The Legal Environment of Business 9th ed. Notes.
The Legal Environment of Business 9th ed. Notes. MGMT 246 - 03
Cal State Fullerton
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Chapter 17 Small Business Organizations 1 Sole Proprietorships A The simplest form of business is a sole proprietorship when the owner is the business Anyone who does business without creating a separate business organization has sole proprietorship A major advantage of the sole proprietorship is that the proprietor owns the entire business and receives all of the profits It is often easier and less costly No documents need to be filed with the government to start a sole proprietorship a This form of business organization offers more exibility The sole proprietor is free to make any decision they want concerning the business b They pay only personal income taxes on the business s profits which are reported as personal income on the proprietor s personal income tax They are also allowed to establish certain retirement accounts that are taxexempt until the funds are drawn The major disadvantage of the sole proprietorship is that the sole proprietor has unlimited liability or legal responsibility Any lawsuit against the business or its employees can lead to unlimited personal liability for the owner of a sole proprietorship a Creditors can pursue the owner s personal assets to satisfy any business debts b The sole proprietorship also lacks continuity after the death of the proprietor When the owner dies so does the business The proprietor is also limited to their personal assets or funds and funds from any loans 2 Partnerships A A partnership arises from an agreement express or implied between two or more persons to carry on a business for a profit Partners are coowners of the business and have joint control over its operation the right to share in its profits The relationship is similar to an agency relationship because each partner is deemed to be the agent of the other partners and of the partnership They are bound by fiduciary ties However partners in a partnership agree to commit funds or other assets labor and skills to the business with the understanding that profits and losses will be shared The Uniform Partnership Act UPA governs the operations of partnerships in the absence of express agreement and has done much to reduce controversies in the law relating to partnerships The UPA defines a partnership as an association of two or more persons to carry on as coowners a business for profit where a person includes corporations corporations can be partners The intent to associate is a key element of a partnership Chapter 17 Small Business Organizations E To determine whether a partnership exists the courts usually look for a sharing of profits or losses a joint ownership of the business and an equal right to be involved in the management of the business a A court will not presume that a partnership exists if shared profits were received as a payment of a debt by installments or interest on a loan wages of an employee or for the services of an independent contractor rent to a landlord an annuity to a surviving spouse or representative of a deceased partner or a sale of goodwill of a business or property b Joint ownership of a property does not in and of itself create a partnership the parties intentions are key F At common law a partnership was treated only as an aggregate of individuals never a separate legal entity However the UPA treats a partnership as an entity for most purposes Federal procedural law permits the partnership to be treated as an entity in suits in federal courts and bankruptcy proceedings G A passthrough entity is a business entity that has no tax liability the entity s income is passed through to the owners of the entity who pay income taxes on it The partnership itself pays no taxes and is responsible only for filing an information return with the IRS H Agreements to form a partnership can be oral written or implied by conduct A partnership agreement also known as articles of partnership can include almost any terms that the parties wish unless they are illegal or contrary to public policy or statute In the absence of provisions to the contrary in the partnership agreement the law imposes certain rights and duties a A partnership for a term is when the partnership agreement specifies the duration of the partnership by stating that it will continue until a designated date or until the completion of a particular project A partnership at will does not have a specified duration and can be dissolved at any time b Sometimes persons who are not partners hold themselves out as partners and make representations that third parties rely on in dealing with them i When a third person has reasonably and detrimentally relied on the representation that a nonpartner was part of a partnership a court may conclude that a partnership by estoppel exists and impose liability on the alleged partner ii When a partnership by estoppel is deemed to exist the non partner is regarded as an agent whose acts are binding on the partnership I The rights of partners in a partnership relate to the following areas management interest in the partnership compensation inspection of books accounting and property a In a general partnership all partners have equal rights in managing the partnership Each partner has one vote in management matters regardless of the proportional size of his or her interest in the firm Chapter 17 Small Business Organizations unless agreed otherwise They delegate daily management responsibilities to a management committee made up of one or more of the partners i The majority rule controls decisions on ordinary matters connected with partnership business but decisions that significantly affect the ordinary course of the partnership business require unanimous consent of the partners ii There are many decisions that require unanimous consent b Each partner is entitled to the proportion of the business profits and losses that is specified in the partnership agreement If the agreement does not apportion profits the UPA provides that profits will be shared equally c Devoting time skill and energy to partnership business is a partner s duty and generally is not a compensable service A partner s income from the partnership takes the form of a distribution of profits according to the partner s share in the business d Partnership books and records must be kept accessible to all partners Each partner has the right to receive full and complete information concerning the conduct of all aspects of partnership business e An accounting of partnership assets or profits is required to determine the value of each partner s share in the partnership f Property acquired by a partnership is the property of the partnership and not of the partners individually A partner is not a coowner of partnership property and has no right to sell mortgage or transfer partnership property to another The partner s creditor can petition a court for a charging order to attach the partner s interest in the partnership to satisfy the partner s obligation J The duties and liabilities of partners are derived from agency law Every act of a partner concerning partnership business and business of the kind and every contract signed in the partnership s name bind the firm a The fiduciary duties that a partner owes to the partnership and to the other partners are the duty of care and the duty of loyalty Under the UPA the partner s duty of care is limited to refraining from grossly negligent or reckless conduct intentional misconduct or a knowing violation of law The duty of loyalty requires a partner to account to the partnership for any property profit or benefit derived by the partner in the conduct of the partnership s business or from the use of its property b A partner s fiduciary duties may not be waived or eliminated in the partnership agreement Each partner must act consistently with the obligation of good faith and fair dealing A partner cannot make secret profits or put selfinterest before their duty to the interest of the partnership Chapter 17 Small Business Organizations C The UPA affirms general principles of agency law that pertain to a partner s authority to bind a partnership in a contract When a partner is carrying on partnership business with third parties in the usual way apparent authority exists and both the partner and firm share liability i A partnership may limit a partner s capacity to act as the firm s agent or transfer property on its behalf by filing a statement of partnership authority ii The extent of implied authority generally is broader for partners than for ordinary agents Some customarily implied powers include the authority to make warranties on goods in the sales business