and systematically kept, the question of raising addi- tional capital is comparatively a simple one, and its acquirement is based primarily upon the financial re- sponsibility and business prospects of such an enter- prise. Conditions that influence sales of stocks and bonds are often created at the time of the organization of the corporation creating them. It is when some or all of the foregoing features are lacking that difficulties are encountered and failures occur, where the business itself would otherwise justify a different result. And, it might be added, that the majority of failures are, in some measure at least, due to the fact that the proper attention has not been given to some practical ques- tion concerning the organization, or other essential matters, at the inception of the undertaking. "When the corporation is confronted with embar- rassing questions of finance, the defects, if any, in its formation or subsequent conduct " stand out in bold relief/' and often make it quite impossible to accom- plish the result desired, without a reorganization.* Capital is a power well known to the average pos- sessor, and it is necessary to take this fact into con- sideration when it is sought after ; then, the viewpoint of the man with money must also be taken into account. *See "Reorganization," page 115. 62 BAISING OF ADDITIONAL CAPITAL. While there are many selfish and grasping persons, the average business man looking for a business oppor- tunity is fair and reasonable from his point of view; and if that can be ascertained, and his requirements fulfilled, the matter of interesting him in a business is simplified. The business corporations which are ordinarily seeking capital might properly be included within the following three general classifications, and they will therefore be here adopted, and considered in their order, namely: First: The new undertaking which has passed through the experimental period (which is usually the first year), and finds itself without sufficient capital to accomplish the original objects. Second: The established business which has been built up by a firm or individual, and transferred to a corporation, but for some reason the capital at its disposal proves insufficient. Third: The business with visionary plans, and whose objects are impractical, desiring to obtain capi- tal for its conduct or continued operation. In considering the first class of enterprises named it will be assumed that all necessary and proper steps have been taken in the organization, and that the business itself is of recognized merit. It is also here assumed that no mistakes had been made, either in RAISING OF ADDITIONAL CAPITAL. 63 the domicil, amount of capitalization, or other practi- cal features, and also, that the business itself shows a fair and reasonable prospect for ultimate success. In this case, as in all others, the particular circum- stances must govern ; but generally the increasing of the capital stock of such a company is the most satisfac- tory method to acquire additional capital, particularly from a financial standpoint. Of course, the sale of such stock is necessary, and if the business will admit of additional executive assistance, the inducement to an investor of filling an office of responsibility with reasonable compensation is always a great help and an important element in effecting such a sale. The sale of a large issue of stock is always difficult, unless the corporation is well known, in the hands of recognized dealers in the line of business, or its stock is listed on the local Stock Exchange. The issuance of bonds or preferred stock with a common stock bonus, is always to be discouraged from a business standpoint, if from no other; and the con- servative man of money is rarely, if ever, influenced thereby. Many of the questions here presented have been already considered in determining the capitalization of a new corporation under the preceding heading and therefore need not be repeated; the general prin- ciples there announced will be found useful in the solu- 64 RAISING OF ADDITIONAL CAPITAL. tion of questions of finance whenever a business falling within this classification requires financial assistance. The next class of business corporations seeking cap- ital, and referred to above, are not as numerous as the first. For, assuming that no mistakes have been made in the essential features of reorganization and that the business is established, little difficulty should be met in raising any reasonable amount of necessary capital consistent with the security to be given. Here we are also confronted with the peculiar, im- portant circumstances which surround every case of this character. Generally such a business has assets of a permanent nature often a plant which would readily be accepted as ample security for a bond issue sufficient to provide the necessary working capital; and where this can be done to advantage, it is well to be considered, as such bonds usually are salable at par, and bear a low rate of interest and can be made to mature far enough in the future to make such a plan advisable from every standpoint. Then the question of changing location is to be con- sidered here, as it is in the class of companies first above named; numerous outlying towns and localities desire additional manufacturing industries, and they are frequently prepared to provide locations and financial assistance, either in the form of a bonus, or by subscribing for a certain amount of additional KAISING OF ADDITIONAL CAPITAL. 65 capital stock. These opportunities may be investi- gated, and reliable information obtained by consult- ing the Industrial Agents of the various railroads, whose business it is to give assistance in such mat- ters, both to the industry seeking a location and to the town in procuring the enterprise desired. The third class of enterprises named comprise the majority of the seekers after capital, and this fact alone makes it more difficult for the legitimate and worthy enterprises to secure such assistance. Manifestly, the greatest benefit to all persons in- terested in such a company would be to wind up its affairs as speedily and economically as possible; but it is safe to predict that few readers of this book will ever concede that their undertakings or business ven- tures fall within the lines here drawn. It is surprising, however, to know the large per- centage of enterprises struggling to keep alive and going which in reality may be fairly considered within this class. It is not infrequent, however, for the lawyer to be called upon to scrutinize the affairs of such enter- prises, and he should be qualified and ready to advise his client, not alone upon the legal status of affairs but upon the general aspect of the business and its pros- pects. This he may do by simply investigating along lines that are well defined and demonstrated by ex- 66 RAISING OF ADDITIONAL CAPITAL. perience. For instance, a company that to all intents and purposes has " stock- jobbing"* for its principal object should be avoided and condemned; a company organized for the purpose of conducting some specu- lative venture at a great distance is suspicious ; a busi- ness with vast natural resources wanting "a small amount of money for development purposes, " which should readily be obtained upon the company's alleged assets, is usually a fraud; the company that has been incorporated without an established business for a nucleus, and is dependent upon the sale of its stock for working capital, and which has sold a portion of its stock to a number of small investors, the proceeds received from such sale being insufficient to dem- onstrate the success of the business contemplated, or to materially advance it beyond the organization or ex- perimental period, is, as a rule, of doubtful prospects and so on. In fact the earmarks of unworthiness are as appar- ent in a business enterprise as elsewhere, and are dis- cernible by proper investigation, and knowledge of the affairs investigated. No one is justified in undertaking a business venture without at least the moderate capital usually required to carry it on (or the means of raising such capital), and trusting to financial accommodations and credit *See "Stock-Jobbing," page 129. RAISING OF ADDITIONAL CAPITAL. 