Business Organizations

Three ways that a business can obtain financing

1. Borrow = obtaining liability

2. Generating profit

3. Equity investors

   1. Residual claimant

   2. Fixed claimant

Difference between a residual claimant and a fixed claimant

Fixed claimant: entitled to the return of their loan with interest (creditor)

Residual claimant: entitled to everything left over after paying creditors (equity investor)

Limited Liability

An owner’s liability is limited to the amount paid for his ownership interest in the business. If they cannot pay their debts, creditors bear the loss.

Tax Planning

The selection of a business form in order to take advantage of a difference in taxation.

Double Taxation vs. Pass-Through Taxation

Double Taxation - taxed at the corporate level and the personal level

Pass-Through Taxation - taxed only at the personal level

Agency Costs

The risk that investors’ funds will be used for purposes other than those that further the interests of the investors

General Partnership

An association of two or more persons to carry on as co-owners in a for-profit business

General Partnership - Pros and Cons

Pros

1. does not require filing with the state

2. all partners have the right to participate in the management of the business

3. relatively easy exit

4. Structural flexibility

5. Pass-through taxation

Cons

1. Restricted transferability of ownership interests

2. personal liability

Features of the Corporation

Business structure in which the legal entity is distinct from its owner

• Requires filing with the state (articles of incorporation

• Shareholders have no legal right to participate in the management of the business

• Shareholders elect a board of directors

• Double taxation

• Limited liability

• Ownership interests are freely transferable

Limited Partnership

Requires a filing with the state (unlike general partnerships) and is comprised of both limited and general partners

Limited partners: passive investors with limited liability (may be forfeited if they participate in the management of the company)

General partners: Managers of the company with personal liability

Limited Liability Partnership (LLP)

Requires a filing with the state; distinct from LP’s because all partners (no general partners) have limited liability for the partnership’s tort and contract obligations

Limited Liability Corporations (LLC)

Preferred business structure - combination of most attractive features of corporation and partnership form (restricted exit rights, structural flexibility, pass-through taxation)

Agency

The fiduciary relationship that results from…

1. Consent: Manifestation of consent by one person to another that…

2. Action: The other shall act on his behalf and…

3. Control: Be subject to his control and consent by the other so to act

If these elements are met, the principal is liable for the agent’s actions. It does not depend on the intent of the parties.

Common law applies unless displaced by statute.

What are the factors for determining whether someone is a servant or an independent contractor?

Restatement 2d of Agency §220

1. Extent of control the master exercises over the details of the work

2. Whether the one employed is engaged in a distinct occupation or business

3. Skill required in the occupation

4. Which party supplies the tools and place of work

5. Length of time for which the person is employed

6. Whether the work is a part of the regular business of the employer

7. Whether the parties believe they are creating a master-servant relationship

Duties of the principal and agent to each other

1. Agents are to act only as authorized by the principal

2. Agent owe fiduciary duties to the principal

   1. Duty of care

   2. Duty of loyalty

   3. Duty to disclose relevant information 

3. Principals do not owe fiduciary duties to agents

Principal-Agent Relationship in Tort Liability

A master is liable for torts committed by a servant within the scope of employment.

A master is not liable for torts committed by an independent contractor. BUT, an IC can also be an agent.

Three Types of Principals

Determined by third party’s awareness at the time of the transaction

1. Disclosed: Notice of principal and principal’s identity

2. Partially Disclosed: Notice that there is or may be a principal

3. Undisclosed: No notice that there is a principal

Four Ways Agents Can Bind Principal

1. Actual authority (express or implied)

2. Apparent authority

3. Inherent authority

4. Ratification

Principal-Agent Liability: Actual Authority

The manifestation of a principal to an agent that the agent has the power to deal with others as a representative of the principal. It can be express or implied.

Incidental authority: Authority to do incidental acts related to the authorized transaction.

Liability applies even if the principal is undisclosed.

Principal-Agent liability: Apparent Authority

The manifestation of a principal to a third party that another person is authorized to act as an agent for the principal. This can be created through a combination of the position/title given to the agent and prior dealings with the third party.

If there is apparent authority → liability against the principal to the third party BUT ALSO

If the agent acted outside the scope of his authority → liability against the agent to the principal

Principal-Agent Liability: Inherent Authority

Where an agent acts on behalf of an undisclosed principal - very rare

Principal-Agent Liability: Ratification

The affirmance by a person of a prior act which did not bind him but which was done on his behalf whereby the act is given effect as if originally authorized by him.

The principal will be liable if the agent acts on the principals’s behalf and the principal either expressly or impliedly ratifies the agents act.

If, at the time of ratification, the principal is unaware of his ignorance of important facts to the transaction, they can avoid the ratification.

Effect of Termination on Agent’s Authority

This eliminates their actual authority. However, they may still have apparent authority.

