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Chapter Overview

13.1 Partnerships • Must Be Association of Two or More

Competent Persons • Must Carry On a Business • Must Be Co-Owners • Must Be for Profit • Partnership by Estoppel • Advantages and Disadvantages of Partnerships • Rights and Obligations of Partners • Dissolution and Termination of Partnerships • Limited Partnerships

13.2 Corporations • Advantages and Disadvantages of Corporations • Who’s Who in Corporations: Incorporators, Promo-

tors, Directors, Officers, and Shareholders

13.3 Limited Liability Companies

13.4 Chapter Summary • Focus on Ethics • Case Study: C&J Builders and Remodelers, LLC v.

Geisenheimer • Case Study: Malone v. Patel • Critical Thinking Questions • Hypothetical Case Problems • Key Terms

13 Learning Objectives

After studying this chapter, you will be able to:

1. Describe the main characteristics of partnerships, corporations, and LLCs.

2. Explain the advantages and disadvantages of the different business forms.

3. Discuss how partnerships operate.

4. Describe the different roles of promoters, directors, shareholders, and officers of corporations.

Business Organizations

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One of the most fundamental decisions all businesspersons face in starting a busi-ness is how that business will be organized. Business owners must carefully weigh a number of different factors. There is no one right form, but the better informed the participants in a business are about the legal consequences of being a sole proprietorship, a partnership, a lim- ited partnership, a corporation, or an LLC, the better off they will be.

The simplest form of business orga- nization is the sole proprietorship, where a single owner owns and oper- ates the business. It has the advan- tage of being very easy, with no for- malities and no expense attached to creation. The disadvantage is that a sole proprietor has limited options for raising capital and no limits on liability for business debts; thus if the business does not fare well, the sole proprietor can face personal bankruptcy.

Beyond the sole proprietorship, there are three basic types of business organizations with which we must become familiar: the partnership, the corporation, and the limited liability company. This chapter will be devoted to exploring the unique qualities of each of these basic forms of business organization.

13.1 Partnerships

A partnership can be defined as an association of two or more competent persons to carry on a business as co-owners for profit. To help understand this definition, we will break it down and look at the individual clauses. Must Be Association of Two or More Competent Persons By competent, the law means that the partners must have contractual capacity (rather than that the people involved are actually good at what they’re doing). In a partnership, each partner is simultaneously both a principal and an agent, thus the requirement makes sense. Minors can be partners, but they can also void partnership agreements (as was dis- cussed in the chapter on contractual capacity). Anyone would therefore be wise to either require emancipation or be cautious about going into partnership with a minor.

Must Carry On a Business Partnership is more than just joint ownership; it must involve enough activity to be con- sidered operating a business. Not all joint investment, even though done with a profit motive, constitutes a partnership.

A sole proprietor is both the owner and manager of her business.

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Example 13.1. Arielle and Bradley both chip in $50,000 and buy Blackacre, a piece of real estate. A year later, they sell Blackacre for $150,000 and split the profit equally. Arielle and Bradley are concurrent owners of Blackacre, but they are unlikely to be deemed a partnership, since they were not car- rying on a business.

To be carrying on a business, Arielle and Bradley would need to be more actively involved in their profit-making venture, rather than just passively holding on to property until they are ready to sell.

Exampe 13.2. Arielle and Bradley, emboldened by their first real estate success, decide to do land speculation full time. They both now put up $100,000 and buy six properties. They fix up the properties and sell them at a profit, and buy six more, reinvesting part of the profit and sharing in the rest equally. Arielle and Bradley are now a partnership; they are clearly carrying on a business.

Must Be Co-Owners Partners are automatically owners and managers of the business, and the law presumes equal rights unless the partners have specified otherwise.

Example 13.3. Ethan, Fabian, and Gina have formed a partnership to do public relations for corporations. Ethan puts in $10,000 in capital, and Fabian and Gina both contribute $5,000 each. Nothing is said about how they will split profits or losses. At the end of their first quarter, the firm has made $12,000 in profit. Ethan thinks that since he put in half the capital,

he should get half the profit, or $6,000. But Ethan should have taken business law! Since noth- ing was specified, he’s only entitled to a one-third share, the same as Fabian and Gina.

If the partners didn’t specify how to share a loss, the law states that they will share in the same percentage they share profits.

Must Be for Profit Note that while there can be unprofit- able partnerships, there is no such thing as a nonprofit partnership. The partners must intend to make a profit.

You will recall from the chapter on agency that agents owe their principals a fiduciary duty. This means that a partner also owes this same duty to the partnership and the other partners (along with the corresponding duty of loyalty, right to indemnification, etc.). Note that partnership law is essentially a combination of agency law and contract law,

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

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with the contract in question being the partnership agreement, whether it is express or implied from the parties’ conduct.

Partnership by Estoppel Don’t be fooled by the name; these are not real partnerships, but a situation in which to protect a third party the law holds people liable as though they had been partners. It is essentially the principle of apparent authority that you learned in agency transplanted to a partnership situation. A partnership by estoppel rests upon a holding out of partnership and reasonable reliance by the third party.