67 for success. It is undoubtedly true that no one who has tried to establish a business without a suitable capital, even if he has succeeded, would advise another to attempt to do likewise ; for it involves an amount of anxiety, labor, embarrassment and hazard which is unpleasant to reflect upon. To do business altogether on credit requires a fortunate combination of circum- stances to make it successful that no prudent man would predict. It might be said with propriety that the universal law of trade is that the enterprise which attempts to conduct its business upon borrowed capital alone must sooner or later fail that is, where the company at- tempts to conduct its business upon financial accom- modations secured from regular sources, such as bank- ing houses, brokers, etc., upon trade paper. At the same time, a company may do a large increased volume of business upon such accommodations ; in fact, a large Chicago corporation practically conducts the principal volume of its business upon funds secured in that way, and loans its own capital through banking and regular financial channels, upon a higher rate of interest than it is required to pay for its own accom- modation. But it is not such a corporation as the ordinary business enterprise could safely imitate; its securities or trade paper could be converted into 68 EAISING OF ADDITIONAL CAPITAL. money at any time and nnder any circumstances, with- out difficulty. There is a tendency among aggressive business men to " mortgage the future, " so to speak, and this with- out regard to repayment. The securing of judicious, long-time loans upon a bond issue where the busi- ness requires additional capital, is not alone a saving in the rate of interest but renders the undertaking less hazardous, and more convenient and certain of pay- ment out of the profits that may be safely estimated; besides, the bonds of a staple business concern, with tangible assets, are invariably in good favor with in- vestors. The practical questions concerning the issu- ing of such bonds and preferred stock as well, have already been considered.* In regard to the extent to which the credit of a business enterprise may safely be extended that is, the proportion which the capital of an enterprise should bear to its liabilities necessarily varies with conditions. It has been stated, however, by eminent and experienced financiers that a man should not ex- tend his business more than three times the amount of his capital under the most favorable circumstances, and if it be a large business, not more than twice his capital. We have already alluded to what has proven to be *See "Capital, Bonds and Stocks," also "Capitalization of Corporations." TBANSFEBBING AN ESTABLISHED .BUSINESS. 69 a very satisfactory method for the raising of addi- tional capital, under ordinary circumstances, and that is by the issuance of bonds, drawing a reasonable rate of interest, that may be convertible into stock within a certain given period, at the option of the holder. This enables the purchaser of such bonds to avail him- self of the privilege of becoming a stockholder at any time within the period provided in such bonds, should he so elect, after the business has demonstrated its merit, and the enterprise is thereby provided with the necessary additional capital, which it can repay out of the profits. Many business men will readily invest in such bonds, with the privilege of changing the form of investment after the business is established, who would not in the first instance purchase stock. The topic of this section has fur- rin- of An m * sne ^ the material for much of the un- favorable criticism which has been made Business to upon the corporate plan and abuses of Corpora- ^ e corporate system; and this is made tion. the subject of a separate discussion un- der appropriate headings.* At the same time, some *See "Consolidation of Enterprises" and "Stock-Jobbing." 70 TKANSFERBING AN ESTABLISHED BUSINESS. of the legitimate advantages offered through the con- summation of transactions of this character have already been pointed out.f In the preceding pages we have necessarily dis- cussed many of the important questions pertaining to, and which invariably arise in the transferring of an established business to a corporation. Those hereto- fore discussed have had to do with the advance finan- cial arrangements and objects to be accomplished rather than to the subsequent rights of the parties to be protected. In the following pages particular atten- tion is given to the substantial benefits to be derived from the corporate plan of conducting business, as well as the rights of the parties interested therein. It is through transactions of this character that advantages are obtained by the owners of a business, such as the preservation of the good will, facilitating the sale of a part or the whole of the business, and the obtaining of an advantageous price for the business transferred, etc. The opportunity last referred to is frequently abused; that is, the valuation placed upon a business about to be transferred to a corporation is inflated, and the question frequently occurs "to what extent may a business or property be over- valued without rendering the parties in interest liable therefor?" tSee "The Corporation and Its Advantages." TRANSFERRING AN ESTABLISHED BUSINESS. 71 This question has been the subject of much litiga- tion, and different courts have taken different views thereon. Without attempting to enumerate the rules announced in the various decisions, the most favored rule, and the one to be everywhere regarded as safe, reliable and sound, is that if the directors act in good faith, and the property transferred has a substantial value, and there is no fraud connected with the trans- fer, their valuation is final, even if excessive. A different rule, however, obtains in some of the States, where the statutes make the action of the Board of Directors in relation to such matters final in any event. This rule obtains in Delaware, Maine, New Jersey and New York; and in some States, where mines and mining is the chief subject of corporate organizations, this rule is recognized either by statute or by the courts to encourage development of the min- ing industry. More latitude is everywhere allowed in the valua- tion of what are known as speculative assets than where the property is staple and easily valued ; and in every case the question of what the property is worth to the corporation, rather than what it is worth to the individuals selling, will govern. A business that has been established by an individ- ual or an association of individuals under a firm name, usually possesses a valuable property right in the 72 TRANSFERRING AN ESTABLISHED BUSINESS. name itself which is in reality the subject-matter of the good will. While the good will of a firm, or individual doing business alone, may be the subject of transfer and sale, and therefore valued and conveyed, still it is never possible to utilize and protect this form of property, or obtain its full value, except by trans- ferring the same to a corporation. The reason of this is that while the trade name may be thoroughly estab- lished and the means of influencing trade, it is, in a measure, perishable, and loses much of its value once the individuals who have created it are known to be no longer its owners; while if it is transferred to a corporation organized by the same persons who es- tablished the name, it becomes permanently associated with the corporation and with the other advantages that accrue to the trade name of a corporation (that are not possible to an individual) it thereby derives a permanency and utility that cannot be lost. It is these and other considerations which justify the adequate valuation of the immaterial assets of a firm or co-partnership when transferring the same to a corporation for the ultimate purpose of effecting an advantageous sale enlargement or permanent estab- lishment of a business. There is much of the "personal relation " existing between the proprietor of a business conducted by an individual or co-partnership and the patrons thereof TEANSFEEEING AN ESTABLISHED BUSINESS. 