Third Party Liability to Principal

The third party will be liable to the principal if the agent acted with actual authority, apparent authority, inherent authority, or ratification.

Exceptions

1. When the agent of an undisclosed principal falsely represents that he is not acting for a principal, the third party can avoid the contract if the principal or the agent had notice that the party would not have dealt with the principal.

2. An undisclosed principal cannot bind a third party to a contract if the principal’s role in the contract substantially changes the third party’s rights or obligations.

Liability of the agent to the third party

1. Disclosed principal —> No liability

2. Partially disclosed or undisclosed —> Liability

3. If an agent purports to act on behalf of a principal but lacks the power to bind the principal, the agent will be liable, even in a disclosed principal situation.

Definition/Formation of General Partnership

UPA §6: A partnership is an association of two or more persons to carry on as co-owners a business for profit.

RUPA (2013) - §202(a): The association of two or more persons to carry on as co-owners a business for profit forms a partnership whether or not the persons intend to form a partnership.

Why would individuals create general partnerships if it opens them up to personal liability?

• Other types of business organizations…

  • Take significant time to set up

  • Require public filing

• This creates significant red tape and slows momentum for the venture

  • Parties start to get lawyers to minimize their risk

• General Partnership = Calculated decision

  • Recognizes the risk, but there is also risk involved with going too slow

Determining whether someone is a partner - Relevant statutes and case law

Relevant Statutes

RUPA (2013) - §202(c)(3): A person who receives a share of the profits of a business is presumed (rebuttable presumption) to be a partner in the business unless the payment was received in payment…

1. (i) Of a debt by installment or otherwise

2. (ii) For services as independent contractor or of wages or other compensation to an employee

3. (v) of interest or other charge on a loan - prevents lending arrangements from being seen as partnerships and precludes lenders from liability if the partnership becomes insolvent.

UPA §7(4)(a)(b)(e): Substantially similar

Note: There are other exceptions that Parikh called “not relevant”.

Case Law: These cases relate to whether or not a lender (Martin) or an employee (Simpson) should be designated as a partner.

Martin v. Peyton (Application of Traditional Test): There must be profit-sharing + (1) none of the elements in relevant statutes above ((a-e) (i-vi)); (2) intent to create partnership; or (3) retention of the power of affirmative control over the enterprise by the party.

Simpson v. EY (Application of Economic Reality Test ← Qualitative approach): Factors considered…

1. Sharing the firm’s net profits; 

2. Joint liability for partnership debts and obligations; 

3. Partners receive a share of profits after all liabilities are satisfied; 4. Partnership must indemnify the partner; 

5. Partners have equal rights in the management and conduct of partnership business; 

6. No person may become a member of the partnership without the consent of all partners; 

7. Every partner must have access to and may inspect and copy and of the partnership records; 

8. A partner has a duty to render, on demand, all information affecting the partnership; 

9. Partners owe fiduciary duties to one another; 

10. With certain exceptions, partners have a right to participating in the management of the partnership; 

11. The right of a partner to be a co-owner of partnership property. 12. The extent of the individual’s ability to control and operate the business; 

13. The extent to which the individual’s compensation was calculated as a percentage of the firm’s profits; and 

14. The extent of the claimant’s employment security.

Can parties contract around the UPA? RUPA? RUPA (2013)?

RUPA (1997) §103(b) & RUPA (2013) §105(c)(3) - list of items that cannot be modified - includes right to inspect partnership’s books and records

UPA has no analogus provision - many provisions include phrase “unless otherwise agreed”

Entity vs. Aggregate View of Partnerships

Two effects of entity vs. aggregate view:

1. Whether the departure of a partner dissolves the partnership

2. Whether a plaintiff can sue the partnership or must name the individual partners

UPA: aggregate view - partnership is the aggregation of the partners.

RUPA (1997) §201(a): entity view - partnership is a distinct entity separate from the partners.

Partnership by Estoppel: Private Representation

Reliance required under both the UPA and the RUPA

UPA §16(1): “When a person, by words spoken or written or by conduct, represents himself, or consents to another representing him to any one, as a partner in an existing partnership or with one or more persons not actual partners, he is liable to any such person to whom such representation has been made who has…

(i) on the faith of such representation

(ii) given credit to the actual or apparent partnership

RUPA (1997 & 2013) - §308: Substantially similar

Partnership by Estoppel: Public Representation

Reliance not required under the UPA but required under the RUPA

UPA §16(1): “If he has made such representation or consented to its being made in a public manner he is liable to such person, whether the representation has or has not been made or communicated to such person so giving credit by or with the knowledge of the apparent partner making the representation or consenting to its being made.

RUPA (1997 & 2013) - §308: If the representation, either by the purported or by a person with the purported partner’s consent, is made in a public manner, the purported partner is liable to a person who relies upon the purported partnership even if the purported partner is not aware of being held out as a partner to the claimant.