Example 13.4. Michael, who is romantically interested in Lorraine, intro- duces her as his new partner in a computer services firm to a group of cli- ents at a social function. Lorraine, flattered, smiles and goes along with it, although in fact she and Michael have never discussed going into business together. Later Lorraine, who is a recent graduate with a degree in informa- tion technology but no prior work experience in the field, agrees to work as a consultant to a company owned by one of Michael’s clients to oversee the purchase and installation of a new network system. She recommends the purchase and installation of computer equipment that is not well suited to the client’s needs, costing the client millions of dollars to subsequently cor- rect the problem. If the client sues both Lorraine and Michael, both of them will be liable for any judgment against Lorraine if the client can establish that he retained Lorraine in reliance on her being Michael’s partner.

However because there is no real partnership, Lorraine would not be liable for Michael’s business debts to people who had not been at the party and had not heard Michael say she was his partner.

Advantages and Disadvantages of Partnerships One of the advantages of the partnership form of business is that it is simple to create. All that is required is that the parties agree to carry on the business as co-owners for profit. There are no formalities, such as filing with the state. Another advantage is taxa- tion: the individual partners will be taxed on their earnings, but the business itself will not (although it must file an informational return). There is no requirement of a written agreement, although it is a very good idea, and will avoid a lot of headaches in most cases.

Example 13.5. Carla and Daniel have never discussed being partners, but they both put in cash to buy cans of soda at a discount store, along with coolers and bags of ice. They each mount a cooler on a bicycle, and sells cans of soda at a considerable markup at different locations around town. At the end of the day, they meet up and divide the profits equally. Carla and Daniel may not realize it, but they are partners.

The downside of a partnership is liability. Because each partner is an agent of the partner- ship and the other partners, he or she has the power to bind the partnership and the other partner to transactions within the scope of the partnership business. All partners have full, personal liability for these partnership obligations.

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Example 13.6. While pedaling around town selling soda, Daniel sees that Bigbox store is having a sale on crates of soda. He contracts to buy a dozen crates for $120. Since Daniel would have either apparent or implied author- ity to buy the soda for the partnership, Carla is equally bound by this debt. If Daniel doesn’t pay the bill, Bigbox could collect the full amount from Carla personally.

Example 13.7. Meanwhile, on her way to her next location, Carla negli- gently runs over Peter. Since this is a tort within the scope of the partner- ship business, Peter could hold Daniel liable.

Liability is joint and several with those of the other partners, which means that partners may be sued together or separately for the full amount of the debt. Thus if Carla now wins $10,000 in the lottery, the partnership creditor might collect the entire amount from her (although they must first attempt to satisfy the debt from partnership assets). If creditors collect the entire debt from a single partner, that partner will be able to seek indemnifica- tion from his copartners for their equitable share of the debt. But note that if Daniel is a deadbeat with no assets to speak of, it is Carla who (literally) will pay the price, not the plaintiffs Peter or Bigbox. As a practical matter, any partnership should consider business insurance, and look carefully at its coverage. This will help to alleviate some, but not all, of the liability concerns associated with partnerships.

Rights and Obligations of Partners Remember, partners are fiduciaries, and this is probably the most important duty they have to each other and the partnership. However, there are some other rights and duties provided in partnership law.

All partners have the right to participate in managing the partnership, and unless other- wise specified, majority vote will govern partnership decisions.

Example 13.8. Back to Ethan, Fabian, and Gina, who have formed a part- nership to do public relations. Ethan puts in $10,000 in capital, and Fabian and Gina contribute $5,000 each. Fabian now proposes that they should contract with Anna, a freelance artist, for some designs for brochures. Gina thinks this is a good idea, but Ethan says that because he put more money in, he has the right to veto the contract. Ethan, who obviously should have taken business law, is wrong. His two partners can approve a contract with Anna over his objection.

When it comes to partnership property, all partners own the property as tenants in part- nership, and have a right to use the property for partnership purposes and no other purpose without full consent and disclosure from other partners. If a partner dies or otherwise leaves the partnership, the remaining partners own the property. But if the partnership terminates, the property is sold and the assets distributed, first to creditors and then to the partners.

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Example 13.9. The PR partnership owns a van that they use for travel to trade shows and conferences. Fabian wants to take the van on a weekend camping trip. Can he do so?

The answer is no, because this would not serve the purpose of the partnership (unless Ethan and Gina are fully aware of the circumstances and choose to give their consent).

Example 13.10. Fabian dies in a motorcycle accident. The van still belongs to the remaining partners, and Fabian’s estate or heirs have no rights to it specifically, although they have a right to be paid Fabian’s share in the partnership, as the next example illustrates.