73 that has its advantages, and in some degree at least and in certain forms of enterprises may argue in favor of the personal as against the impersonal, i. e., corporation relation ; but the details of the business of a corporation can and should be so organized as to overcome this objection that is, by creating personal responsibility, if not a personal interest, for depart- ment heads in the various important departments of the corporation, and in that way retain the personal interest and responsibility so essential to the welfare of every business conducted upon the competitive sys- tem. As to the approved manner of transferring assets of an established business to a corporation for money, bonds or in payment for its stock: If the business is to be valued and purchased from an inventory, where the property conveyed is itemized, the resolution of the Board of Directors taking over or purchasing such property should recite that the property had been itemized and valued at the aggregate sum of whatever is to be paid for the business conveyed ; and the inven- tory may, with propriety, be copied and made a part of the bill of sale. If, on the other hand, the business is purchased in bulk or the amount of property esti- mated then the resolution of the Board should recite that the property had been appraised in bulk and val- 74 TEANSFEEEING AN ESTABLISHED BUSINESS. ued by the Directors at the total amount to be paid therefor. It is essential that all due formality should be ob- served in the purchase and transfer of assets to a cor- poration in payment for its stock or otherwise, and where it is feasible, the proposition to sell should be made to the corporation by formal writing. This will enable the officers to make proper investigation of the business offered, and at the same time the written proposition will form the basis of an appropriate reso- lution of purchase and a complete contract of sale when accepted. If there is real estate involved in the transfer, naturally the title will be carefully examined by com- petent legal counsel, before passing upon the proposi- tion to purchase; and in such cases the resolution should recite that such examination had been made and the title found merchantable or otherwise, and that the proper conveyance or title deed had been exe- cuted by the owner or owners and tendered to the cor- poration at the time of the proposed formal acceptance of the offer by the Board of Directors. In the Appendix hereto, will be found a general form of resolution which, according to the facts there assumed, purports to purchase and take over through the commissioners appointed by the Secretary of State TBANSFERBING AN ESTABLISHED BUSINESS. 75 of Illinois from a corporation that is in the process of reorganization, an established business in payment for stock subscribed for by the reorganizer mentioned in the Eeorganization Certificate shown.* The reso- lution there given will suggest the method, and also the form of resolution applicable for the purchase of any established business by a corporation except that in the case there assumed no written proposition was made or necessary, on account of the fact that the purchasing company was incorporated for the express purpose of operating the business purchased, and the directors are assumed to be all the stockholders as well, and all present and acquiesce in the terms of pur- chase and sale. In such a case, the peculiar facts there assumed (for the purpose of illustrating an approved plan of effecting a reorganization which will be fur- ther explained under a subsequent heading), dispense with such written proposition. In every case where a business is transferred from one or more of the directors, or parties in interest, to the corporation, it is always advisable to have the formal consent of the stockholders to such a purchase ; and this may be done by convening a special meeting of the stockholders for that purpose, and submitting the question of purchase to a vote, and having the *See form, page 206. 76 TRANSFERRING AN ESTABLISHED BUSINESS. action of the stockholders in that regard, a matter of record. Such a resolution would simply recite the facts, and authorize and direct the Board of Directors to consummate the transaction and purchase the busi- ness at a given price, or at the best price obtainable. And, it might be added, that the consent of the stock- holders to the acquiring of a separate business, or to the transaction of any unusual important business, is always to be recommended. Particularly is this ad- visable where the stockholders are few, or the cor- poration small. CORPORATE MANAGEMENT CHAPTER III. CORPORATE MANAGEMENT. DIRECTORS, OFFICERS THEIR DUTIES AND LIABILITIES. STOCKHOLDERS' RIGHTS AND LIABILITIES. BY-LAWS AND THEIR USES. CORPORATE RECORDS AND BOOKS OF ACCOUNT. EXAMINATION OF BOOKS AND RECORDS. Directo r s Duties an ^ liabilities of a director ana officers. ^ a business corporation are co-exten- Their Duties sive that is, his powers and authority and Liabil- on ^ one ^^ are O f guch a nature that they lead to a corresponding re- sponsibility both to the corporation and its creditors. As has been heretofore shown, the authority to bind the corporation emanates from the Board of Directors ; and in consequence, the officers are responsible to them. The officers are chosen by the Board of Direct- ors, and, unless restricted by the by-laws, they may be removed by the Board for sufficient cause; and if the by-laws so provide, any officer may be removed at the pleasure of the Board. Directors cannot, however, act individually; they must do so as a body. That is, no legislation on be- (79) 80 DIRECTORS, OFFICERS DUTIES AND LIABILITIES. half of the corporation can be enacted except by the Board in meeting assembled, and the will of the Board when thus indicated, is to be carried into effect by the officers of the corporation. The peculiar characteristics of a corporation often renders notice to a director or officer also notice to the corporation; and this is important in relation to the conduct of all corporate business; such notice simply means information. In order to charge a corporation with such notice, however, the directors or officers must be shown to be acting for the corporation at the time the notice is received, and also that the employment of the director or officer concerns the subject-matter of the notice ; in other words, the director or officer must be then engaged for the corporation in such a way as to ren- der the notice appropriate to his office or employ- ment. Notice to a Board of Directors while assembled, and such notice to one of them, who afterward com- municates the same to the Board in session, is suffi- cient notice to the corporation in any event. Under the common law, directors are liable for issu- ing stock as fully paid, when in fact the same is not so. They are also liable for the payment of dividends out of the capital stock of the company, and for any ultra vires acts and fraud generally, as well as for DIRECTORS, OFFICERS DUTIES AND LIABILITIES. 81 negligence which results in a loss to the corporation. In other words, they are responsible for many acts of omission, as well as commission. Under the statutes of the various States they have a further liability imposed, whereby they are held to the responsibility of a trustee under certain circum- stances. They are always trustees for the creditors of a corporation, and also in certain dealings in rela- tion to the property of it. The question of their deal- ing directly with the corporation is frequently the sub- ject of litigation, and they are invariably held to a strict rule of conduct in such matters. A business corporation has no power or authority to loan money; hence it could not lawfully do so to a director. And the rule that one cannot properly oc- cupy the dual position of buyer and seller is particu- larly applicable to directors of such companies to the extent that any secret advantage thus acquired may be recovered from such directors. At the same time, they may not abuse any information acquired as a director, or obtain secret advantages therefrom to the detriment of the company. A safe rule for the director to adopt is to act in all things pertaining to his office and the company of which he is such a director in the same way as he would act if the business transacted for the corpora- tion was his own exclusively. 