Actual Authority Provisions

ordinary course of business → majority vote (UPA/RUPA)

outside ordinary course of business → silent (UPA); unanimity (RUPA)

contravention of the agreement → unanimity (UPA)

amendment to the agreement → unanimity (RUPA)

UPA §18(h): Any difference arising as to ordinary matters connected with the partnership business may be decided by a majority of the partners; but no contravention of any agreement between the partners may be done without the consent of all the partners.

RUPA (1997) - §401(j): A difference arising as to a matter in the ordinary course of business of a partnership may be decided by a majority of the partners. An act outside the ordinary course of business of a partnership and an amendment to the partnership agreement may be undertaken only with the consent of all of the partners.

RUPA (2013) - same as 1997 version

Why do governing authorities draft unanimity provisions?

Such provisions are very unattractive to business people. This is a signal to practitioners to contract around the default rule.

What factors determine whether something is an extraordinary matter for purposes of actual authority?

• Frequency (counter-example: regularly-scheduled maintenance - may happen infrequently but not extraordinary)

• Cost

• Fundamental to the company - selling assets or selling the company

Partnership - Apparent Authority Provisions

A partner acting in the ordinary course of business binds the partnership unless the partner lacked actual authority and apparent authority.

UPA §9(1): Every partner is an agent of the partnership for the purpose of the business, and the act of every partner, including the execution in the partnership name of any instrument, for apparently carrying on in the usual way the business of the partnership, unless the partner so acting has in fact no authority to act for the partnership in the particular matter, and the person with whom he is dealing has knowledge of the fact that he has no such authority.

RUPA (1997 & 2013) - §301(1): Each partner is an agent of the partnership for the purpose of the business. An act of a partner, including the execution of an instrument in the partnership name, for apparently carrying on in the ordinary course the partnership business or business of kind carried on by the partnership binds the partnership, unless the partner had no authority to act for the partnership in the particular matter, and the person with whom the partner was dealing knew or had received a notification that the partner lacked authority.

What are the two sources of actual authority in a partnership?

Explicit provision in the partnership agreement or a longstanding course of performance

How does a partner effectively separate from the partnership and cut off his/her future liability?

RUPA Section 601 provides that a partner can disassociate under Section 601(1) by express will. By doing so the partner will not be liable for partnership obligations incurred after dissociation, except as provided in Section 703(b) (which protects certain creditors who did not receive notice of the disassociation). To address this exception, the partners should give notice of dissociation to any known creditors and file a statement of dissociation (see Section 704).

UPA: Substantially similar

Partnership - Winding Up and Order of Payment

Different language but same effect in UPA §40(b)(1-4) and RUPA (1997) §807 and RUPA (2013) §806

1. Non-partner creditors

2. Partner creditors

3. Partners - capital invested

4. Partners - profits

Difference is that in the RUPA, the partner creditors are technically considered part of the same class as the non-partner creditors. However, if there is not enough money to compensate all the creditors, the partner creditors’ interests are subordinated.

Partners’ Liability to Creditors in the Event of Partnership’s Insolvency: Partners are held jointly and severally liable for the debts of the partnership. Creditors can sue any or all of the partners in their personal capacity to recover their debts.

Partner’s Liability to Other Partners: Partners subject to a judgment from unpaid creditors can seek reimbursement after the fact from other partners in their personal capacity. Partner-creditors (just like other creditors) can also sue partners in their personal capacity.

Is a partner’s estate liable for a deceased partner’s liabilities?

UPA §40(g) - Yes

RUPA (1997) §807(e) - Yes

RUPA (2013) §806 - No

Partnership - Sharing Profits and Losses

UPA §18: Partners must contribute toward the losses of the partnership according to their share in the profits

RUPA (1997) - §401: Substantially the same

RUPA (2013) - Substantially the same

Problem with Default Provision - Capital-contributing Partner + Labor-contributing Partner

tThe default rules of the above sections (UPA and RUPA) would require the labor partner to reimburse the capital partner in the event of a loss even though they have already suffered by their labor not being rewarded… seems unfair.

The default rules are meant to act as a signal here to the parties to contract around them because the courts are not well positioned to determine the fair value of the labor. 

Partnership - Liability to Third Parties

Liability in this context assumes that the partner is acting in the ordinary course of business (Roach v. Mead) or with the authority of the partnership

UPA §13-15: Joint liability for contract claims; Joint and several liability for tort claims.

RUPA (1997) §305-306: Joint and several liability for tort and contract claims.

RUPA (2013: §305: Substantially similar

Principles Understood in UPA - Made Explicit in RUPA

1. No retroactive liability for partners who join the partnership after its formation - RUPA §306(b)

2. Exhaustion requirement - RUPA 307

Exhaustion Requirement: This default rule requires that creditors with a judgment against a partnership must show that the partnership is unable to satisfy the judgment before they can proceed against an individual partner. Many lenders contract around the exhaustion requirement by requiring a personal guaranty.