and the power to enter into contracts consistent with the firm s regular course of business Partners are personally liable for the debts of the partnership The liability is essentially unlimited because the acts of one partner in the ordinary course of business subject the other partners to personal liability i Each partner in a partnership generally was jointly liable for the partnership s obligations Joint liability means that a party must sue all of the partners as a group but each partner can be held liable for the full amount ii Partners are both jointly and severally liable for all partnership obligations including contracts torts and breaches of trust Joint and several liability means that a third party has the option of suing all of the partners together or one or more of the partners separately The partnership s assets must be exhausted before a creditor can enforce a judgment against a partner s separate assets iii With joint a several liability a partner who commits a tort can be required to indemnify reimburse the partnership for any damages it pays iv A partner newly admitted to an existing partnership is not personally liable for any partnership obligations incurred before the person became a partner K Dissociation occurs when a partner ceases to be associated in the carrying on of the partnership business It entitles the partner to have their interest purchased by the partnership and terminates the partner s actual authority to act for the partnership and to participate in running its business a b Under UPA a partner can be dissociated from a partnership in many ways A partner has the power to dissociate from a partnership at any time but if they lack the right to dissociate the dissociation is considered wrongful under the law A partner who wrongfully dissociates is liable to the partnership and to the other partners for damages caused by the dissociation Chapter 17 Small Business Organizations c Dissociation terminates some of the rights of the dissociated partner requires that the partnership purchase their interest and alters the liability of the parties to third parties i ii iii Their right to participate in the management and conduct of the partnership business terminates as well as the partner s duty of loyalty A partner s duty of care continues with respect to evens that occurred before dissociation Their interest in the partnership must be purchased according to the rules in UPA and the buyout price is based on the amount that would have been distributed to the partner if the partnership had been wound up on the date of dissociation If a third party reasonably believed at the time of a transaction that the dissociated partner as still a partner the partnership may be liable To avoid this a partnership should notify its creditors customers and clients of a partner s dissociation L The same events that cause dissociation can result in the end of the partnership The termination of a partnership is referred to as dissolution commencement of the winding up process Winding up is the actual process of collecting liquidating and distributing the partnership assets a Dissolution of a partnership general can be brought about by acts of the partners by operation of law or by judicial decree i ii Any event that makes it unlawful for the partnership to continue its business will result in dissolution Under the UPA a court may order dissolution when it becomes obviously impractical for the firm to continue Each partner must exercise good faith when dissolving a partnership b After dissolution the partnership continues for the limited purpose of winding up the business The partners cannot create new obligations on behalf of the partnership only complete transactions begun but not finished at time of dissolution i ii Winding up includes collected and preserving partnership assets discharging liabilities and accounting to each partner for the value of their interest in the partnership The UPA provides that a partner is entitled to compensation for services in winding up partnership affairs above and apart form their share in the profits Both creditors of the partnership and individual partners can make claims on the partnership s assets A partnership s assets are distributed according to certain priorities payment of debts including those owed to partner and nonpartner creditors and return of capital contributions and distribution of profits to partners Chapter 17 Small Business Organizations M Before entering into a partnership partners should agree on how the assets will be valued and divided in the event hat the partnership dissolves A buy sell agreement provides for one or more partners to buy out the others 3 Franchises A A franchise is an agreement in which the owner of intellectual property such as a trademark a trade name or a copyright licenses others to use it in the selling of goods or services A franchisee can operate as an independent businessperson but still obtain the advantages of a regional or national organization B Franchises generally fall into one of three classifications distributorships chainstyle business operations and manufacturing agreements a A distributorship is when a manufacturer licenses a dealer to sell its product b In a chainstyle business operation a franchise operates under the franchisor s name and is identified as a member of a select group of dealers that engage in the franchisor s business 0 In a manufacturing arrangement the franchisor transmits to the franchisee the essential ingredients or formula to make a particular product C Franchises are governed by contract law Generally laws are designed to protect prospective franchisees from dishonest franchisors and to prevent franchisors from terminating franchises without good cause a The federal government regulates franchising through laws that apply to specific industries and through the Franchise Rule created by the Federal Trade Commission i Congress has enacted laws that protect franchisees in certain industries from unreasonable demands and bad faith terminations of the franchise by the franchisor ii The FTC s Franchise Rule requires franchisors to disclose certain material facts that a prospective franchisee needs in order to make an informed decision concerning the purchase of a franchise b State regulation varies but often is aimed at protecting franchisees from unfair practices and bad faith terminations by franchisors i A disclosure document Franchise Disclosure Document must be registered or filed with a state official ii To protect franchises against arbitrary or bad faith terminations state law may prohibit termination without good cause or require that certain procedures be followed in terminating a franchise D The franchise relationship is defined by the contract between the franchisor and the franchisee It specifies the terms and conditions of the franchise and spells out the rights and duties of the franchisor and the franchisee Chapter 17 Small Business Organizations a The franchisee ordinarily pays an initial fee or lumpsum price for the franchise license The franchise agreement may also require the franchisee to pay a percentage of the franchisor s advertising costs and certain administrative expenses b The franchise agreement may specify Whether the premises for the business must be leased or purchased outright The agreement Will specify Whether the franchisor or the franchisee is responsible for supplying equipment and furnishings for the premises c Typically the franchisor determines the territory to be served Many franchise cases involve disputes over territorial rights and the implied covenant of good faith and fair dealing often comes into play in this area of franchising d The franchisor may require that the business use a particular organizational form and capital structure The franchise agreement may set out standards such as sales quotas and recordkeeping requirements e The franchise agreement may specify that the franchisor Will provide some degree of supervision and control so that it can protect the franchise s name and reputation i The contract often states that the franchisor will establish certain standards for the facility As a means of controlling quality franchise agreements also typically limit the franchisee s ability to sell the franchise to another party ii If a franchisor exercises too much control over the operations of its franchisees the franchisor risks potential liability A franchisor may occasionally be held liable under the doctrine of respondeat superior for the tortious acts of the franchisees employees f Depending on the nature of the business the franchisor may require the franchisee to purchase certain supplies from the franchisor at an established price A franchisor can suggest retail prices but cannot