82 DIRECTORS, OFFICERS DUTIES AND LIABILITIES. A director is not disqualified to act in any official capacity for his corporation on account of his being a director. In fact, it is usual for directors to be also the officers of the corporation. Particularly is this true in small or medium-sized companies. It is always necessary that there should be a Presi- dent and Secretary in every business corporation, and it is usual and necessary under the laws of some States (e. g., Illinois) to have a Treasurer, as well. The number of officers that a company may have is only limited by the will of the Board of Directors. It is frequently provided by the by-laws that cer- tain officers of the corporation should also be direct- ors, and this is proper and convenient; for, if they are directors as well as officers, they are at all times conversant with the consensus of opinion of the Board in relation to its policy, and upon all matters pertain- ing to the business. The powers and duties of the officers of a corpora- tion depend entirely upon the provisions of the by- laws, and the delegating of such powers, and the classification and the stating of the duties of the various officers is a subject that should receive special attention at the time of the organization of every cor- poration. By properly defining the powers and responsibilities of each officer the best possible results are obtained, DIRECTORS, OFFICERS DUTIES AND LIABILITIES. 83 and each officer has a certain clearly-defined responsi- bility ; besides, any possibility of controversy over con- flicting authority is thereby averted. The compensation of both directors and officers is a proper question for the directors themselves; it is a proper subject of resolution by the Board of Direct- ors, enacted and recorded on the records of the cor- poration prior to the performance of the service in question, and unless abused, the action of the directors in this regard is final. Directors are not entitled to compensation unless it is expressly provided that they shall receive pay for their services; and a salary voted to a director after the services have been performed is voidable by the stockholders. Directors are usually vitally inter- ested in the corporate enterprise, and their election as directors is usually due to that fact. A director who performs extra services, outside of his duties as a director, however, may be entitled to compensation therefor. The established rule concerning compensation of directors is that authority for its payment must be obtained without fraud, either actual or constructive, and that the amount thereof must be reasonable for the services performed. A salary paid to directors under certain circum- stances, e. g., when the corporation is insolvent or 84 DIRECTORS, OFFICERS DUTIES AND LIABILITIES. financially embarrassed, or where the amount is excessive or paid out of the capital of the corporation to the detriment of the stockholders, may be recovered from the directors by an appropriate proceeding. Another familiar principle concerning compensation of directors and officers alike is that where the salary is authorized by the vote of the party receiving it that is, if his vote is necessary to its creation such compensation is illegal. At the same time proper and adequate compensation may be voted directors and officers, and the amount of such compensation must be governed by the circumstances of the particu- lar case. There is a growing disposition among legislators generally to increase the visitorial power of the State over corporations, and to this end require cer- tain reports to be made by officers periodically con- cerning their affairs, such as the furnishing of names and addresses of all directors and officers; whether the corporation is availing itself of the privileges con- ferred by its charter; the amount of the capital stock paid in since its organization, etc., and providing cer- tain penalties and responsibilities for such officers for the failure to comply therewith. In addition to such penalties imposed by the State, an officer may be held liable to the corporation for any injury resulting from his negligence or failure to comply with such laws; DIRECTORS, OFFICERS DUTIES AND LIABILITIES. 85 and generally an officer may be held liable to the cor- poration for all negligence or fraud. Nearly all the States now have special laws regulat- ing foreign corporations; that is, where corporations organize in one State and undertake to do business in another, in the latter State they are regarded as ' ' for- eign corporations. " The special acts of the various States in relation to such foreign corporations are far- reaching in their effect, as will be seen upon reference to the copy of such Act now in force in the State of Illinois, given in the Appendix.* It will be observed that in Illinois a foreign corporation is obliged to com- ply with the act referred to, before doing business in the State. What constitutes " doing business " means the establishment of a local agency or branch for the carrying on of the business ; in which event, it is neces- sary to designate some person upon whom service of process can be had in case of litigation, and to other- wise comply with such act. Upon the failure of such foreign corporations to comply with the terms of such local laws, no contract can be enforced by it in the foreign State; and it has been held in Illinois that subsequent compliance with such provision of the law will not entitle such foreign corporations to enforce a contract that was made prior to such compliance. * Page 258. 86 STOCKHOLDEBS' BIGHTS AND LIABILITIES. The functions of stockholders in a Stockhold- ers' Rights business corporation are limited; the and Liabii- general and principal rights of the stockholder are (a), to form the cor- poration, or bring it into existence in the first instance ; (b) to elect its Board of Directors from time to time; (c) to make its by-laws, unless that power is delegated to the directors; (d) to increase or decrease the capital stock; (e) to authorize all amendments to the charter; (f ) to participate in the dividends ; (g) to dissolve the corporation ; (h) to authorize the giving of mortgages, in case the statutes of the State require it; (i) to examine the books and records of the corporation at all reasonable times; (j) to pass upon the necessity or advisability of the sale of the entire business. The liabilities of a stockholder are even less than his rights as such. It might be said, if the corpora- tion is regularly and legally formed, that the stock- holder's liabilities are limited to the unpaid portion if any of the stock held by him; and unless the laws of the State under which the corporation is formed are complied with the stockholders are liable in the same manner and to the same extent as partners. In some States the stockholder has a liability in addition to the par value of his stock. This liability is imposed by the statutes of such States. Such liability is strictly construed by the courts where the same STOCKHOLDERS' EIGHTS AND LIABILITIES. 