Example 13.11. After Fabian’s death, Ethan and Gina decide to wind up the partnership. The van will be sold along with the other partnership prop- erty. Once the assets are liquidated, the partnership will pay off its outside creditors, then repay any loans partners made to the business, then repay partners’ capital contributions, then distribute profits. Fabian’s estate or heirs are entitled to what would have been his share, if he had lived and the partnership had terminated.

Partnership does require unanimous consent of all partners for some types of transactions to bind the partnership. If partners’ interest will be changed, or if the partnership is to engage in a new kind of business, there must be unanimous agreement.

Example 13.12. Heinrich, Ileana, and Jessica enter into a partnership to operate a pizza parlor. After three years, Ileana wants to add new menu items that are lower in calories and carbs. Jessica thinks it’s a good idea, but Heinrich objects. Since this is a normal business decision, not entering into a new business, Ileana and Jessica can change the menu.

Example 13.13. Heinrich now proposes adding a massage parlor in the basement (so customers have something to do while they wait for their pizza). Ileana says she’s okay with it, but Jessica objects. No massage par- lor, since this is a different line of business and requires unanimous consent.

Example 13.14. Ileana thinks the business should expand, and proposes bringing Kevin in as a partner. Heinrich votes no, but Jessica says yes to Kevin. Kevin is not a partner, as this would be creating a new partnership and all must consent.

Dissolution and Termination of Partnerships A partnership dissolves whenever there is a change in membership, but it may or may not terminate (which means it is going to wind up its affairs and cease to exist). Traditionally in the law there was a presumption that a dissolution would lead to termination, which

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made partnerships a somewhat precarious proposition, as any partner could decide to leave and force liquidation. The modern trend has favored letting the remaining partners continue to operate the business, as long as they can pay the leaving partner his propor- tionate share.

Example 13.15. Heinrich, Ileana, and Jessica are partners operating Pizza Palace. Heinrich is now tired of pizza and wants to try something new. Under the old rule, Heinrich could force Ileana and Jessica to liquidate Pizza Palace. Under the modern rule, if they can come up with the money to pay him his share of profits and surplus, they can continue to run Pizza Palace as a new partnership.

Partnerships dissolve both by act of the parties and by operation of law, in a fashion very similar to agencies.

Example 13.16. Suppose in the above example, Heinrich is dissolving in the second year of a five-year partnership agreement. Although he has the power to dissolve, he does not have the right, and his former partners can hold him liable for any damages. If, for example, Jessica and Ileana have to hire someone to take over Heinrich’s workload, they could deduct the new employee’s wages from Heinrich’s share of the business.

Limited Partnerships Unlike a general partnership, the limited partnership did not exist at common law. It is a creature of statute that owes its existence to legislation in the states that specifically allow it as a form of business organization. The main difference between general and limited partnerships is that a limited partnership makes it possible for individuals to invest in a partnership and retain limited liability for partnership losses to the extent of the amount

invested in the partnership. Like a gen- eral partnership, a limited partnership requires an agreement by two or more people to enter into a business for profit as joint owners. Some of the salient features of a limited partnership are as follows:

1. The partnership must contain at least one general partner with unlimited liability;

2. The partnership must be entered into pursuant to a written agreement as specified by statute;

3. The limited partnership agreement must be filed with the appropriate state agency (usually the secretary of state); and

4. Limited partners cannot be involved in the running of the business, but must merely be investors who share in its profits and losses to the extent of their investment.

For years, law firms traditionally operated as partnerships. More recently, some have elected to become LLCs.

Tim Barker/Associated Press

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If a limited partner becomes involved in the day-to-day operation of the business or has a voice in its management, he becomes liable as if he was a general partner and loses the protection of the limited liability offered by the limited partner status.

Example 13.17. Arielle’s Antiques is organized as a limited partnership, with Arielle as general partner and Fred as limited partner. Arielle contrib- utes $5,000 in start-up capital, and Fred puts in $20,000 in exchange for a 25 percent share of the profits. Arielle manages the business, works in the store, and supervises all employees. Fred is not actively involved in the business. Arielle fails to pay rent for the store, and the landlord sues. While Arielle is potentially personally liable, Fred is not. He stands to lose his capital contribution and share of undistributed profits to business credi- tors, but his personal assets such as his personal bank account and his car are not at risk.

Example 13.18. Arielle becomes ill and can’t work at the store for two months. Fred steps up and takes over, managing the business. Now Fred is personally liable for business debts, because he is acting like a general partner. The partnership could have hired an employee to fill in for Arielle, which would have allowed Fred to retain his limited partner status.

Limited partnerships are somewhat more stable than general partnerships, and do not automatically dissolve with changes in membership, as long as there is always at least one general and at least one limited partner.

13.2 Corporations

Like limited partnerships, the corporation did not exist at common law; it is a form of business organization that owes its existence to statutes in all states that provide guidelines for its creation and management. Unlike a partnership, the corporation is a legal entity in the eyes of the law—an artificial person that enjoys an existence apart from the individuals who own or manage it. As an entity, a corporation enjoys most of the privileges and shares in most of the responsibilities of natural persons: it can avail itself of most constitutional protections offered to natural persons and can own property in its own name, but it must also pay taxes (albeit at a lower rate than natural persons) and is subject to civil and some criminal penalties for acts it performs through its agents.