Partnership - Contribution & Indemnification

UPA §18(b) + RUPA (1997) §401(c)

Contribution: partner’s obligation to cover the unpaid obligations of the partnership

Indemnification: partnership’s obligation to reimburse a partner for expenses incurred by a partner in the ordinary course of partnership business. If the partnership is insolvent, then the partners can demand that the other partners pay their proportionate share of the obligation.

Partnership - Fiduciary Duties Provisions

UPA §21(1): This is essentially an anti-theft provision. It does not include the duties of loyalty or care. However, the common law has evolved in such a way that, even in UPA states, these fiduciary duties are recognized.

RUPA (1997) §404: This limited fiduciary duties to only including the duty of loyalty (§404(b)) and the duty of care (§404(c)) and limited the scope of these duties to only what was explicitly stated in the statute.

RUPA (2013) §409: This relaxed the limitations on the scope of fiduciary duties both in regards to the duty of loyalty (§409(b)) and the duty of care (§409(c)). Statutes are substantially similar other than the removal of the limiting language.

What constitutes breach of the duty of loyalty? - RUPA (1997 + 2013)

1. Stealing from the partnership

2. Acting as or on behalf of a party having an interest adverse to the partnership

3. Competing with the partnership 

What Constitutes breach of duty of care? - RUPA (1997 + 2013)

1. Engaging in grossly negligent or reckless conduct, intentional misconduct, or a knowing violation of the law

What has been the evolution of the duty of loyalty over time? (Meinhard v. Salmon → Present)

Meinhard v. Salmon: Justice Cardozo believed that partners held the finest loyalty to one another. This is clearly not the case today.

Partnership - The Duty of Good Faith and Fair Dealing

RUPA (1997 & 2013) §404(d) - Partners have an obligation of good faith and fair dealing in discharging their duties to the partnership.

Example in Page v. Page: At-will partnership - partner has the right to leave at any time. However, if it is shown that he is leaving in order to dissolve the partnership and subsequently take over the company and reap the profits for himself, this is a violation of the obligation of good faith and fair duty. TLDR: The what (leaving the partnership) is your right, but the why (to keep all the profits for yourself) is impermissible.

Subjective Component → Good faith - What public policy effect will this have? Do we want to allow this in any industry?

Objective Component → Fair Dealing - How does the industry in question affect what fair dealing is?

Partnerships cannot eliminate this duty, but they can set a standard for how courts will determine whether a violation has taken place - Example: Breach is limited to a violation of the law - not what we typically think of as a violation of good faith and fair dealing.

Not a fiduciary duty - “ancillary obligation that applies whenever a party discharges or exercises a right under the partnership agreement”

Partnership - The Elimination or Alteration of Fiduciary Duties

2013 version gives more flexibility to partners to change the fiduciary duties that will govern the partnership.

RUPA (1997) - §103(b)(3)(i)(ii): The partnership agreement may not eliminate the duty of loyalty but they may identify specific types or categories of activities that do not violate the duty of loyalty if not manifestly unreasonable.

RUPA (2013) - §105(c)(5); (d)(3): The partnership agreement may not eliminate the duty of loyalty or the duty of care except as otherwise provided in subsection (d) → If not manifestly unreasonable they may…

• (A) alter or eliminate the aspects of the duty of loyalty stated in §409(b)

• (B) identify specific types or categories of activities that do not violate the duty of loyalty

• (C) alter the duty of care, but may not authorize conduct involving bad faith, willful or intentional misconduct, or the knowing violation of the law

• (D) alter or eliminate any other fiduciary duty

RUPA (2013) - §105(e): The court can only invalidate a provision in the partnership agreement if, in light of the purposes and business of the partnership, it is readily apparent that

• (A) the objective of the term is unreasonable OR

• (B) the term is an unreasonable means to achieve the term’s objective

Partnership - Non-fiduciary Duty - Duty to Render Information

UPA §20: Partners shall render on demand true and full information of all things affecting the partnership to any partner…

RUPA (1997) - §403: Each partner and the partnership shall furnish to the partner… (1) without demand, any information concerning the partnership’s business and affairs reasonably required for the proper exercise of the partner’s rights and duties under the partnership agreement or this act and (2) on demand any other information concerning the partnership’s business and affairs, except to the extent the demand or the information demanded is unreasonable or otherwise improper under the circumstances.

Unfinished Business Doctrine

The question is whether, when a partner leaves and brings clients with them, if the old firm is entitled to some of the future profits from that client.

Neither Fiduciary duties nor other provisions provide protection for the firm against such practices by partners. Therefore, firms generally implement provisions in the partnership agreement to compensate themselves when partners leave.

New Guidance for Law Firms - Terms that will minimize departure disputes

1. Uniform Treatment: The partnership agreement should not penalize partners who leave for other, competing law firms, while rewarding those who retire, move in-house, or go to work for the government.