87 exists, and it is now confined to but a few States, and the tendency is to abolish it altogether. In discussing the liabilities of a stockholder, they will be referred to in the order in which they naturally arise that is, the liability of an original stockholder for any unpaid portion of the stock standing in his name, and in connection therewith, the liability of the transferee of such stock. Most of the States hold the transferee liable jointly with the original subscriber or owner of stock, where the same has not been fully paid for at the time the stock was issued. It has been already shown that stock originally issued upon inadequate consideration, i. e., where property has been fraudulently accepted by the direc- tors in exchange for stock, or where the value of the property has been flagrantly inflated, is not thereby paid for, even as between the corporation and the seller, notwithstanding the stock certificate upon its face purports to be " fully paid and non-assessible." In such cases, the transferee is liable jointly with the transferor (especially to creditors of the corporation) for the differences between the value of the property received by the corporation and the par value of the stock issued therefor. Where the statutes of a State do not make the action of the Board of Directors in this regard final in any 88 STOCKHOLDERS' EIGHTS AND LIABILITIES. event, the above mentioned rule applies to both the original owner of the stock and any subsequent trans- feree; and the only difficulty in determining the lia- bility of a subsequent stockholder in such a case is to establish sufficient notice to the transferee of unpaid stock, or to determine what circumstances or state of facts will constitute legal notice that the stock accepted by him is not fully paid, when the stock cer- tificate recites on its face that the stock thereby rep- resented is fully paid and non-assessible. The rule laid down in Illinois is that an exchange of property for stock in a corporation must constitute a valid contract of bargain and sale in good faith and by the result of honest judgment of the Board of Directors of the corporation accepting such property, or the person to whom such stock is issued is liable, both to the corporation and its creditors for the dif- ference between the actual value of the property con- veyed and the face or par value of the stock received ; and as to what constitutes constructive notice to a subsequent purchaser of such stock may be illustrated by a leading case in Illinois on that question : A corporation was organized for $1,000,000, and all its stock, excepting two shares, was issued for an interest in a patent. The stock certificates issued for this invention recited on their face that the capital stock represented thereby was " fully paid and non- STOCKHOLDERS' EIGHTS AND LIABILITIES. 89 assessible." Some of this stock was sold or conveyed to a third party, namely, one who was not originally connected with the organization of the corporation. The corporation in question failed, and the creditors instituted appropriate proceedings for the purpose of holding the assignee of such stock jointly liable with the original owner. In holding that the transferee was liable as con- tended, the Supreme Court of Illinois said: "It is not conceivable that a person of ordinary intelligence and prudence buying shares of stock in such a cor- poration would not become advised as to what prop- erty the corporation had. * * * It is clear that appellees knew that the corporation had no money and no property aside from the patent, and it would not be creditable to them to say that they believed the pat- ent to be worth $999,800. " * * * "We regard the proof as establishing the fact of notice to appellees of the transaction and over-valuation. They knew that the corporation did not have a paid-up capital of $1,000,000 and that * * * had not paid for the stock, unless it was given for the patent. " Hence it will be seen that not only the original sub- scribers of stock may be liable for any unpaid portion thereof, but that in many cases subsequent owners of such stock may be likewise liable. In the language of the Illinois Supreme Court: "The relation of the 90 STOCKHOLDERS' EIGHTS AND LIABILITIES. stockholder who has not paid for his stock, to the cor- poration or the creditors, is the ordinary one of debtor. " The presumption is that a corporation has, or at some time had, money or property equal in value to the amount of its capital stock, and creditors have a right to presume that such is the case ; hence the issu- ing of stock for less than the par value is ordinarily held to be a fraud upon the law, creditors and sub- sequent purchasers. It is ultra vires of the corpora- tion to issue stock for less than its face value in money, and creditors (and under certain circumstances other stockholders) may insist upon the balance being paid into the treasury. There is a rule, however, that where a corporation has increased its capital stock, and becomes insolvent, it may then issue any portion of such increased stock for the best price obtainable and no one will be liable therein, especially to existing creditors; the reason being that they did not extend credit upon the in- creased capitalization. One of the fundamental principles in the law of cor- porations is that the majority may exercise the right to control the corporation's affairs. This right has suggested many opportunities for the perpetration of fraud upon the minority stockholders, and the re- peated instances of such attempts which have come STOCKHOLDEKS' EIGHTS AND LIABILITIES. 91 before the courts of last resort have developed a sys- tem of jurisprudence for the protection of the minority stockholder. Some of the familiar methods of attempting to take advantage of the minority stockholder is for the majority to vote large salaries to themselves, with- hold dividends, incorporate an auxiliary enterprise, and favor such undertaking at the expense of the parent company, and various other devices, which all tend to the same result, namely, the detriment of the minority stockholder. Majority stockholders, through directors who are their tools, often perpetrate such wrongs for their direct benefit. The dummy director is now an old de- vice in the law of corporations, and courts of equity are inclined to look behind all such devices to ascertain the real parties in interest. The language of the United States Supreme Court announces the modern rule in relation to this subject, to-wit: "When a number of stockholders combine to constitute themselves a majority in order to control the corporation as they see fit, they become for all practical purposes the corporation itself, and assume the trust relation occupied by the corporation toward its stockholders. " While courts of equity will interfere for the protec- tion of minority stockholders, they will not undertake 92 STOCKHOLDERS' EIGHTS AND LIABILITIES. to control the policy or business methods of the cor- poration, so long as they are conducted in good faith, although it may be seen that a wiser policy might be adopted, and the business more successfully conducted if other methods were pursued. It is in cases of fraud, or where some undue advantage is being taken of the minority stockholders, that courts will intervene and afford relief. It is not infrequent that stockholders undertake to make an agreement among themselves whereby cer- tain policies shall be carried out; that is, where cer- tain individuals shall be retained in office, and other- wise attempt to regulate the voting of stock, and in that way control the corporation. Another, and not unusual question, is that of limit- ing the sale of stock either to a class of persons, or to give one another the first opportunity and right to purchase stock which may be offered for sale. All of these objects are difficult to accomplish, for the reason that they are fundamentally against public policy. Any contract which amounts to an unreasonable restraint of trade is illegal that is, where the contract attempts to perpetually or unreasonably deprive the stockholder of his right to sell or control stock, or his right to vote thereon; but an agreement to place stock in escrow for a reasonable time to accomplish a lawful purpose or to insure the right to purchase such STOCKHOLDEKS' EIGHTS AND LIABILITIES. 