The corporation is governed primarily by the statutory guidelines of the state statute that provides for its creation. The requirements for the creation and management of a corpo- ration vary somewhat between the states, but as is usually the case, there are common threads that can be found in the corporate statutes of all states.

Advantages and Disadvantages of Corporations As noted, the corporation is legally a person, which makes it unlike a sole proprietorship (which does not exist outside of the person who owns the business), a partnership, or a limited partnership. As already mentioned , the corporation as its own person is entitled to many constitutional rights, but it cannot claim the privilege against self-incrimination

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under the Fifth Amendment (since it lacks a body to take the witness stand and a mouth to make statements with). Likewise, a person is not necessarily a citizen, and so a corpora- tion is also not entitled to vote and does not have other rights given to citizens.

Limited liability of the shareholders (who are essentially the owners) makes corporations an attractive alternative in some cases to partnerships. While the corporation itself is liable for its debts, shareholders’ personal assets are not at risk.

Example 13.19. Pizza Palace Inc. is a corporation with ten shareholders, including Danielle. A Pizza Palace delivery driver negligently runs over Tiffany, who sues the corporation and obtains a judgment of $100,000. Although Danielle’s stock holdings in Pizza Palace may be affected, she has no personal liability for the debt incurred by the operations of the company.

In order for a corporation to offer its shareholders the protection of limited liability, it must be run in accordance with the requirements under a state’s business corporation law. If the corporate form of business organization is used to defraud creditors, stockholders will lose the protection of limited liability and will be held personally liable for all debts of the corporation. Likewise stockholders can be subject to unlimited personal liability if a corporation is set up merely to insulate its owners from unlimited liability but is run as a partnership or sole proprietorship. When this is the case, courts can “pierce the corporate veil” of dummy corporations to find its owners personally liable for its debts.

Example 13.20. Barney, a contractor, sets up Gorgeous Homes, Inc., a cor- poration involved in the home remodeling business. Barney is the corpora- tion’s sole stockholder and president. He and his wife serve on the board of directors, and his wife is the corporation’s secretary. Barney and his wife never hold stockholders’ or board of directors’ meetings. All profits from the corporation go into Barney’s personal bank account, held jointly with his wife. Payments for corporate debts are made from the couple’s joint checking account.

Under the above facts, Gorgeous Homes, Inc. is basically being used to defraud credi- tors. It really has no separate existence from Barney himself. If the corporation is sued for breach of contract or a tort, a court would pierce the corporate veil and ignore the exis- tence of the corporation to hold Barney personally liable for all corporate debts.

Another advantage of the corporate form of business is potentially perpetual existence. We have already seen that partnerships are somewhat unstable: a partner can leave at any time and cause major disruption, or even termination, of the partnership. But corpora- tions can live forever, even though the management and the shareholders change with the passing years.

Formation of a corporation, however, may be considered a disadvantage, since it requires filing fairly complicated documents with the state (as well as annual reports after the corporation is created) and paying a registration fee, which can make it a costly process.

Double taxation is also one of the disadvantages of the corporate form. The corporation itself is taxed on its earnings, and the shareholders are also taxed when they receive

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dividends or sell shares at a profit. A type of corporation that avoids the double taxa- tion is the Subchapter S corporation, which has “flow through” taxation, meaning that only the shareholders are taxed on their earnings. However, there are a number of specific qualifications that must be met for S status, such as having no more than 100 stockholders, and restrictions on how corporate income is earned and types of share- holders, which mean that these corporations will be primarily smaller businesses.

Who’s Who in Corporations: Incorporators, Promotors, Directors, Officers, and Shareholders Incorporators are probably the least important people involved in corporations, since their main role is to sign the articles of incorporation (the documents submitted to the state) and they may never be heard from again. While incorporators may be people actively involved in setting up the business, they can just as easily be the secretary or paralegal who works in the law office where the papers are drawn up.

Promoters, on the other hand, are the motivating force behind creation of a corporation. It is the promoters who organize on behalf of the corporation-to-be, securing financing by making subscription contracts (agreements to buy stock) with prospective stockhold- ers, and making any arrangements necessary for the corporation to do business once it is granted life by the state (by securing its certificate of incorporation). Being a promoter is a risky business, as they are generally personally liable for preincorporation contracts unless they secure a release or waiver of some type from the other party.

Example 13.21. Peter is a promoter for the yet-to-be-formed Alpha Inc. Peter contracts for retail space for Alpha with Lisa Landlord, signing the lease “Peter, agent for Alpha Inc.” However since Alpha does not yet exist, Peter cannot in fact be its agent, and so he will be personally liable to Lisa on the contract.