2. Transparency and Clarity: The partnership agreement should have a clear definition of when and how an equity partner’s accrued capital is to be calculated, and a clear, unbiased process for determining whether any changes can be made to that calculation.

3. Reasonable Notice Requirements:  Law firms can have a reasonable notice requirement for departing partners, but no longer than necessary to allow for the windup and transition of client matters.

4. Hard Breaks are Verboten: Law firm must allow departing partners to continue to work on client matters during the transition period and have access to the client materials.

Dissolution - UPA

There is no dissociation under the UPA ← This is a by-product of the aggregate view adopted by the UPA.

UPA §29: Dissolution - The change in the relation of the partners caused by any partner ceasing to be associated with the carrying on … of the business.

Rightful Dissolution - UPA §31(1): Dissolution is caused without violation of the agreement between the partners (a) term ends; (b) partner’s at-will departure; (c) partners vote unanimously to expel a partner in a term partnership; (d) partner is expelled pursuant to provision in partnership agreement

Wrongful Dissolution - UPA §31(2): In contravention of the agreement between the partners, where the circumstances do not permit a dissolution under any other provision of this section, by the express will of any partner at any time. - subject the dissolving partner to damages and other penalties (§38)

Other Causes of Dissolution - UPA §31(3-6): (3) unlawful to carry on business; (4) death of any partner; (5) bankruptcy of partner or partnership; (6) by decree under Section 32

Court-Ordered Dissolution - UPA §32: On application by or for a partner the court shall decree a dissolution whenever… (c) partner’s conduct prejudicially effects carrying on the business; (d) willful breach of the partnership agreement such that it is not reasonably practicable to carry on the business with him; (f) other circumstances renders dissolution equitable

Dissociation and Dissolution - RUPA

RUPA (2013) has substantially similar provisions.

Dissociation - partner leaving the partnership - separation or withdrawal (General partnership is intended to be easy to leave, RUPA allows for this).

Dissolution - liquidation of the partnership assets

Events Causing Dissociation - RUPA (1997) §601(1-7): 

1. at-will departure

2. a dissociation provision in the partnership agreement is triggered

3. partner is expelled pursuant to a partnership agreement

4. partners vote unanimously to expel a partner because

   • (i) it is unlawful to carry on business with the partner OR

   • (ii) partner’s interest in the partnership has been transferred OR

   • (iii) corporate partner is being dissolved OR

   • (iv) corporate partner has been dissolved

5. Court-ordered expulsion because

   • (i) wrongful conduct that adversely or materially affected business OR

   • (ii) material breach of the partnership agreement OR

   • (iii) not reasonably practicable to carry on business with a particular partner

6. partner’s bankruptcy

7. partner’s death or incapacity

Partner Wrongful Dissociation - RUPA (1997) §602(b)(1-2): A partner’s dissociation is wrongful only if

1. it is in breach of an express provision in the partnership agreement; OR

2. for a term partnership

   • (i) partner withdraws by express will (unless the withdrawal occurs shortly after a rainmaker partner’s departure); OR

   • (ii) partner is expelled under 601(5); OR

   • (iii) partner is a debtor in bankruptcy; OR

   • corporate partner willfully dissolves

Partner Dissociation (Buyout) - RUPA (1997) §701(b,e,i): 

(b) Buyout Price: The buyout price … is the amount that would have been distributable to the dissociating partner if the assets were sold either the liquidation value or the value of the business as a going concern.

(e) Negotiation Period: If no agreement is reached the partnership shall pay the amount the partnership estimates to be the buyout price. This creates a one-time “Take it or Leave it” offer to the dissociating partner. If declined, you go to Court. The threat of going to Court acts as an incentive to negotiate in good faith.

(i) Court Assessment: Dissociated partner has the right to request a court of law to determine the appropriate buyout price.

Partnership Dissolution - RUPA (1997) §801 (1-6) - Courts are hesitant to order a dissolution; has to be a compelling reason

1. at-will partnership can be dissolved by express will of dissociated partner who was not dissociated under Section 601(2)-601(10)

2. for term partnership…

   • (i) dissociation of a partner due to death or under sections 601(6) through (10) or wrongful dissociation and a 50% vote of remaining partners; OR

   • (ii) express will of all partners; OR

   • (iii) expiration of the term or project completion - most common basis for dissolution

3. a dissolution provision in the partnership agreement is triggered

4. unlawful to carry on the business

5. dissolution application filed by partner

6. judicial determination that dissolution is equitable

Partnership - Could the partnership agreement eliminate the buyout provision under RUPA?

It is unlikely that buyouts could be eliminated entirely, but the agreement could include a formula that determines the amount of the buyout in such a way that greatly reduces its value.

However, such provisions are uncommon because partners obviously do not want to be beholden to them if they decide to leave one day.