93 s\;ock at a given price is legal. And a condition in- serted in the body of the stock certificate, regulating the transfer of such stock, either to a class of stock- holders, such as dealers in a given line of trade, or to existing members may be legal. In addition to the foregoing, any lawful object may be accomplished in the regulating of transfers of stock, but as before intimated, the terms employed in accom- plishing such objects must necessarily receive care- ful attention. A stockholder's right to vote upon his stock, either in person or by proxy, is* necessarily an important one. In order that the minority stockholder may have repre- sentation in the directory, the laws of most States provide what is termed, " cumulative " voting; e. g., where the number of directors is five, and the stock- holder votes his shares of stock under the cumulative system, he would have five votes for each share of stock held by him, which he could cast for one director, or divide them among the five, as he may choose. In case a stockholder cannot be present at the meet- ing of the stockholders of his corporation, he may appoint a proxy (to represent him), with full power to exercise all the rights of a stockholder ; a proper form of such proxy will be found in the Appendix.* Such proxies may be made for a single meeting or for a *Fage 243 94 BY-LAWS AND THEIB USES. given length of time, and until acted upon, they are subject to be revoked at the will of the stockholder. By-La ws importance of a proper code of and Their by-laws for the government of a cor- uses. poration cannot be overestimated. They are the internal law for the government of the cor- poration itself; the duties and powers of its officers emanate from them, and the rights of the stockholders are often curtailed or enlarged by their provisions. By-laws may not contravene any provision of the charter itself or the laws of the State under which it owes its existence, nor the common law, or be against public policy or the laws of the land, and they may not be inequitable or unjust or unreasonable in their nature. Aside from these limitations they may contain any rule or provisions that the framer may choose to in- corporate therein. It is always wise to include in the by-laws of a new company the well-settled rules of law of the State of its creation, governing its conduct for the guidance of the directors and officers. Frequently it is desired that the duties as well as the authority of each officer should be clearly and minutely denned in order that no conflict between such officers shall occur, and this is BY-LAWS AND THEIR USES. 95 always to be commended where such a course is prac- ticable or feasible, but in small companies it is unwise to burden and handicap the management with unneces- sary rules which would interfere with the conduct of the business itself. Every stockholder and officer is bound by the lawful provisions of the by-laws, and this whether they ever consented to their enactment or ever knew of their existence, but there is a different rule obtaining in regard to the public. The by-laws of a corporation should not affect strangers dealing with the corpora- tion, and the violation of a rule contained in the by-laws will not relieve the corporation from liability to third persons. At the same time, creditors may insist that the provisions of the by-laws shall be enforced, and, of course, the stockholders have the same right. Forfeitures, fines and the like can only be enforced through and in accordance with the by-laws, unless there are statutory provisions therefor; and the ques- tion of a stockholder's right to vote may be within certain lawful limits regulated thereby. It is impossible to suggest an arbitrary or " stock' ' form of by-laws, as the exigencies and peculiar con- ditions of each organization must be taken into account ; but the form of by-laws given in the Appendix hereto,* will be found satisfactory, or to contain use- * See page 217. 96 BY-LAWS AND THEIR USES. ful suggestions in the preparation of such by-laws for any ordinary corporation, particularly where it is organized under the laws of Illinois. In the organization of companies under the laws of the various States, the by-laws should be drawn in conformity with such local laws, and invariably re- quire the utmost skill in their preparation. The right to make by-laws is primarily in the stock- holders of the corporation, unless that power is dele- gated to the directors, either by charter provision or statute law of the State where the corporation is created. The tendency of modern legislators is to delegate the power to the directors of the corpora- tion, and where the right to make by-laws is vested in the directors, either by statutes or by the stock- holders themselves, the directors also have the power to amend or repeal the same. The difference between the by-laws of a corpora- tion and its formal resolutions is chiefly the perma- nency of the former. While both are subject to amend- ment or repeal, unless the power to act upon the reso- lution is limited by the by-laws, it is subject at all times to the will of the directors or stockholders, as the case may be. For this reason, it is customary to make the question of compensation of officers a sub- ject of special resolution, and to have such resolution embody the amount of the compensation to be voted, BY-LAWS AND THEIE USES. 97 and to conclude with the phrase "subject to the fur- ther action of this Board. " The purpose of this limitation is to make the compensation of an officer wholly subject to the will of the Board of Directors that is, to leave the power and to facilitate the right to change such compensation as the circumstances may suggest. It is not infrequent that the directors and officers themselves violate or ignore important provisions of the by-laws. Where this has been done, it is well to ratify the acts done contrary to the provisions of the by-laws, where the same are not contrary to the in- terests of the corporation itself. Such ratification may be accomplished by proper resolution adopted by the Board of Directors in meeting assembled. It should be borne in mind that the by-laws of every corporation, as well as all important resolutions of the directors, should be accurately transcribed upon the Minute Book of the corporation, and preserved in this way.* In the case of large corporations it is not infrequent that the by-laws are printed and circu- lated among the members. *Under the law of some jurisdictions (South Dakota, for instance), by-laws are not operative until so recorded. 98 CORPORATE RECORDS AND BOOKS OP ACCOUNT. The books of account that are peculiar Corporate Records and to corporations, and not in use by gen- Books of AC- eral unincorporated concerns, are few. count. T}l ey consist generally of the Minute Book, Stock Certificate Book, Transfer Book and Stock Ledger. Aside from these, it is not unusual for the treasurer to have a Private Ledger in which to keep Controlling Accounts. Besides, it is customary for all modern business corporations to have a more strict and comprehensive System of Accounting, par- ticularly a complete Voucher System, by which an ac- curate and conclusive accounting can be furnished of all departments, and at any and all times, for the bene- fit and information of stockholders. The statutes of a few States of the Union require other corporate books to be kept, known as Books of Publicity, but they are the exception. Perhaps the book that is universally conceded to be first in importance among those peculiar to the cor- poration is its Minute Book by which is meant the book wherein the acts and proceedings of the corpora- tion itself are recorded, and particularly the acts that require sanction or authority from the Board of Directors; and these include the Eecord of the Adop- tion, as well as a Transcript of the By-Laws and their Amendments. [When the corporation is sufficiently large to justify CORPORATE RECORDS AND BOOKS OF ACCOUNT. 