The corporation only becomes liable if it adopts the contract, either by express action, such as the board of directors approving the lease, or by implied action, such as Alpha moving into Lisa’s building once it has incorporated. So is Peter now off the hook? No, the adop- tion of the corporation gives Lisa a choice of who to hold liable. If Alpha adopts, she has the choice now of suing either Alpha Inc. or Peter (but not both).

Directors are elected by the shareholders to serve a specific term, and are responsible for the broad, policy-based management of the company. They do not necessarily act as cor- porate agents, but they do owe the corporation a fiduciary duty. Officers, such as the Chief Executive Officer (CEO) and Chief Financial Officer (CFO), are agents of the corporation and manage the regular, ongoing business of a corporation and are generally appointed by the board of directors. Directors and officers are not necessarily shareholders, although they may be if the corporate rules allow it. Shareholders are the owners of the corporation

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who earn dividends from corporate profits, and have no right to be involved in regular management of the company, although they do retain some indirect control, through their right to elect directors. Shareholders must vote (and generally approve by a super major- ity, such as two-thirds of the outstanding shares) on changes to articles (and sometimes bylaws), fundamental corporate changes such as a merger with another company or dis- solution, and extraordinary business that is the subject of a shareholder proposal. For example, some corporations require that shareholders have a vote on executive bonus pay.

13.3 Limited Liability Companies

The first thing we need to establish about this form of business organization is that it is relatively new and there is more variation from state to state than you will find with partnerships and corporations. In some states, rather than just LLCs you may find limited liability partnerships (which are different than limited partnerships) and other variations, but we shall focus here on the essential features of a basic LLC that most states have in common.

The LLC represents an attempt to combine the best features of a partnership with the best features of a corporation. Thus LLC statutes typically feature easier formation (although filing under the statute is required) and lower filing fees, flow-through taxation where members of an LLC are taxed on their earnings but the business itself is not taxed, the stability of a corporation (a member’s leaving will not dissolve the LLC), and limited liability, where the business is liable for its debts and the people who own it are not.

At this point you may be thinking, wow, why would anyone ever be a partnership or bother with a corporation? Why even have those anymore? (And why did I just have to read all that stuff about partnerships, which are surely obsolete?) Remember, many cor- porations (which can have infinite life) have been around for decades, long before the first LLC statute was passed by the Wyoming legislature in 1977. It may be structurally impos- sible, or not worth the cost, of switching to LLC status. For partnerships, it is important to remember that many people go into business without even realizing that they are a partnership! Also, because LLC law is relatively new and in many cases state legislatures passed statutes without putting in much detail, courts have often held that where an LLC law does not cover an issue, the default setting is to partnership law. One way or another, partnership law is still relevant in today’s business world.

Although many LLCs are small businesses that in earlier years would have been partner- ships, others are very large-scale businesses such as Internet giant Google.

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In the Media: The Business Organization of the Social Network

The 2010 film The Social Network chronicles the rise of Face- book and Mark Zuckerberg. It shows, in short, how the world’s most powerful social media site began and then morphed as a business entity.

Before Facebook there was “Facemash,” which Zuckerberg cre- ated on October 23, 2003 in his Harvard dorm, with the help of classmates Eduardo Saverin, Chris Hughes, and Dustin Mos- kovitz. It was Saverin who the film portrays as Zuckerberg’s for- mer best friend, who was eventually kicked out of Facebook and who then sued Zuckerberg. Facemash was a website that allowed Harvard students to click-vote on the hotness of side- by-side pictures of Harvard females.

As shown in The Social Network, Facemash gave way to Thefacebook.com in 2004, in a scene where Zuckerberg asks Saverin to join him in Thefacebook, offering Saverin a minority stake in the venture. But Facebook’s official timeline lists Moskovitz and Hughes as cofounders of Thefacebook.com in 2004. Regardless, that would seem to make their business a partnership. Soon thereafter, The Facebook was officially formed as a Florida Limited Liability Company (LLC)—Florida is where Saverin was from. The company moved to Palo Alto, California, in June 2004, when Sean Parker, the Napster creator, became president. In 2005, “Thefacebook.com” became “Facebook.com.” Various series of company shares were created in the mid-2000s, as various investors such as PayPal cofounder Peter Theil and Microsoft began purchasing stakes.

By 2012, Facebook announced it was seeking to become a publicly traded corporation and was hoping to raise $5 billion in its initial public offering (IPO). After the IPO, Zuckerberg would retain 22 percent of the company and would have 57 percent of the voting stock. On May 18, 2012, Facebook went public, raising $16 billion, making it one of the largest IPOs in history. However, the Facebook IPO was by all accounts a public relations disaster, as technical glitches in the trading of the stock and its eventual significant price decline after one week of trading left securities regulators scrambling to investigate what happened, and some investors scrambling to find lawyers who filed suit against Facebook and Zuckerberg.

Since it began, Facebook has operated under a number of business organization forms. And as the Facebook saga continues to unfold, the way in which the business is organized will keep playing a silent but pivotal role in the outcomes of future court rulings and the liability of all involved.