Formation of an LLP

Transition from Partnership to LLP → RUPA (1997) §1001 (a-b): vote to change from Partnership to an LLP = vote necessary to amend the partnership agreement

Requirements of the Statement of Qualification → RUPA (1997) §1001(c):

1. name of the partnership

2. address of the partnership

3. address for the partnership’s agent for service

4. statement that the partnership elects to be a limited liability partnership

5. deferred effective date (if applicable)

Effective Date of an LLP → RUPA (1997) §1001(e): Either the date of the filing or the date of the deferred effective date from §1001(c)(5) - remains effective unless it is canceled or revoked 

Effect of Errors in Statement of Qualification → RUPA (1997) §1001(f): The status is not affected by errors or later changes in the information required to be contained in the statement of qualification.

RUPA (2013) §901 is substantially similar.

LLP - Limited Liability Provision

No Personal Liability: RUPA §306: An obligation of an LLP whether arising under tort, contract, or otherwise is solely the obligation of the partnership. A partner is not personally liable, directly, or indirectly, by way of contribution or otherwise, for such an obligation solely by reason of being or so acting as a partner.

Clarification: This does not protect partners from liability for their own tortious conduct.

Ill-gotten Gain for the Partnership: However, if one partner’s malfeasance resulted in the partnership wrongfully earning money, that money can be clawed back from the partnership. The point is just that the innocent partners are not opened up to personal liability.

Possibility of Vicarious Liability: While the model act clearly does not include vicarious liability, some state statutes do include the possibility of such liability (Kus v. Irving) - “or that of any person under his direct supervision and control."

LLP - Effect of Administrative Revocation: RUPA vs. State Law

RUPA §306(c): An obligation of a partnership during a period when its statement of qualification is administratively revoked will be considered as incurred by an LLP provided the partnership’s status is reinstated within two years under Section 1003(e).

The incentive for states to make it easy for companies to set up their preferred business structure is to reap the financial reward of annual fees. Therefore, if LLP's fail to pay such annual fees, then the state will likely be less forgiving than RUPA regarding the effect of the nonpayment on LLP status.

Biggest Differences Between Partnerships and Closely Held Corporations

• Liability of Partners/Owners: Partners face general liability. Shareholder losses are generally limited to the value of the investment.

• Management: Centralized vs. Diffused

• Transferability of Ownership Interests: It is generally difficult to admit new partners. Shares are freely transferable.

• Tax Status: Partnership is taxed on a “pass-through” basis with each partner taxed on a pro-rata basis, individual taxes based on this allocation. A corporation is taxed as a separate legal person.

Closely-held Corporations

Stock is not freely traded and there are relatively few shareholders - requirements and rights vary by jurisdiction

Ultra Vires

unauthorized; beyond the scope of power allowed or granted by a corporate charter or by law

Shareholder’s Agreement / Pooling Agreement

Contractual agreement by which compote shareholders agree that their shares will be voted as a unit

Promoter

Founder/organizer of a corporation or business venture - one who takes the entrepreneurial initiative in founding or organizing a business or enterprise

Promoter & Pre-Incorporation Activities:

1. Can a corporation become liable on a contract if the corporation did not exist at the time of contracting but did subsequently come into existence? 

2. Is the promoter absolved of liability if the newly created corporation does in fact become liable on the contract? 

In the absence of clear agreement to the contrary, the majority view holds that the non-existent corporation for which the promoter conceivably acted does not automatically assume liability once it comes into existence. The corporation must adopt the contract at issue, either expressly or impliedly.

How do ratification, novation, and adoption affect promoter/organizer liability?

Ratification: A corporation cannot ratify a contract that was entered into prior to its existence. This is because the promoter could not have been acting as an agent of a principal that did not exist.

Novation: The corporation takes liability away from the promoter but only from the date of the novation onward. It is not retroactive. Therefore, if there is a breach before the novation, the promoter is not protected from liability. In addition, the creditor must agree to a novation, which they are unlikely to do.

Adoption: The corporation could adopt the contract. However, this is a less attractive option because this does not negate the promoter’s liability. It just opens the corporation up to liability as well. Therefore, if the corporation is insolvent, this does not help the promoter.

Defective Corporation - Liability for Pre-Incorporation Transactions

Three Types of Defective Corporation under the Common Law (Robertson v. Levy)

1. De Jure Corporation: Substantial compliance but minor deviation from the statutory incorporation; properly recognized by the state - not subject to direct or collateral attack

2. De Facto Corporation: A corporation that has been defectively incorporated and thus is not de jure; not recognized by the state but still a corporation - only a state can bring action

3. Corporation by Estoppel: Arises where one has contracted with an association in a manner that admits its a corporation

Defective Incorporation: MBCA

MBCA § 2.04 - All persons purporting to act as or on behalf of a corporation, knowing there was no incorporation under this Act, are jointly and severally liable for all liabilities created while so acting

Piercing the Corporate Veil

The judicial act of imposing corporate liability on otherwise immune corporate officers, directors, and shareholders for the corporation’s wrongful acts. 