mandate them E The duration of the franchise is a matter to be determined between the parties a Usually the franchise agreement specifies that termination must be for cause and then defines the grounds for termination i Most franchise contracts provide that notice of termination must be given A franchisee must be given reasonable time to Wind up the business ii A franchise agreement may state that the franchise may attempt to cure an ordinary curable breach Within a certain period of time after notice so as to postpone or even avoid the termination of the contract Chapter 17 Small Business Organizations b The franchisee which normally invests a substantial amount of time and financial resources in making the franchise operation successful may receive little or nothing for the business on termination c In determining Whether a franchisor has acted in good faith When terminating a franchise agreement the courts usually try to balance the rights of both parties If a court perceives that a franchisor has unfairly terminated a franchise the franchisee Will be provided with a remedy for wrongful termination Chapter 18 Limited Liability Business Forms 1 The Limited Liability Company A A limited liability company LLC is a hybrid that combines the limited F liability aspects of a corporation and the tax advantages of a partnership Less than onefifth of the states have adopted the Uniform Limited Liability Company Act making LLCs far from uniform LLCs must be formed and operated in compliance with state law The owners of an LLC members enjoy limited liability a Members of LLCs are shielded from personal liability in many situations even sometimes when sued by employees of the firm b Sometimes when a corporation is deemed to be merely an alter ego of the shareholderowner a court will pierce the corporate veil and hold the shareholderowner personally liable c LLCs are legal entities apart from their owners The LLC can sue or be sued enter into contracts and hold title to property To form an LLC articles of organization must be filed with a central state agency usually the secretary of state s office a The articles of organization must include the name of the business its principal address the name and address of a registered agent the members names and how the LLC will be managed b Businesspersons sometimes enter into contracts on behalf of a business organization that is not yet formed Preincorporation contracts are contracts entered into by persons when forming incorporation but before the corporation becomes a legal entity The federal jurisdiction statute does not mention the state citizenship of partnerships LLCs and other unincorporated associations but the courts have tended to regard these entities as citizens of every state of which their members are citizens The LLC offers many advantages to businesspersons which is why this form of business organization has become increasingly popular a The liability of members is limited to the amount of their investments b An LLC that has two or more members can choose to be taxed as either a partnership or corporation Unless an LLC indicates that it wishes to be taxed as a corporation the IRS automatically taxes it as a partnership which means that the LLC pays no taxes as an entity c LLCs offer exibility in terms of business operations and management The main disadvantage of the LLC is that state LLC statutes are not uniform 2 LLC Management and Operation A The members of an LLC have considerable exibility in managing and B operating the business LLC members have two options for managing the firm membermanaged LLC or managermanaged LLC In a membermanaged LLC all of the members participate in management and decisions are made by majority vote Chapter 18 Limited Liability Business Forms In a managermanaged LLC the members designate a group of persons to manage the firm C Under the ULLCA managers in a managermanaged LLC owe fiduciary duties to the LLC and its members D The members of an LLC can decide how to operate the various aspects of the business by forming an operating agreement Operating agreements typically contain provisions relating to management and how future managers will be chosen or removed how profits will be divided how membership interests may be transferred whether the dissociation of a member will trigger dissolution of the LLC whether formal members meetings will be held and how voting rights will be apportioned a If the agreement does not cover a topic the state LLC statute will govern Most LLC statutes provide that if the members have not specified how profits will be divided they will be divided equally among the members b If a dispute arises and the state s LLC statute does not cover the issue courts sometimes apply the principles of partnership law 3 Dissociation and Dissolution of an LLC A A member of an LCC has the power to dissociate from the LLC at any time but may not have the right to The events that trigger a member s dissociation from an LLC are similar to the events causing a partner to be dissociated under the UPA voluntary withdrawal expulsion by other members or by court order incompetence and death B When a member dissociates from an LLC they lose the right to participate in management and the right to act as an agent for the LLC The member s duty of loyalty to the LLC terminates and the duty of care continues only with respect to events that occurred before dissociation C The dissociated member has no right to force the LLC to dissolve The remaining members can opt either to continue or to dissolve the business D When an LLC is dissolved any members who did not wrongfully dissociate may participate in the winding up process To wind up the business members must collect liquidate and distribute the LLC s assets 4 Limited Liability Partnerships A The limited liability partnership LLP is a hybrid form of business designed mostly for professionals who normally do business as partners in a partnership It allows a partnership to continue as a passthrough entity for tax purposes but limits the personal liability of the partners B LLPs must be formed in compliance with state statutes which may include provisions of the UPA The appropriate form must be filed with a central state agency C An LLP allows professionals to avoid personal liability for the malpractice of other partners A partner in a LLP is still liable for their own wrongful acts a When an LLP formed in state wants to do business in another state it may be required to register in the second state Under the UPA states Chapter 18 Limited Liability Business Forms D apply the law of the state in which the LLP was formed even when the firm does business in another state b When more than one partner in an LLP is negligent there is a question as to how liability should be shared Some states provide for proportionate liability separate determinations of the negligence of the partners A family limited liability partnership is a limited liability partnership in which the partners are related to each other All partners must be natural persons or persons acting in fiduciary capacity for the benefit of natural persons Limited Partnerships A F Limited partnerships consist of at least one general partner and one or more limited partners A general partner assumes management responsibility for the partnership and has full responsibility for the partnership and for all its debts A limited partner contributes cash or other property and owns an interest in the firm but is not involved in management responsibilities and is not personally liable for partnership debts beyond the amount of their investment The formation of a limited partnership is a public and formal preceding that must follow statutory requirements A limited partnership must have a sign a certificate of limited partnership General partners are personally liable to the partnership s creditors Limited partners enjoy limited liability only so long as they do not participate in management A limited partner who participates in management will be just as liable as a general partner to any creditor who transacts business with the limited partnership Limited partners have essentially the same rights as general partners with the exception of the right to participate in management On dissolution of the partnership limited partners are entitled to return of their contributions in accordance with the partnership certificate A general partner has the power to voluntarily dissociate from a limited partnership unless the partnership agreement specifies otherwise A limited partner theoretically can withdraw from the partnership by giving six months notice unless the partnership agreement specifies a term a A general partner s voluntary dissociation from the firm normally will lead to dissolution