Sources: http://www.renaissancecapital.com/ipohome/rankings/biggestus.aspx http://en.wikipedia.org/wiki/History_of_Facebook#cite_note-NYT517-85 http://tech.fortune.cnn.com/2012/03/01/inside-facebook/ http://online.wsj.com/article/SB10001424052702304019404577420660698374718.html http://www.huffingtonpost.com/2012/06/05/facebook-ipo-shareholders-lawsuit-zuckerberg_n_1572246.html

Facebook CEO Mark Zuckerberg has seen his business organized in a number of different ways.

Paul Sakuma/Associated Press

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http://www.renaissancecapital.com/ipohome/rankings/biggestus.aspx

http://en.wikipedia.org/wiki/History_of_Facebook#cite_note-NYT517-85

http://tech.fortune.cnn.com/2012/03/01/inside-facebook/

http://online.wsj.com/article/SB10001424052702304019404577420660698374718.html

http://www.huffingtonpost.com/2012/06/05/facebook-ipo-shareholders-lawsuit-zuckerberg_n_1572246.html

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Section 13.4 Chapter Summary CHAPTER 13

13.4 Chapter Summary

Business owners are wise to consider the fundamental issue of organizational form before they become too deeply immersed in business operations. By default, if they do not file appropriate papers with the state, a business will be a sole proprietorship or, if more than one person is an owner, a partnership. Both of these have the disadvan- tage of unlimited liability for the owners themselves. In contrast, either a corporation or LLC has potentially limited liability, as long as the owners are careful to observe statutory formalities and do not merely treat the business form as a shield to hide behind. When it comes to raising capital, the corporation and limited partnership are generally best; for taxation purposes, an LLC is preferable. Essentially, being knowledgeable about the legal consequences of organizational forms and weighing all the factors involved when starting up a business will save businesspersons from a number of headaches in the future.

Focus on Ethics

As an American politician recently said, “Corporations are people, my friend.” While this is true from a legal standpoint, it is important to remember that the law does not always treat all people in identical fashion. Aliens are people who are often treated very differently from citizens, for example. Minors are certainly people, but the law places different rules on their ability to contract and even interprets their constitutional rights differently. Their right to free speech can be severely limited by their schools, and their freedom of movement curtailed by government curfew restrictions in a way that an adult’s rights would not be.

So does it follow that a corporation’s right to political expression should include the same right to contribute to political campaign funding that an individual person has? The Supreme Court appeared to answer the question in the affirmative when they struck restrictions on corporations in the case Citizens United v. Federal Election Commission, 558 U.S. 50 (2010). Corporations can indeed now con- tribute to individual political campaigns as an individual citizen would.

As a practical matter, however, even if a corporation itself is a disclosed donor to a political action group or campaign, it can be almost impossible to find out who is ultimately behind the corporate veil. A corporation’s stock may be held by another corporation, which may in turn be owned by another cor- poration, which may in turn be owned by another, and so on. As we discussed in this chapter, though a corporation is legally considered a person, it has no actual physical body; it operates solely through its agents, who are in fact real, living, breathing people. Thus agents of a corporation perhaps now wield more power than individual citizens do, and they can potentially do so anonymously, which brings up lots of space for ethical debate.

Questions for Discussion

1. Does it matter who spends money on U.S. political advertisements or otherwise attempts to influence elections? Do you think it affects the integrity of the political process?

2. Do you think the law should distinguish between natural persons (those with a body and a brain) and legal persons such as corporations when it comes to political spending?

3. Would it affect your perception of a political candidate if you learned that some of the nega- tive ads against his opponent were financed by a large oil company? By a Saudi Arabian sheik? By a labor union? By a foreign government? By a drug cartel?

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Case Study: C&J Builders and Remodelers, LLC v. Geisenheimer

733 A.2d 193 (Conn. 1999)

Facts: In March of 1996, Charles Pageau, doing business as a sole proprietorship that went by the name C&J Builders, contracted to renovate the defendant’s summer residence. The agreement had a clause that provided for disputes to be submitted to arbitration.

In October, Pageau caused C&J to become an LLC. C&J then proceeded to renovate the defendant’s residence. In June 1997, a dispute arose regarding $87,667.12 that C&J claimed was owed on the con- tract. C&J sought arbitration. The defendants, however, claimed that the plaintiff LLC was not a party to their contract with the sole proprietorship, and, therefore, that the plaintiff was not entitled to compel the defendants to arbitrate the dispute.

Issue: Can C&J as an LLC enforce a contract made by Pageau as a sole proprietorship?

Discussion: The LLC statute in Connecticut did not specifically consider the issue of an LLC taking over a business previously operated as a sole proprietorship, but it did address what happened if a general or limited partnership converted to an LLC. The court recognized that the statute did not necessarily control the present situation, but found that the statute was still a useful point of reference. Under the statute, when a partnership business became an LLC, all property and obligations of the previous entity became those of the LLC. Furthermore, the court found that a basic purpose of the LLC statute was to facilitate a seamless transition from partnership to LLC, and that there was no reason to treat a sole proprietorship that becomes an LLC any differently.