99 it, there should be two separate Minute Books, one for the stockholders, and the other for the Board of Directors, in which to record the meetings and pro- ceedings of each. The most approved and convenient plan of keeping the Minute Book of the corporation is to have a Certi- fied Copy of the Charter attached to the first page of this book, or to have the secretary copy the Charter verbatim at the beginning thereof. Then the minutes of the organization meetings should follow in their proper order and dates. The By-Laws should be recorded elsewhere in the Minute Book, preferably at the back, leaving enough unused pages after their recording to insert any and all amendments that may be made to the By-Laws. After this the minutes of each succeeding meeting should be recorded as they occur, following, of course, the meetings to organize. It is not necessary that the minutes of meetings be written up at or immediately following the meeting to be recorded, nor is it necessary that the minutes be in the handwriting of the secretary; but it is advisable that the minutes of every meeting should be promptly recorded in order that no errors or omissions may be made, and in every case they should be signed, at least, by the secretary. Care should invariably be taken to preserve all 100 COKPOKATE EECOEDS AND BOOKS OF ACCOUNT. documents and writings coming into the hands of the secretary, such as proxies, original motions and reso- lutions that have been reduced to writing by the mem- ber offering the same. After such documentary rec- ords have been recorded they should be preserved for future reference or comparison. If the minutes of meetings are not taken in short- hand, there should be notes, at least, made of all im- portant transactions, and the minutes should then be written up from such notes. It is unquestionably advisable to approve the minutes of all meetings at the next succeeding regular meeting of the body, and this may be done by proper resolution after the same have been read; but the approval of the minutes of a regular or special meeting of a Board of Directors of a corporation cannot, in the absence of a special call being made therefor, be amended or approved at a subsequent special meeting of the same body, unless, of course, all directors are present, and the amendment or approval is unani- mously concurred in. Erasures should never be made to correct errors or omissions. The approved method is to draw a red line through any error that may have occurred and to insert the correction directly over the word or phrase corrected, and in this way errors may be corrected, COEPOKATE RECORDS AND BOOKS OF ACCOUNT. 101 and the manner of accomplishing the same is explana- tory of all resolutions authorizing such corrections. In supplying omissions from minutes, unless the matter omitted is too voluminous, it should be inserted at, or near the point of omission in the record; but where a resolution or other complete transaction has been omitted, then it is advisable to make a separate entry thereof, either at the bottom of the page where the matter omitted should have been originally re- corded, or in any convenient place in the Minute Book, taking care to make a note of such omission in red ink in the body of the minutes where the omission oc- curred, calling special attention to the omission and where the matter omitted may readily be found in the Minute Book. The Stock Ledger should show to whom the capital stock was issued, and how it has been paid, and by whom. This ledger can be made self -balancing by establishing a Controlling Account in the General Ledger, entitled " Stock Ledger Balances, " and the bal- ance of which will show the standings of the Stock Ledger without drawing off the individual accounts, the net balance of which should always be in agree- ment with that of the controlling account. It is the custom in most corporations for the secre- tary, treasurer or some confidential employe to keep a Private Ledger, provided with a lock in which are 102 COEPOBATE BECOEDS AND BOOKS OF ACCOUNT. kept the accounts which it is desired shall not be accessible to the regular employes. These are usually Capital Stock, Profit and Loss, Loans and Investments, Personal Drawing Accounts, Salaries, and any special Accounts of a Confidential Nature. A Controlling Ac- count is then opened in the General Ledger entitled, " Private Ledger," to which the amount of the net debit or credit balance of these accounts is posted in one item at the close of each month. This provides the amount necessary to complete the General Trial Balance, and determine whether errors have been made in any of the other accounts, besides furnishing complete protection against the forcing of balances. In some companies, the controlling account in the General Ledger is dispensed with, the list of Balances drawn off by bookkeepers at close of the month being handed to a person keeping the Private Ledger, to which he then adds his Net Balance, and determines whether or not the general books are correct. In keeping the Stock Certificate Book of a corpora- tion, care should be taken to avoid real or apparent over-issue of stock. This may be accomplished by insisting upon a proper surrender and cancellation of all outstanding certificates at the time of a transfer, by observing and complying with the usual Blank Forms provided in every properly worded Stock Cer- tificate Book, and by making proper entries of all pay- EXAMINATION OF BOOKS AND RECORDS. 103 ments and transfers of stock this important branch of a corporation's accounting may be easily handled. i nves ting public are now almost tion of Books universally demanding an Independent and Bee- Investigation and Report On the Condi- tion and Operative Results of a going business before seriously considering or taking any favorable action thereabout. Particularly is this so where financiers are directly or indirectly concerned. The cautious business man also demands such in- formation, and the seller, or party desiring financial assistance, is usually ready and willing to furnish such a report where his business is prosperous, or even solvent, and presents a reasonable business oppor- tunity. The great public, or quasi public corporations, pub- lish annually a report of this character for the benefit of their stockholders. The compilation and furnishing of this important information is often entrusted to audit companies, whose equipment for the preparation and supplying of such reports is a force of accountants. But the varying conditions and vitally important 104 EXAMINATION OF BOOKS AND RECOKDS. questions which are necessarily met in the compila- tion of such information brings the most important part of this service viz., suggestions which will assist the client in accomplishing the results desired out- side and beyond the scope and qualifications of the accountant. All these features are so closely allied to the work of the corporation lawyer, who is experi- enced in the science of organization and the conduct of transactions of this character, that a combination of the two undertakings necessarily proves of great advantage to the client. Hence, the larger corpora- tions are now almost universally examined under the direction of legal counsel. In making an examination of corporate books and records, the Minute Book should invariably furnish evidence of the authority for all large transactions outside the regular course of business; and recourse is necessarily had to this book as a basis for an intelli- gent examination of the corporation's transactions. Besides, it is frequently advisable and necessary to determine whether the corporation is exceeding its authority and transacting business outside the scope of its Charter, and reference for this purpose is neces- sarily had to the Charter or Certificate of Incorpora- tion itself. Important contracts may necessarily have to be con- strued in order to ascertain their real import. Then, EXAMINATION OF BOOKS AND RECORDS. 