unless all partners agree to continue the business Bankruptcy of a limited partner does not dissolve the partnership unless it causes bankruptcy of the firm b On dissolution creditors claims take first priority After that partners and former partners receive unpaid distributions of partnership assets c Disputes commonly arise about how the partnership s assets should be valued and distributed and whether the business should be sold A limited liability limited partnership is a type of limited partnership The liability of a general partner in an LLLP is limited to the amount of their investments in the firm Chapter 19 Corporations 1 The Nature and Classi cations of Corporations A A corporation is a legal entity created and recognized by state law that can have one or more owners and operates under a name distinct from the names of its owners The owners may be individuals or other businesses A corporation is recognized as a person and it enjoys many of the same rights and privileges under state and federal law that US citizens enjoy B The responsibility for the overall management of the firm is entrusted to a board of directors whose members are elected by the shareholders They made policy decisions and hire corporate officers and other employees to run the daily business A shareholder is an individual that purchases a share of stock in a corporation C Corporate shareholders are not personally liable for obligations of the corporation beyond the extent of their investments In certain situations a court can pierce the corporate veil and impose liability on shareholders for the corporation s obligations D When a corporation earns profits it can either pass them on to shareholders in the form of dividends or retain them as profits Retained earnings can yield higher corporate profits in the future and thus cause the price of the company s stock to rise if invested properly a Whether a corporation retains its profits or passes them on to the shareholders as dividends those profits are subject to income tax by various levels of government A major disadvantage of the corporate form is double taxation from the government b Some corporations use holding companies to reduce or defer their income taxes A holding company is a company whose business activity consists of holding shares in another company E A corporation is liable for the torts committed by its agents or officers within the course and scope of their employment F Under modern criminal law a corporation may also be held liable for the criminal acts of its agents and employees provided the punishment is one that can be applied to the corporation G Classification of a corporation normally depends on its location purpose and ownership characteristics a A corporation is referred to as a domestic corporation by its home state the state in which it incorporates A corporation formed in one state but doing business in another is referred to in the second state as a foreign corporation A corporation formed in another country but doing business in the US is an alien corporation Sometimes It must obtain a certificate of authority in any state in which it plans to do business b A public corporation is a corporation formed by the government to meet some political or governmental purpose A publicly held corporation is any corporation whose shares are publicly traded in a Chapter 19 Corporations 6 f securities market Private corporations are created either wholly or in part for private benefit profit Nonprofit corporations are formed for purposes other than making a profit It is a convenient form of organization that allows various groups to own property and to form contracts without exposing the individual members to personal liability A close corporation is one whose shares held by members of a family or by relatively few persons There is no trading market for these shares It is often operated like a partnership If all of a corporation s shareholders agree in writing the corporation can operate without directors and bylaws i To prevent a majority shareholder from dominating the company a close corporation may require that more than a simple majority of the directors approve any action taken by the board ii A close corporation has a small number of shareholders therefore the transfer of one shareholder s shares to someone else can cause serious management problems iii A shareholder agreement can provide for proportional control when one of the original shareholders dies Agreements between shareholders can also restrict the transfer of a close corporation s stock in other ways iv Sometimes a majority shareholder in a close corporation takes advantage of their position and misappropriates company funds The remedy for minority shareholders is to have their shares appraised and to be paid the fair market value for them A S corporation is a close corporation that meets the qualifying requirements specified in Subchapter S of the Internal Revenue Code It can avoid income taxes at the corporate level while retaining many of the advantages of a corporation such as limited liability i There are numerous requirements for S corporation status such as the corporation must be a domestic corporation not be a member of an affiliated group of corporations have no more than one hundred shareholders have only one class of stock and shareholders must be individuals estates or certain trusts and taxexempt organizations and not be a nonresident alien ii An S corporation is taxed like a partnership so the corporate income passes through to the shareholders who pay personal income tax on it instead of going through double taxation The shareholders brackets may also be lower than for the average corporation The laws governing the formation and operation of professional corporations are similar to those governing ordinary business Chapter 19 Corporations corporations However shareholderowners are held to a higher standard of conduct A benefit corporation is a forprofit corporation that seeks to have a material positive impact on society and the environment The purpose of the benefit corporation is to provide a longterm shareholder value Shareholders of a benefit corporation determine whether the company has achieved a material positive impact Shareholders also have a right of private action benefit enforcement proceeding which enables them to sue the corporation if it fails to pursue or create public benefit A benefit corporation must issue an annual benefit report on its overall social and environmental performance that uses a recognized third party standard to assess its performance 2 Corporate Formation A Incorporating a business is much simpler today than it was twenty years ago and many states allow businesses to incorporate via the Internet Today due to the relative ease of forming a corporation in most states persons incorporating their business rarely if ever engage in preliminary promotional activities Personal liability continues until the newly formed corporation assumes liability for the preincorporation contracts through a novation Procedures differ among states but the basic steps to incorporating are selecting a state of incorporation securing the corporate name preparing the articles of incorporation and filing the articles of incorporation with the secretary of state B a Because state laws differ individuals may look for the states that offer the most advantageous tax or incorporation provisions Close corporations of a professional nature generally incorporate in the state where most of the corporation s business will be conducted The choice of a corporate name is subject to state approval to ensure against duplication or deception i All corporations need to have an online presence to compete effectively in today s business climate ii A new corporation s name cannot be the same as the name of an existing corporation doing business within the same state If a firm does business under a name that is the same as or deceptively similar to an existing companies name it may be liable for trade name infringement The articles of incorporation include basic information about the corporation and serve as a primary source of authority for its future organization and business functions They must include the name of the corporation the number of shares the corporation is authorized to issue the name and street address of the corporation s initial registered agent and registered office and the name and address of each Chapter 19 Corporations incorporator Bylaws are internal rules of management adopted by the corporation at its first organization meeting 1 ii iii iv The articles must specify the number of shares of stock the corporation is authorized to issue as well as the various types or classes or stock authorized for issuance The corporation