Held: The plaintiff, C&J Builders and Remodelers, LLC, has a right to enforce the contract entered into by Pageau as a sole proprietorship, including the right to compel arbitration.

Questions for Discussion

1. In what way are partnerships and sole proprietorships different and the same? Do you agree with the court that in this case it is the similarities that are most relevant?

2. What is the purpose of LLC laws? Is it served by the court’s analysis in this case? 3. If the court had found for the defendant and taken a strict view that a contract made by one busi-

ness entity cannot be enforced by another, what would be the effect on business organizations?

Case Study: Malone v. Patel

__ S.W.3d __, 2012 WL 1142251 (Tex. App. 1st Dist.–Houston 2012)

Facts: Malone invited Patel, an Indian national, to work for Prescendo Consulting, LP (Prescendo). Patel quit his lucrative job (with an annual salary of $100,000) to work for his friend Malone for $24,000 per year. Malone orally promised Patel an equal partnership at Prescendo. Malone told Patel to sign papers indicat- ing his at-will employee status but promised to write a partnership agreement when Patel became a per- manent resident of the United States. According to Patel, Malone claimed that until Patel obtained a green card he would be unable to own equity in an American business. Patel worked for Prescendo (continued)

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Case Study: Malone v. Patel (continued)

for three years, bringing in significant revenue. Patel’s salary was raised to $85,000 and eventually to $166,000, by the mutual agreement between Patel, Malone, and another person who later claimed to have been promised an equal partnership. After receiving his green card, Patel asked Malone for a written partnership agreement with an equal partnership share, but Malone objected. Patel sued Malone for the breach of contract. Malone argued that, first, there was no written partnership agreement. Second, he claimed that Patel was never a partner because numerous documents show that Malone was the only owner of Prescendo and that Patel was his at-will employee. Patel argued that the documents reflect- ing his employee status “do not conclusively prove that the parties did not agree to be equal partners.” At the trial, four witnesses testified that Malone expressed an intention to make Patel an equal partner. The trial court ruled for Patel and awarded him $495,000 in actual damages. Malone appealed.

Issues: Was there an oral agreement between Malone and Patel to be equal partners in Prescendo, and if there was one, would it trump the signed employee-at-will documents?

Discussion: In reviewing evidence in the most favorable light for the defendant, the appellate court analyzed “the totality of the known circumstances rather than reviewing each piece of evidence in isolation.” Since the law recognizes oral contracts, “the lack of a written agreement cannot conclusively establish that an oral agreement does not exist.” Though there was no evidence of Patel’s sharing in the profits, there was evidence of his right to the profits. His nominally low salary (at least at the beginning) was another proof of his partner status, as it showed he preferred to invest in the company instead of receiving a larger salary. Finally, there was evidence that Malone and Patel regularly discussed Pre- scendo’s business affairs and made collaborative decisions. The court found that Patel had a right to exercise some control over Prescendo’s executive decisions, and this cumulatively proves his status as an equal partner. Finally, the court found that Patel’s positions as an at-will employee and an equal partner were not mutually exclusive. One can be an at-will employee and still have a partner’s status. Therefore, the court concluded that Malone and Patel agreed to be equal partners in Prescendo.

Holding: The appellate court affirmed the judgment of the trial court.

Questions for Discussion

1. What was the initial agreement between Malone and Patel? Why they did not sign the part- nership agreement if they agreed to be equal partners in Prescendo?

2. Why did Patel sue Malone for the breach of contract? Why did Malone object to the equal partnership of Patel? What was Patel’s argument?

3. What was the decision of the trial court? Do you agree with it? 4. What legal principle did the appellate court use to analyze evidence? What evidence proved

Patel’s status as an equal partner? Why did Patel’s status as an at-will employee not contradict his status as an equal partner?

5. Imagine that you are an attorney, and your client, Patel, asks your legal advice with respect to his friend’s oral promise to make Patel an equal partner in a company. What would you advice Patel to do to make sure that there will be no disputes about his equal partner status?

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Critical Thinking Questions

1. New restaurants are a type of business with a high failure rate: many don’t even last a year. At the same time, they are a type of business that can be something of a status symbol for their owners. Suppose Marina, a business school graduate, and Stephen, a chef, are interested in starting a new restaurant, which would aim to be a destination for the in crowd. They need at least $50,000 more than either of them can raise. Kareem, a professional athlete who earns $15 million a year, and Brooke, a supermodel, are interested in being involved, partly to establish themselves as something other than a jock and a pretty face. Discuss what busi- ness organizations might best suit the restaurant.