Piercing the Corporate Veil Vocabulary - Capital

1. Money or assets invested or available investment in a business

2. The total assets of a business, especially those that help generate profits

3. The total amount or value of a corporation's stock; corporate equity

Piercing the Corporate Veil Vocabulary - Working Capital

Current assets (cash, inventory, AR) - Current liabilities

Measures liquidity and the ability to discharge short-term obligations

Piercing the Corporate Veil Vocabulary - Capitalization

The total amount of long-term financing used by a business, including stocks, bonds, retained earnings, and other funds - ability to address long-term obligations

Piercing the Corporate Veil Vocabulary - Undercapitalization

The financial condition of a firm that does not have enough capital to carry on as a business

Piercing the Corporate Veil - Three Types of Cases

1. Tort Claims

   • No assumption of risk - question is whether it is reasonable for business to transfer risk to members of the general public by conducting business with an entity that may be marginally financed

2. Contractual Claims

   • Assumption of risk argument - could have contracted around it (provided that if the corporation was insolvent that there would be personal liability against the directors)

3. Cases involving parent and subsidiary entities

Piercing the Corporate Veil - Instances in which Court will pierce the corporate veil

1. There is fraud = independent basis for piercing the corporate veil OR

2. There is a failure to adhere to basic corporate formalities AND Some significant inequity or injustice results

   • extreme detriment realized by failing to adhere to corporate formalities

Piercing the Corporate Veil - Test for Contractual Claims

Woodruff Construction v. KW “Casey” Clark (1981) - Factors for establishing Constructive Fraud

1. Corporation is undercapitalized

2. Nonpayment of dividends

3. Insolvency of the corporation at the time

4. Its finances are not kept separate from individual finances or individual obligations are paid by the corporation

5. Lack of separate books

6. Nonfunctioning of the other officers and directors other than Defendant

7. Corporate formalities aren’t followed

8. The corporation is a mere sham

Piercing the Corporate Veil - Test for Tort Claims

Baatz v. Arrow Bar (1990) - Piercing the corporate veil in tort law

1. Fraudulent representation by corporation directors, undercapitalization

2. Failure to observe corporate formalities

3. Absence of corporate records

4. Payment by the corporation of individual obligations

5. Use of the corporation to promote fraud, injustice, or illegalities

Piercing the Corporate Veil - Test for Parent-Subsidiary Claims

Radaszewski v. Telecom Corp - Test to hold parent liable for subsidiary

1. Control by corporate entity

2. Control was used for some inequitable reason

3. The control was the proximate cause of the inequitable outcome

Successor Liability: Merger vs. Acquisition

Merger - There is no issue in this context. The merged company takes on the liability of each of the previously separate companies.

Acquisition - The general rule is that the acquiring company does not inherit the liability of the target, but this is more complex.

Successor Liability: General Rule + Exceptions

Nissen Corp v. Miller (1991): A corporation that acquires all of part of the assets of another corporation does not acquire the liabilities and debts of the predecessor, unless…

1. There is an express or implied agreement to assume the liberties;

2. The transaction amounts to a consolidation or merger;

3. The successor entity is a mere continuation or reincarnation of the predecessor entity; ← Prevents owner of a failing corporation from simply starting a new corporation and transferring the assets of the failing corporation to the new one

4. The transaction was fraudulent, not made in good faith or made without sufficient consideration

What is the rationale behind the general rule of successor liability?

The general rule of not imposing the liabilities of the target onto the acquirer is to protect the general class of creditors.

If the acquirer knew it would be subject to an uncertain amount of liability from acquiring the target, that uncertainty would act as a huge disincentive to acquire the company. This would make it very difficult for failing companies to sell their assets to other companies.

If the failing company is unable to sell these assets, then many creditors would have no chance of getting the money they are owed.

Known and Unknown Claims and Mass Tort Legislation

Known Claims - MBCA 14.06(c)(d): A claim against a company is barred if…

(i) A claimant who was given written notice does not deliver the claim to the dissolved corporation by the deadline; OR

(ii) A claimant who claim was rejected by the dissolved corporation does not commence a proceeding to enforce the claims within 90 days from the effective date of the rejection notice

(d) Claim ≠ contingent liability or liability based on event happening after effective date of dissolution

*Unknown Claims - MBCA 14.07(b)(d): This allows a company to provide dissolution notice to unknown claimants based on federal bankruptcy law. Thus, an unknown claimant is barred unless they bring a claim within three years of the publication date of the notice.

Determination of the Amount of Money to Set Aside - Court - MBCA §14.08 - This provides for a court proceeding that dictates an amount that a dissolving corporation must set aside to satisfy claims. While this provides certainty that there will not be personal liability for the directors, this causes the directors to lose control of the process and they are bound by what they may see as an excessively high amount.