must indicate the location and street address of its registered office within the state They must also give the name and address of a specific person who has been designated as an agent Each incorporator must be listed by name and address They do not need to have any interest in the corporation and sometimes signing the articles is their only duty A corporation has perpetual existence unless the articles state otherwise A corporation can be formed for any lawful purpose The articles can describe the corporation s internal management structure although this usually is included in the bylaws adopted after the corporation is formed They cannot con ict with the incorporation statute or the articles of incorporation d Once the articles have been prepared and signed they are sent to the appropriate state official along with the required filing fee D After incorporation the first organizational meeting must be held The most important function of this meeting is the adoption of bylaws E If the procedures for incorporation are not followed precisely others may be able to challenge the existence of the corporation Errors in incorporation procedures are important when a third party is attempting to enforce a contract or bring a suit for a tort injury learns of them a If a corporation has substantially complied with all conditions precedent to incorporation the corporation is said to have de jure right and lawful existence b If the defect in information is substantial the outcome will vary depending on the jurisdiction Some states still recognize the common law doctrine of de facto corporation In those states the courts will treat a corporation as a legal corporation despite the defect in its formation if a state statute exists under which the corporation can be validly incorporated the parties have made a good faith attempt to comply with the statute and the parties have already undertaken to do business as a corporation F When a business holds itself out to others as being a corporation when it has made no attempt to incorporate the firm normally will be estopped prevented from denying corporate status in a lawsuit by a third party 3 Corporate Powers Chapter 19 Corporations A When a corporation is created the express and implied powers necessary to achieve its purpose also come into existence These powers are found in its articles of incorporation law of the state of incorporation and in state and federal constitutions When a corporation is created certain implied powers arise The corporation has the implied power to perform all acts reasonably necessary to accomplish its corporate purposes Certain corporate officers have the implied power to bind the corporation in matters directly connected with the ordinary business affairs of the enterprise There is a limit to what a corporate officer can do The term ultra vires means beyond the power In corporate law acts of a corporation that are beyond its express or implied powers are ultra vires acts a Most private corporations are organized for any legal business and do not state a specific purpose so the ultra vires doctrine as declined in importance Today the ultra vires acts usually involve nonprofit corporations or municipal public corporations b Shareholders can seek an injunction from a court to prevent corporations from engaging in ultra vires acts The corporation or its shareholders can seek damages from the officers and directors who were responsible for the ultra vires acts 4 Piercing the Corporate Veil A When owners use a corporate entity to perpetrate a fraud circumvent the law or in some other way accomplish an illegitimate objective the courts will ignore the corporate structure and pierce the corporate veil expose the shareholders to personal liability Courts pierce the veil when the corporate privilege is abused for personal benefit or when the corporate business is treated so carelessly that it is distinguishable from that of a controlling shareholder There are many factors that cause the courts to pierce the corporate veil a party is tricked or misled into dealing with the corporation rather than the individual the corporation is set up never to make a profit or always to be insolvent the corporation is formed to evade an existing legal obligation statutory corporate formalities are not allowed and personal and corporate interests are commingled mixed together to such extent that the corporation has no separate identity The separate status of the corporate entity and the sole shareholder must be carefully preserved Certain practices invite trouble for the oneperson or close corporation commingling of corporate and personal funds failure to hold board of directs meetings and record the minutes and shareholders continuous personal use of corporate property Under the alter ego theory courts will pierce the corporate veil under the theory that the corporation was not operated as a separate entity but was just an alter ego of the individual or group that actually controlled the corporation This theory is applied when a corporation is so dominated and controlled by Chapter 19 Corporations an individual or group that the separate identities of the person and the corporation are no longer distinct 5 Directors and Of cers A Sometimes actions that may benefit the corporation as a whole do not coincide with the separate interests of the individuals making up the corporation It is therefore important to know the rights and duties of all participants in the corporate enterprise B The board of directors is the ultimate authority in every corporation They have responsibility for all policymaking decisions necessary to the management of all corporate affairs No individual director can act as an agent to bind the corporation a The initial board of directors serves until the first annual shareholders meeting The directors are then elected by a majority vote of the shareholders i A director can be removed for cause for failing to perform a required duty as specified in the articles or bylaws or by shareholder action A director cannot be removed without cause unless the shareholders have reserved the right to do so at the time of election ii When vacancies occur either the shareholders or the board itself can fill the vacant position depending on state law or on the provisions of the bylaws A court can invalidate results if the directors were attempting to manipulate the election in order to reduce the shareholders in uence b Directors are often paid at least nominal sums and may receive more substantial compensation in large corporations because of the time work effort and especially risk involved An inside director is one who is also an officer of the corporation whereas an outside director is one who does not hold a management position c The board of directors conducts business by holding formal meetings with recorded minutes Special meetings can be called with notice sent to all directors i A majority of the board of directors normally constitutes a quorum the minimum number of members of a body of officials or other group that must be present for business to be validly transacted ii Once a quorum is present the directors transact business and vote on issues affecting the corporation Ordinary matters generally require a simple majority vote but certain extraordinary issues may require a greaterthanmajority vote d The boards of large publicly held corporations typically create committees of directors and delegate certain tasks to these committees An executive committee handles interim management decisions between board meetings and is limited to dealing with ordinary Chapter 19 Corporations business matters An audit committee is responsible for the selection compensation and oversight of the independent public accountants that audit the firm s financial records e A corporate director must have certain rights to function properly in that position i ii iii The right to participation means that directors are entitled to participate in all board of directors meetings and have a right to be notified of these meetings The right of inspection means that directors can access the corporation s books and records facilities and premises They are essential for directors to make informed decisions and exercise the necessary supervision over corporate officers and employees When a director becomes involved in litigation by virtue of their position or actions they may have a right to indemnification reimbursement for legal costs fees and damages incurred C Corporate officers and other executive employees are hired by the board of directors Corporate and managerial officers act as agents of the corporation therefore the ordinary rules of agency normally apply to their employment D Directors and officers are considered to be fiduciaries