2. A business consultant at a seminar for realtors who also buy investment property counseled the realtors to form a different corporation or LLC for each one of their properties, in order to avoid liability. In other words, if Rihanna Realtor owns three rental properties, located at 100 Elm Street, 200 Maple Avenue, and 300 Oak Boulevard, Rihanna should have three LLCs. According to the consultant, if Peter Plaintiff slips, falls, and breaks his leg at Elm Street, he would not be able to reach the rents from Maple, or have Oak sold, to satisfy his judgment. Discuss under what circumstances the consultant would be correct, and whether it is really a practical solution.

Hypothetical Case Problems

Case 1. Carli, Donald, and Thomas are three attorneys who share office space and a receptionist. They have a sign outside the office that reads “Carli, Donald and Thomas, Attorneys at Law” and all three of them use stationary with the same heading. They do not share profits or make joint decisions about clients or refer to each other as partners. A client of Donald alleges he did an incom- petent job of representation and sues all three for damages. The client paid for Donald’s services at the time with a check made out to “Carli, Donald and Thomas,” which was deposited by Donald in his account. Carli and Thomas defend on grounds that there has never been a partnership.

A. Are the three attorneys a partnership? B. What other theory could the plaintiff use to hold all three liable? C. What recommendation would you make to the three attorneys as to how

to avoid this type of problem in the future?

Case 2. Maria, James, and Neko operate Dreamscapes, a gardening and landscape firm. All three contributed capital and they share equally in profits. They have no written agreement, nor have they filed anything with the state. Maria and James do most of the work, although occasionally Neko designs advertising materials.

A. Is this a partnership? B. Maria and Neko now want to buy a new truck for the business. James

objects. Is there authority for the truck?

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C. A dissatisfied customer sues Maria, James, and Neko. Neko argues that she was a limited partner and thus cannot be held personally liable. What is the result?

D. While working on a customer’s landscape, James carelessly dumps a load of mulch on Sarah, who is injured, sues, and recovers a judgment against the business for $50,000. Sarah discovers that the assets of Dreamscapes will be inadequate to satisfy her judgment, but that Maria has a lot of money in her personal bank account, which she inherited from her great aunt. May Sarah recover the judgment from Maria? What are Maria’s rights against her partners?

Case 3. Regina is a seamstress who makes clothing to order for customers. She conducts her business out of a small boutique in Yonkers, New York, under the name of Regina’s Fashions. Business has been good over the past several years and she would like to expand by opening a second store and hiring additional employees to help her run it.

A. Compare the relative advantages and disadvantages of different business forms for Regina. What would you recommend?

B. Regina decides to form a Subchapter S corporation, mainly because her uncle the accountant has done this before and is willing to help her with it. In the meantime, Regina’s friend Lawrence offers to help her expand her business. He finds a great location for the second store and signs a lease in the name “Regina’s Fashions Inc.” However, Regina doesn’t care for the space, and tells the landlord she won’t be using it. Can the land- lord hold Regina’s Fashions Inc. liable once it incorporates? How about Lawrence?

C. Regina’s Fashions Inc. is duly incorporated and a board of directors comprising Regina, Lawrence, and Uncle Saul is elected. Regina owns 90 percent of the stock; Lawrence owns the other 10 percent. Regina is appointed CEO. She now makes a contract with Best Bank for a $50,000 loan to finance expansion, signing as “Regina, CEO, Regina’s Fashion’s Inc.” The corporation defaults on the loan. Discuss the potential liability of the corporation, Regina, Uncle Saul, and Lawrence.

Case 4. Benson and Tyler, two certified public accountants, do business as B & T, LLC. After five years, Tyler wants to quit accounting to be a professional comedian. Neither Benson and Tyler’s operating agreement nor the state’s LLC statute specifies what should happen in this situation.

A. Does Tyler have a right to quit the business? Should he be held liable for any costs Benson has as a result?

B. Will the court be more likely to use partnership law or corporate law as guideline in this situation?

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corporation A business entity that is formed through application to the state, which allows shareholders limited liabil- ity. Corporations have the legal status of persons.

director A person elected by sharehold- ers to engage in broad management of a corporation.

dissolution In a partnership, any change of membership. For a corporation, termi- nation of the business entity.

dividend A share of corporate profits paid to its shareholders.

incorporator The individuals who sign the articles or charter of incorporation.

limited liability company A business organization form that is formed through application to the state, which attempts to combine the relative advantages of part- nerships and corporations.

limited partnership A business organiza- tion that can be created only by filing with the state, which must have at least one general and at least one limited partner. The limited partner or partners will not be ordinarily personally liable for the debts of the business.

officer A person appointed by the board of directors for a corporation, who acts as an agent for the corporation.

partnership An association of two or more competent persons to carry on a business as co-owners for profit. The business itself is not a legal entity.

promoter The individual who organize the creation of a corporation. Promoters gen- erally have liability for pre-incorporation contracts unless released by the third party.

shareholder An owner of a corporation; those individuals who hold stock or shares in equity in a company.

sole proprietorship A business owned and operated by a single person. The busi- ness has no separate legal existence from its owner.

Subchapter S corporation A type of corporation sanctioned by the IRS, which qualifies for single taxation.

Key Terms

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