The Business Corporation:
Limited liability and the corporate entity
by: Garnet Brooks
What is a Corporation?
Entrepreneurship involves risk. One of the most common ways entrepreneurs limit their risk is through the operation of a corporate entity, known as a corporation, or company.
A corporation or company is a creation of law. The federal legislation which governs corporations is the Canada Business Corporations Act (“CBCA”). The provincial legislation in Nova Scotia is the Nova Scotia Companies Act (“NSCA”). From a strict legal perspective the entity will be a corporation or a company, depending in which jurisdiction it is incorporated. For the purposes of this article, I will refer to both as simply a “corporation”.
A corporation is a distinct and separate legal entity from its “owners”. That means it can enter into contracts incur debt, hold assets and sue and be sued. Its value is divided into shares which are owned by shareholders. The shareholders elect the directors, who are the directing “mind(s)” of the corporation who manage and control the company. The directors in turn, appoint the officers who are responsible for the daily operations of the business.
Advantages of using a Corporation
An advantage of using a corporate set-up for business is that it facilitates ease of capital investment from various people. For instance, the people who have great business ideas and expertise may not have money to get their business off the ground. With a corporate structure, they could sell shares in the company to investors to raise capital (this may be subject to securities laws however, so it is best to seek the advice of a lawyer). These people can benefit from the company’s success through the increased value of their shares as a result of the success of the company. Different types of “classes” of shares can also be designed to have different characteristics depending on the needs and wants of the entity and the investors.
Corporations also provide limited liability to its shareholders. Liability is limited to the assets of the corporation, which means creditors are limited in recovery to the assets of the corporation, and therefore shareholder risk is limited to their investment in the company. Needless to say, this model is well suited to business people who may want to protect various assets such as a home, retirements savings, and other assets. Often, business people set up a corporation for each separate business venture in order to shelter each from the others, in case one runs into trouble, the others will not be affected.
That being said, there are circumstances in which the “corporate veil” may be pierced, or set aside, resulting in personal liability to the shareholders. Courts will not tolerate abuses of the corporate form as a shield from certain wrongdoings by the shareholders who also may be the directors of the corporation.
Also, If debt capital is sought (i.e. business loans), be aware that creditors may require personal guarantees from the “owners” (the principals of the company), which give the creditors a right to take action against the guarantor personally, if the corporation doesn’t make its loan payments. This means that, even though a corporation has been formed to run the business, there is still a risk of personal liability where a guarantee has been provided.
Registration & Record Keeping Requirements
There are more registration requirements involved with setting up a corporation than with a partnership or sole proprietorship. These include the incorporation documents which must be filed with the Registry of Joint Stock Companies, for a Nova Scotia corporation. Among these are the articles and memorandum of association, as well as various notices and resolutions, which contain information that will be accessible by the public.
Additionally, a corporation is obligated to keep its corporate records up to date and accurate. This is typically done by maintaining what is known as a “minute book”. It is common for the corporation’s lawyer, or law office to keep and update the corporate minute book on behalf of the corporation. Annual “minutes” should also be prepared which update and confirm the corporate information and changes on record from year to year.
Corporations must also file an annual renewal with the governing office in its jurisdiction and pay an annual renewal fee as well. Corporations are also required to file a separate corporate tax return each year.
There are more initial and ongoing costs and efforts involved with a corporation, but depending on the business, it may be well worth it for many reasons including the benefits of limited liability, freely-transferrable shares, perpetual existence and the relative ease of attracting investment.
What is a Share?
Generally, a share is a proportional part of certain rights in a corporation, and in its assets upon dissolution. There are basically two types of shares; common and preferred shares. Common shares represent the residual ownership of the corporation, and may have more rights to control and long term gain, while preferred shares normally have more discretionary rights as well as preferential dividends.
If there is only 1 class of share, it will be a common share. The NSCA and CBCA both require that shares of a company distribute the right to vote, dividends and rights to share property/assets on dissolution. Shares may be divided into different classes and all shares in each class must have identical rights but not every class of shares must. This allows the company to facilitate the varied needs of the parties involved in a corporation through creating and issuing shares with different characteristics, as long as all required rights are distributed.
“Par value” is a concept which causes confusion and misleads investors and is not used widely anymore, though still alive in the NSCA (but not CBCA). A share with a “par value”, simply means an arbitrary or nominal dollar amount assigned to the shares by the issuing company, and it has no significance as to the real market value. (When dealing with par value shares, however, it is important to be careful, especially when reorganizations are undertaken to ensure that the shares are dealt with properly to avoid negative tax consequences. This is beyond the scope of this article and will be addressed in a future article).
There are two essential documents that each corporation will have. These are the Memorandum of Association and Articles of Association in a NSCA company, and in a CBCA Company the Articles of Incorporation and By-laws.
These are the company’s constitution and set out such things as the name, objects of the company and original subscribers. The Articles of Association (NSCA) (Bylaws for CBCA company) set out the detailed information regarding the capital structure, powers, and procedures and obligations of/when doing business.
It is prudent for shareholders to enter into a shareholders’ agreement. This sets out the rights and obligations of each shareholder in respect of his/her involvement in the business and procedures for compensation, entering, exiting the business (in regards to share ownership), duties and obligations. The topic of shareholders’ agreements is vast, and will be addressed in a future article dedicated to that topic.
This article was intended to be a brief and general discussion, and is NOT intended to be legal advice. As each situation varies, and it is recommended that entrepreneurs seek the advice of a qualified lawyer.
Garnet Brooks is a Business Lawyer, practicing corporate law and commercial law in Halifax. Click to Contact Garnet.