of the corporation because their relationship with the corporation and its shareholders is one of trust and confidence a Directors and officers must exercise due care in performing their duties The standard of due care has been codified and generally requires a director or officer to act in good faith exercise the care than an ordinarily careful person would exercise in similar circumstances and do what they believe is in the best interests of the corporation i ii iii Directors and officers must do what is necessary to be adequately informed attend meetings and presentations ask for information from those who have it read reports and review other written materials Directors are also expected to exercise a reasonable amount of supervision when they delegate work to corporate officers and employees When an individual director disagrees with the majority vote it should be entered in the minutes as a dissention If the directors are later held liable for mismanagement as a result of a decision dissenting directors are rarely held individually liable to the corporation b Under the business judgment rule a corporate director or officer will not be liable to the corporation or to its shareholders for honest mistakes of judgment and bad business decisions Corporate decisions Chapter 19 Corporations C makers are not subjected to secondguessing by shareholders or others in the corporation i The business judgment rule will apply as long as the director or officer took reasonable steps to become informed about the matter had a rational basis for their decision and did not have a con ict of interest between their personal interest and that of the corporation ii The rule provides broad protections to corporate decision makers and generally protects directors and officers who make bad business decisions from liability for those choices Duty of loyalty requires directors and officers to subordinate their personal interests to the welfare of the corporation Directors cannot use corporate funds or confidential corporate information for personal advantage and must refrain from selfdealing Directors are precluded from entering into or supporting businesses that operate in direct competition with corporations on whose boards they serve Their fiduciary duty requires them to make a full disclosure of any potential con icts of interest that might arise in any corporate transaction Directors and officers are exposed to liability on many fronts They can be held liable for negligence and crimes and torts committed by themselves or by corporate employees under their supervision 6 Shareholders A The acquisition of a share of stock makes a person an owner and a shareholder in a corporation Shareholders thus own the corporation Shareholders have no responsibility for the daily management of the corporation but they are responsible for choosing the board of directors which does have control B Shareholders must approve fundamental changes affecting the corporation before the changes can be implemented Some powers are subject to prior board approval C Shareholders meetings must occur at least annually but special meetings can be called to deal with urgent matters a A corporation must notify its shareholders of the date time and place of an annual or special shareholders meeting at least ten days but not more than sixty days before the meeting date The law allows stockholders to appoint another person as their agent to vote their shares at the meeting The signed appointment form or electronic transmission authorizing an agent to vote the shares is called a proxy When shareholders want to change a company policy they can put their ideas up for a shareholder vote This is done by submitting a shareholder proposal to the board of directors and asking the board to include the proposal in the proxy materials that are sent to all shareholders before meetings Chapter 19 Corporations d The Securities and Exchange Commission SEC requires all publicly held companies to distribute electronic proxy materials D Shareholders exercise ownership control through the power of votes Corporate business matters are presented in the form of resolutions which shareholders vote to approve or disapprove a For shareholders to act during a meeting a quorum must be present A quorum generally exists when shareholders holding more than 50 of the outstanding shares are present but state laws permit the articles of incorporation to set their own quorum requirements Only persons whose names appear on the corporation s stockholder records as owners are entitled to vote The voting list contains the name and address of each shareholder as shown on the corporate records on a given cutoff date record date and the number of voting shares held by each owner Shareholders can elect directors by cumulative voting a voting method designed to allow minority shareholders to be represented on the board of directors i With cumulative voting each shareholder is entitled to a total number of votes equal to the number of board members to be elected multiplied by the number of voting shares that the shareholder owns Before a shareholders meeting a group of shareholders can create a shareholder voting agreement by agreeing in writing to vote their shares together in a specified manner Corporate managers must be careful that such agreements do not constitute a breach of their fiduciary duties A voting trust is an agreement trust contract under which a shareholder assigns the right to vote for their shares to a trustee The trustee is then responsible for voting the shares on behalf of all the shareholders in the trust The shareholder retains all rights of ownership E Shareholders possess numerous rights such as the right to vote their shares a Stock certificates evidenced ownership of a specified number of shares in the corporation Few jurisdictions still require physical stock certificates Shareholders have the right to demand that the corporation issue certificates Sometimes the articles of incorporation grant preemptive rights to shareholders With preemptive rights a shareholder can purchase a percentage of the new shares that is equal to their current percentage of ownership in the corporation i Preemptive rights allow each shareholder to maintain their proportionate control voting power or financial interest in the corporation Chapter 19 Corporations ii Preemptive rights are most important in close corporations because each shareholder owns a relatively small number of shares but controls a substantial interest in the corporation c Stock warrants are rights to buy a stock at a stated price by a specified date that are given by the company d A dividend is a distribution of corporate profits or income ordered by the directors and paid to the shareholders in proportion to their respective shares in the corporation Only certain funds are legally available for paying dividends such as retained earnings net profits and surplus i Sometimes dividends are improperly paid from an unauthorized account or their payment causes the corporation to become insolvent Whenever dividends are illegal or improper the board of directors can be held personally liable for the amount of the payment ii When directors fail to declare a dividend shareholders can ask a court to compel the directors to meet and declare a dividend To succeed the shareholders must show that the directors have acted so unreasonably in withholding the dividend that their conduct is an abuse of their discretion e Shareholders in a corporation enjoy common law and statutory inspection rights A shareholder only has a right to inspect and copy corporate books and records for a proper purpose and the request to inspect must be made in advance f The law generally recognizes the right of an owner to transfer property to another person unless there are valid restrictions on its transferability When shares are transferred a new entry is made in the corporate stock book to indicate the new owner g The remaining assets of a dissolved corporation are distributed to the shareholders in proportion to the percentage of shares owned by each shareholder h If the corporate directors fail to bring a lawsuit shareholders can do so in a shareholder s derivative suit i The right of shareholders to bring a derivative action is especially important when the wrong suffered by the corporation results form the actions of the corporate directors and officers ii When shareholders bring a derivative suit they are not pursuing rights or benefits for themselves personally but are acting as guardians of the corporate entity F A shareholder can be personally liable in certain other rare instances a When a corporation issues shares for less than their fair market value the shares are referred to as watered stock The