105 there may be other legal objections to the manner of issuing and payment of stock which would suggest themselves only to one versed in the law, and which, if discovered, might change the entire aspect of af- fairs. Therefore, a proper investigation of all these matters should invariably be made in advance of the Audit, whenever it is desirable to have an Earnings Statement to interest outside capital, or for reorgan- ization purposes. The orderly course of an independent examination of corporate books and records is to first examine the Articles or Certificate of Incorporation. This will show the date of organization, the purposes for which the company was organized, the amount of authorized capital stock, and who is liable for its payment. The Minutes of the Stockholders' and Directors' Meetings should then be taken up. This record will show the manner of incorporating, the consideration for which stock has been issued, how the original assets were acquired, authority for all extraordinary expenditures, the remuneration of officers, the au- thority for all dividends paid, and the warrant for the making of important and unusual contracts that may be entered into outside the general course of busi- ness. The Stock Certificate Book and Transfer Journal are then examined and checked against the Stock 106 EXAMINATION OF BOOKS AND RECORDS. Ledger to determine the amount of the capital stock outstanding, and the owners thereof, as well as to guard against any over-issue of stock. The Trial Balances of the initial and terminating dates of the Audit contemplated are next examined and verified with the Books of Account. When the Bal- ance Sheets of either or both dates are given they should be carefully examined, particular attention be- ing given to the closing entries. In all examinations, the verification of the Cash Accounts is of controlling importance. While the investigation may not be conducted with the special object of detecting fraud or shortages, all necessary precautions are to be taken to guard against the pos- sibility of such irregularities being passed over. The count of Cash on Hand is taken at the inception of the Audit, and a detailed list made of all Cash, Cash Tickets, Vouchers and Checks, Money Orders, etc., on hand. The Bank Deposit Book is then sent to the bank to be balanced. After this is done, the Bank State- ment and Canceled Checks are examined, and recon- ciliation made with the Bank Balance as shown by the company's Cash Book. In cases where the date of the examination is sub- sequent to the closing date of the audit, all entries, footings, and bank deposits must be verified for the intervening period. The cash items are then worked EXAMINATION OF BOOKS AND EECOBDS. 107 back by adding to the balance the disbursements, and deducting the receipts, which should give the correct balance as at closing date of audit. The footings of the Cash Book, general and sub- sidiary, for the entire period are checked. The dis- bursements are verified by the Vouchers supporting payments both as to payees and amounts. On the receipts side, the cash sales are checked from the records, and all discounts and allowances verified. The remittances are checked against the Ledger accounts, and the total receipts of each day against the bank deposits. The footing of all books of original entry must be checked and postings to General Ledger verified. If the General Ledger contains controlling accounts with subsidiary ledgers, these must be in perfect agreement. Where differences are found to exist they must be located and corrected. If no controlling ac- counts are kept, they must be constructed, and the balances of subsidiary ledgers verified in the aggre- gate. All cash items and column footings must be checked from General Ledger into Cash Book and afterward reviewed to see that all this class of items are cleared on the receipt side of the Cash Book. The postings from all other books of original entry are checked into the General Ledger. Footings of all 108 EXAMINATION OF BOOKS AND KECOBDS. accounts in the General Ledger, open and closed, must be checked for the entire period and balances verified. Sales Books are footed and charges verified by com- parison with Original Orders and Shipping Eeceipts. Returns and Allowances are compared with Customers ' Correspondence, Entries in Eeturn Goods Journal and Stock-Keeper's Eecords. Journal entries are verified by supporting Vouchers, which must all show proper signatures of approval and authorization. Voucher Eecord is verified by comparison with Original Invoices. All Unpaid Vouchers are listed, the balance showing the amount outstanding, which should be in agreement with Accounts Payable in General Ledger. Pay Eolls must be verified as to extensions and foot- ings, and be signed by some person in authority. Analyses are made of Profits and Loss and such Capital and Expense accounts as may be deemed neces- sary to show the results of operations of business. Adjusting Journal entries are made for such errors and omissions as have been developed in the course of the examination. In the verification and valuation of Assets and Lia- bilities, the Title Deeds to all real estate should be examined and compared with book value of property, EXAMINATION OF BOOKS AND RECORDS. 109 as well as verification with amount actually paid. Proper charge for any depreciation should be made. The Plant and Machinery Account should be verified by actual examination and comparison with Original Invoices. Care should be taken to see that no items which should properly be classed as Eepairs and Main- tenance are charged to Additions and Betterments. Depreciation may be charged off at close of each fiscal period, the percentage being such as to finally reduce the cost of the plant to its residual value at the date when it is estimated it will have to be replaced. Or, another method is, to provide for the depreciation of a plant by crediting out of the net profits for the year a certain fixed percentage of the cost of the plant and machinery to an account called "Beserve for Depreciation. ' ' This maintains, at all times, a charge on the Ledger equal to the actual cost, and is believed by many to be a better plan than charging, each year an arbitrary amount on account of depre- ciation. It would be possible to ascertain the exact cost of the plant by going back over the books for the period and ascertaining how much had been charged each year; but by keeping this account in the manner last suggested, the actual cost is known and the depre- ciation is provided for. Patents, Franchises, Leaseholds, etc., are subject to such annual depreciation; and the conservative plan 110 EXAMINATION OF BOOKS AND RECORDS. is to charge off a sufficient amount each year, so as to extinguish their value at the time of expiration of such rights. Inventories should be signed by the parties taking them, and verified by the accountant as to extensions and footings. Prices must be cost or market, which- ever lowest. Goods on Consignment must be stated separately. All Bonds, Stocks and other securities must be verified by actual examination and valued at cost or market, whichever lowest. Accounts Eeceivable must be examined and Delin- quent Accounts listed. A reserve for these must be created in the Liabilities, and set up on the Balance Sheet. Notes Eeceivable On Hand are checked with Note Eegister and verified by actual examination. Notes Discounted, but not matured, are verified by Certifi- cate with Itemized List from Bank, for which a Con- tingent Liability is set up on Balance Sheet. Notes Payable are checked against Note Eegister, and if deemed necessary, verified by communication with holders. Notes Paid are verified by examination of Cancelled Notes. Notes Payable, unmatured, on which the company are indorsers, must be set up as a Contingent Liability. Eeserves for discounts and all unexpired charges and unmatured obligations must be provided. EXAMINATION OF BOOKS AND EECORDS. Ill Adjusting Journal entries must be made to set back in surplus such bad debts or other charges as properly belong to periods previous to the one under review. Following is a list of exhibits and schedules which should be prepared in order to furnish a