*not a legitimate option for most companies in the real world because this is based on state law - does not help companies that sell products or do business across the country

Par Value

An arbitrary dollar value assigned to shares of stock - after being assigned, this represents the minimum amount for which each share may initially be sold

Right of Shareholders

MBCA §6.01 - Most of these rights have been eviscerated. The primary right of shareholders is just to reap the reward if the stock price goes up.

Common Stock

A class of stock entitling the holder to vote on corporate matters, to receive dividends after other claims and dividends have been paid and to share in assets upon liquidation

Preferred Stock

A class of stock giving its holder a preferential claim to dividends and to corporate assets upon liquidation but that tends to carry no voting rights

• redemption rights (company has to buy back the shares at a certain price based on some triggering event or at the discretion of the shareholder)

• convertible rights (flip from preferred to common)

• protective provisions

Issuance of Shares

MBCA (2008) - §6.21

(b): The BOD may authorize share to be issued for consideration consisting of any tangible or intangible property or benefit to the corporation. The board’s determination regarding the sufficiency of the consideration is conclusive. Promissory notes, services performed, contracts for services to be performed, or other securities can constitute sufficient consideration.

(e): The corporation may place in escrow shares to be issued for a contract for future services or benefits or a promissory note…

MBCA (1969) - §19: Promissory notes do not constitute sufficient consideration for the issuance of shares.

Debt Financing: Bonds

Bond: An obligation, a promise to repay at some future date. While bonds can be secured, they are generally unsecured.

Corporate Bond: An interest-bearing instrument containing a corporation’s promise to pay a fixed sum of money at some future date. Unsecured bonds command a higher interest rate to compensate the additional risk they are taking on.

Debt Financing: Syndicated Bank Loans (Term and Revolver)

Syndicated Bank Loan: Large corporate loans where a consortium of lenders get together to make a loan to a relatively high-credit borrower. The more parties involved, the more the risk is diffused across the group.

Term Loan = long-term borrowing

Revolver = akin to a credit card

Debt Financing: Leverage

To the extent a business is able to earn more on each dollar invested than the cost of borrowing the dollar, all surplus can be allocated to the equity interests in the corporation. The result is that the earnings per share increase much more rapidly in a leveraged situation than in an unleveraged one as earnings increase.

Debt Financing: Leveraged Buyouts

The primary form of acquisition, especially by private equity companies - akin to house flipping

Steps of a Leveraged Buyout

1. Buyers go to “Senior debt and mezzanine lenders” (banks) and requests large secured loan.

   • The loan is secured by the assets of the target company. This gives the lender an incentive to charge a lower interest rate because if the borrower defaults, they can seize the assets.

2. The target company is actually one that borrows the money. The money goes through the target company and to the shell company. The shell company then uses that money to buy up the outstanding shares.

   • Good for private equity firm: The private equity firm has only put down about 10-20% of the money needed to gain control of the company (hence why it is a “leveraged” buyout).

   • Good for Selling Shareholders: They were likely paid above market value for their shares for a company that very possibly not doing well (making it a target for an LBO)

   • Bad for Target Company?: Instead of the target using the money borrowed, it went through the target to the shell to buy the outstanding shares… but it is still on the hook to pay back the loan.

Potential Upside: If the private equity firm is successful in cleaning up the company (improving cash flows, improve perception of the company), then they can sell in 3-5 years, potentially at a huge profit.

Potential Downside: Most of the time, the target company is insolvent at the time of the buyout. There is a fairly high risk that the company never recovers. Further, the short-term incentives of the private equity firms may not be best for the company in the long-term.

1933 Securities Act + 1934 Securities Act

Intended to protect the general public from insiders exploiting their lack of investment knowledge

1933 Securities Act - Initial disclosure requirement (what are the threats/risks to the company?)

1934 Securities Act - Ongoing disclosure requirement (must continue to disclose information - ex: 10k annual filings)

Initial Public Offering (IPO) - Pros and Cons of Going Public

Pros

1. Capital raised for expansion without relying on bank debt

2. Can offer employees shares

3. Publicly traded shares help lure employees with stock options

4. Publicly traded companies tend to be better known

Cons

1. Must make internal affairs public and face scrutiny

2. Hard to innovate - shareholders’ interests require focus on short-term increase in stock price

3. SEC filing requirements

4. Very expensive and complicated process to go public

Now it is a legitimate option to raise huge sums of money in the private space (investment banks like Goldman Sachs) - Staying private allows companies to avoid the headache of complying with filing requirements and avoids potential liability from statements made by your company’s leaders (Elon Musk and Twitter)

Elon Musk’s - Desire to take Tesla private

Elon arguably recklessly tweeted that he was considering to take Tesla private, which caused many shareholders to rely on his statement. For a publicly held company, statements from executives, board members, your founder, etc. can lead to liability for the company.