shareholder who receives watered stock must pay the difference to the corporation 10 Chapter 19 Corporations b A majority shareholder is regarded as having a fiduciary duty to the corporation and to the minority shareholders When a majority shareholder breaches their fiduciary duty to a minority shareholder the minority shareholder can sue for damages Oppressive conduct is a breach of fiduciary duties by those Who control a close corporation 11 Chapter 28 Investor Protection and Corporate Governance 1 The Securities and Exchange Commission A The Securities Exchange Commission administers the Securities Act of 1933 and 1934 and plays a key role in interpreting the provisions of these acts in creating regulations governing the purchase and sale of securities The SEC has some basic functions interpreting federal securities laws and investigating securities law violations issuing new rules and amending existing rules overseeing the inspection of securities firms brokers investment advisers and rating agencies overseeing private regulatory organizations in the securities accounting and auditing fields and coordinating US securities regulation with federal state and foreign authorities B The SEC is working to make the regulatory process more efficient and more relevant to today s securities trading practices C The SEC s regulatory functions have gradually been increased by legislation granting it authority in different areas 2 The Securities Act of 1933 A The Securities Act of 1933 governs initial sales of stock by businesses and was designed to prohibit various forms of fraud and to stabilize the securities industry by requiring disclosure B The Securities Act of 1933 defines a security as instruments commonly known as securities preferred and common stocks treasury stocks bonds debentures and stock warrants any interests commonly known as securities stock options puts calls or other types of privilege on a security notes instruments or evidence of indebtedness any fractional undivided interest in oil gas or other mineral rights and investment contracts a An investment contract is any transaction in which a person invests in a common enterprise reasonably expecting profits derived primarily or substantially from others managerial or entrepreneurial efforts known as the Howey test b The most common form of securities is stocks and bonds issued by corporations Almost any stake in the ownership or debt of a company can be considered a security C A prospectus is a disclosure document that describes the security being sold the financial operations of the issuing corporation and the investment or risk attaching to the security a The registration statement must be written in plain English and fully describe the securities being offered for sale the corporation s properties and business the management of the corporation how the corporation intends to use the proceeds of the sale and any pending lawsuits or special risk factors b The registration statement does not become effective until it has been reviewed and approved by the SEC the 1933 act restricts the types of activities an issuer can engage in at each stage of the registration process and if the issuer violates those restrictions investors can rescind their contracts to purchase the securities Chapter 28 Investor Protection and Corporate Governance i The issuer normally cannot sell or offer to sell the securities during the prefiling period ii The securities can be offered for sale but not be sold during the waiting period All issuers can distribute a preliminary prospectus which contains most of the information that will be included in the final prospectus but usually doesn t include a price A freewriting prospectus is any type of written electronic or graphic offer that describes the issuer or its securities and includes a legend indicating that the investor may obtain the prospectus at the SEC s website iii The issuer can offer and sell securities without restrictions during the posteffective period once the SEC has reviewed and approved the registration statement and the waiting period is over D A wellknown seasoned issuer WKSI is a firm that has issued at least 1 billion in securities in the last three years or has at least 700 million of value of outstanding stock in the hands of the public They can file registration statements the day they announce a new offering and are not required to wait for SEC review and approval E Certain types of securities are exempt from the registration requirements of the Securities Act of 1933 The transaction exemptions are most important because they are very broad and can enable an issuer to avoid the high cost and complicated procedures associated with registration a An exemption from registration is available for an issuer s offerings that do not exceed 5 million in securities during any twelvemonth period i Companies are allowed to test the waters for potential interest before preparing the offering circular To test the water means to determine potential interest without actually selling any securities or requiring any commitment from those who express interest ii Some companies have sold their securities via the Internet using Regulation A b The SEC s Regulation D contains several exemptions form registration requirements for offers that either involves a small dollar amount or is made in a limited manner i Rule 504 is the exemption used by most small businesses which provides that noninvestment company offerings up to 1 million in any twelvemonth period are exempt An investment company is a firm that buys a large portfolio of securities and professionally manages it on behalf of many smaller shareholdersowners ii Rule 505 provides that noninvestment company offerings up to 5 million in any twelvemonth period are also exempt The Chapter 28 Investor Protection and Corporate Governance C offer may be made to an unlimited number of accredited investors and up to 35 unaccredited investors Accredited investors include banks insurance companies investment companies employee benefit plans the issuer s executive offers and directors and persons whose income or net worth exceeds a certain threshold iii Rule 506 exempts private noninvestment company offerings in unlimited amounts that are not generally solicited or advertised often referred to as the private placement exemption because it exempts transactions not involving any public offering The Securities Act of 1933 provides exemption for resales by most persons other than issuers or underwriters Resales of restricted securities acquired under Rule 505 or 506 trigger the registration requirements unless the party selling them complies with Rule 144 or Rule 144A safe harbors i Rule 144 exempts restricted securities from registration on re sale if all of the following conditions are met there is adequate current public information about the issuer the person selling the securities has owned them for at least 6 months if the issuer is subject to the reporting requirements of the 1934 act the securities are sold in certain limited amounts in unsolicited brokers transactions and the SEC is notified of the resale ii Securities that at the time of issue were not of the same class as securities listen on a national securities exchange or quoted in a US automated interdealer quotation system may be resold under Rule 144A F It is a violation of the Securities Act of 1933 to intentionally defraud investors by misrepresenting or omitting facts in a registration statement or prospectus a Criminal violations are prosecuted by the US Department of Justice The SEC is authorized to impose civil sanctions against those who willfully violate the 1933 act There are 3 basic defenses to charges of violations under the 1933 act the statement or omission was not material the plaintiff knew about the misrepresentation at the time the stock was purchased or the defendant exercised due diligence in preparing the registration and reasonably believed at the time that the statements were true 3 The Securities Exchange Act of 1934 A The Securities Exchange Act of 1934 provides for the regulation and registration of securities exchanges brokers dealers and national securities associations This is a ontime disclosure law that provides for continuous periodic disclosures by publicly held corporations to enable the SEC to regulate subsequent trading Chapter 28 Investor Protection and Corporate Governance B Section 10b is one of the more important sections of the Securities Exchange Act of 1934 that prohibits the use of any manipulative or deceptive mechanism in violation of SEC rules and regulations The SEC Rule 10b5 prohibits the commission of fraud in connection with the purchase or sale of any security The basic elements of a securities fraud action are a material misrepresentation or omission in connection with purchase and sale of securities scienter wrongful state of mind reliance by the plaintiff on the material misrepresentation an economic loss and causation there is a causal connection between misrepresentation and loss a One of the major goals is to prevent insider trading when persons buy or sell securities on the basis of information that is not available to the public b No fact by itself is automatically considered material It will be regarded as material fact only if it is significant enough that it would likely affect an investor s decision as to whether to purchase or sell the company s securities 0 Traditional insidertrading cases involve true insiders corporate officers directors and majority shareholders who have access to inside information Outsiders are those who trade on inside information acquired indirectly i Tippees those who receive tips from insiders are liable if there is a breach of duty not to disclose inside information the disclosure is made in exchange for personal benefit and the tippee knows or should know of this breach and benefits from it ii Liability for insider trading may also be established under the misappropriation theory This theory holds liable an individual who wrongfully obtains misappropriates inside information and trades on it for their personal gain because the individual basically stole information rightfully belonging to another C Section 16b of the 1934 act provides for the recapture by the corporation of all profits realized by certain insiders on any purchase and sale or sale and purchase of the corporation s stock within any sixmonth period All such shortswing profits must be returned to the corporation D The disclosure requirements of SEC Rule 10b5 had the unintended effect of deterring the disclosure of forwardlooking information The Private Securities Litigation Reform Act PSLRA provides a safe harbor for publicly held companies that make forwardlooking statements such as financial forecasts E Section 14a of the Securities Exchange Act of 1934 regulates the solicitation of proxies from shareholders of Section 12 companies Whoever solicits a proxy must fully and accurately disclose in the proxy statement all of the facts that are pertinent to the matter on which the shareholders are to vote Remedies for violations are extensive Chapter 28 Investor Protection and Corporate Governance F Violations of Section 10b of the Securities Exchange Act of 1934 and SEC Rule lOb5 may lead to both criminal and civil liability a For either criminal or civil sanctions to be imposed scienter must exist the violator must have had an intent to defraud or knowledge of their misconduct b Violations of Section 16b include the sale by insiders of stock acquired less than six months before the time of sale These violations are subject to civil sanctions c For violations of Section 10b and Rule lOb5 an individual may be fined up to 5 million imprisoned for up to twenty years or both A partnership or a corporation may be fined up to 25 million For a defendant to be convicted in a criminal prosecution under the securities laws there can be no reasonable doubt that the defendant knew they were acting wrongfully d The SEC can bring a civil action against anyone who purchases or sells a security while in the possession of material nonpublic information in violation of the 1934 act or SEC rules 4 State Securities Laws A Today every state has its own corporate securities laws blue sky laws that regulate the offer and sale of securities within its borders Article 8 of the Uniform Commercial Code also imposes various requirements relating to the purchase and sale of securities B State laws typically have disclosure requirements and antifraud provisions State laws also provide for the registration of securities offered or issued for sale within the state and impose disclosure requirements C State securities laws apply mainly to intrastate transactions Issuers must comply with both federal and state securities laws and exemptions from federal law are not exemptions from state laws The SEC has exclusive power to regulate most national securities activities today 5 Corporate Governance A Corporate governance can be narrowly defined as the relationship between a corporation and its shareholders Defined more broadly corporate governance specifies the rights and responsibilities among different corporate participants and spells out the rules and procedures for making decisions on corporate affairs Effective corporate governance B Some corporations have sought to alight the financial interests of their officers with those of the company s shareholders by providing the officers with stock options which enable them to purchase shares of the corporation s stock at a set price Although stock options theoretically can motivate officers to protect shareholder interests stock option plans have sometimes become a way for officers to take advantage of shareholders C Corporate governance involves the audited reporting of financial conditions at the corporation so that managers can be evaluated and legal protections for shareholders so that violators of the law who attempt to take advantage of Chapter 28 Investor Protection and Corporate Governance shareholders can be punished for misbehavior and victims can recover damages for any associated losses a Effective corporate governance can have considerable practical significance Corporations with better corporate governance and greater accountability to investors may also have a higher valuation than a corporation that is less concerned about governance b State corporation statutes set up the legal framework for corporate governance The most important structure is the board of directors because the board makes the major decisions about the future of the corporation 0 Under corporate law a corporation must have a board of directors elected by the shareholders Directors are responsible for ensuring that the corporation s officers are operating wisely and in the exclusive interest of shareholders Shareholders would monitor the directors supervision of the officers but it can be difficult to hold them responsible for corporate failings d An important committee of the board of directors is the compensation committee which determines the compensation to be paid to the company s officers The committee must assess the officers performance and design a compensation system that will best align the officers interests with those of the shareholders D Congress passed the SarbanesOxley Act in 2002 in an attempt to increase corporate accountability by imposing strict disclosure requirements and harsh penalties for violations of security laws It requires chief corporate executives to take personal responsibility for the accuracy of financial statements and reports that are filed with the SEC a The act also introduced direct federal corporate governance requirements for public companies The requirements deal with independent monitoring of company officers by both the board of directors and auditors b Public companies with a market capitalization of less than 75 million no longer need to have an auditor report on management assessment of internal controls 0 Section 906 of the SarbanesOxley Act requires that chief executive officers and chief financial officers certify the accuracy of the information in the corporate financial statements This makes officers directly accountable for the accuracy of their financial report and precludes any ignorance defense if shortcomings are later discovered 6 Online Securities Fraud A The SEC has brought a variety of Internetrelated fraud cases and regularly issues interpretive releases to explain how securities laws apply in the online environment Chapter 28 Investor Protection and Corporate Governance B The Internet has created a new vehicle for criminals to use to commit fraud and provided them with new ways of targeting innocent investors a There are countless variations of investment scams but they almost always promise spectacular returns for small investments Investment seams are simply the electronic version of pyramid schemes in which the participants attempt to profit solely by recruiting new participants b Hundreds of online investment newsletters provide free information on stocks which can help investors gather valuable information but some online newsletters are used for fraud C The SEC has filed an increasing number of enforcement actions against perpetrators of Ponzi schemes a Ponzi schemes sometimes target US residents and convince them to invest in offshore companies or banks b Another type of online fraud scheme offers riskfree or lowrisk investments to lure investors
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