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CHAPTER 19: FORMS OF BUSINESS ORGANIZATIONS

INTRODUCTION

CHOOSING THE PROPER FORM OF BUSINESS ENTITY

One of the first questions facing any entrepreneur starting a business is which form of business organization will best suit the enterprise. In weighing the advantages and disadvantages associated with the various forms, four considerations take on primary importance. First, to what extent will the personal assets of the founders and investors be exposed to the liabilities of the business? Second, which format will make the business most attractive to potential investors, lenders, and employees? Third, what costs are associated with creating and maintaining the organization? Finally, how can taxes be minimized?

Founders enjoy a broad range of options. The decision on the entity form comes in the earliest stages in the life of a business, but it is nonetheless a crucial one. Changing the form of organization can be costly. Not only will administrative and legal fees be incurred, but a change may also give rise to tax liability or cause a business opportunity to be lost. Thus, at the outset of their venture, entrepreneurs should carefully consider its expected evolution and choose the form of organization accordingly. In addition, once the form of entity is chosen, its managers must diligently comply with all statutory requirements.

CHAPTER OVERVIEW

This chapter begins with an examination of the advantages and disadvantages of the most frequently used forms of business organizations: sole proprietorships, general and limited partnerships, limited liability partnerships, master limited partnerships, corporations (including S corporations), and limited liability companies, as well as two new vehicles for socially motivated firms, the benefit corporation and the low-profit limited liability company. Next, the chapter summarizes the basic tax treatment of these different entities. The remainder of the chapter offers a more detailed discussion of how partnerships and corporations are structured and operated.  Chapter 20  discusses the fiduciary duties of corporate officers, directors, and controlling shareholders and how power is allocated between the shareholders and the directors of a corporation in contests for corporate control.

19-1: SOLE PROPRIETORSHIPS

The sole proprietorship is the simplest and most prevalent form of business enterprise in the United States. In a  sole proprietorship , one individual owns all of the assets of the business and is solely and personally liable for all of its debts, contract obligations, and tort liabilities. In other words, the sole proprietor is the business. Any individual who conducts business without creating a separate organization is operating as a sole proprietorship.

There are no formal requirements for forming a sole proprietorship. If, however, the business operates under a fictitious business name—that is, a name other than the name of the owner—then that name must be registered with the state. A sole proprietorship ends on the discontinuation of the business or the death of the proprietor, whichever is earlier.

Advantages of a sole proprietorship include the flexibility afforded by having one person in complete control of the business. Also, because a sole proprietorship can be created without formal agreements or state filings, it is the easiest and least costly form of business organization to set up. Sole proprietorships pay only one level of income tax—the proprietor reports income and losses from the business on his or her personal tax returns. Finally, the proprietor receives all of the profits generated by the business.

If the business loses money, however, the proprietor alone bears liability for the losses, and all of his or her assets are therefore at risk. This element of risk is the major disadvantage of the sole proprietorship. In addition, it is more difficult for sole proprietorships to raise capital. A sole proprietor can only tap personal funds and borrow money.

19-2: GENERAL PARTNERSHIPS

A  general partnership  is created when two or more persons agree to place their money, efforts, labor, or skills in a business and to share the profits and losses. 1  Their agreement can be express or implied, but they must share in real profits, not just receive wages or compensation.

Absent an express agreement to the contrary, each partner has some control over the business, and each may have the authority to bind the partnership with respect to third parties. In some respects, a partnership is like a marriage or a family. Its members share not only the benefits of the relationship but the burdens as well.

A partnership is treated as an entity separate from its partners and can acquire property in its own name. Property that is not acquired in the name of the partnership is nonetheless partnership property if the instrument transferring title refers to (1) the person taking title as a partner or (2) the existence of the partnership.

One of the key advantages of a partnership is that it allows for a wide variety of operational and profit-sharing arrangements. In essence, partners may agree to any terms in forming a partnership as long as they are not illegal or contrary to public policy. An example of this flexibility is that partners may contribute either capital or services to the partnership. Suppose Abigail and Caroline decide to form a partnership, called Rad Waves, to manufacture windsurfing equipment. Caroline contributes the start-up and operating capital, and Abigail contributes only her management services. Even though Abigail has not contributed capital to the partnership, she is (unless agreed otherwise) an equal partner with Caroline in Rad Waves.

Like a sole proprietorship, a partnership has the advantage of being subject to only one level of tax. Though it must file an informational return with the Internal Revenue Service (IRS), a partnership does not pay income taxes as a separate entity. Instead, the profit earned (or loss incurred) by the partnership (whether distributed or not) “passes through” to the individual partners, who report it as income (or loss) on their individual returns. Thus, a partnership is a  pass-through entity .

Unlike a sole proprietorship, which terminates on the death of the owner, a partnership is not automatically dissolved on a partner’s death, bankruptcy, or withdrawal. Instead, the partners holding a majority of the partnership interests may elect to continue the general partnership within ninety days after the occurrence of such an event.

General partnerships face a disadvantage similar to sole proprietorships in that individual partners are subject to personal liability for the obligations of the partnership. Thus, if the partnership is unable to pay its debts, honor its contracts, or satisfy its tort liabilities, the creditors of the partnership have claims against the assets of individual partners.

19-3: JOINT VENTURES

A  joint venture  is a one-time partnership of two or more parties for a specific purpose, such as the construction of a hydroelectric dam or a cogeneration plant. Like a general partnership, a joint venture requires that the parties (1) share a community of interest; (2) have the mutual right to direct and govern; (3) share the partnership’s profits and losses; and (4) combine their property, money, effort, skill, or knowledge in the undertaking. Unlike a general partnership, a joint venture is not a continuing relationship; it terminates when the project is completed.

In a joint venture, the authority of one member to bind the partnership is more limited than in a general partnership. To avoid inadvertently conferring apparent authority to bind the other members, a joint venture should make it clear in its dealings with third parties that it is a joint venture and not a partnership. This distinction should be reflected in the entity’s name and in the recitation of its legal status in its contracts.

19-4: LIMITED LIABILITY PARTNERSHIPS

The  limited liability partnership (LLP)  is designed primarily for groups of professionals, such as law firms and accounting firms. LLPs are created by filing the appropriate forms with a central state agency. A major advantage of the LLP form for existing partnerships, such as law firms and accounting firms, is that they can attain LLP status without significant modification of the business’s partnership agreement. Like other forms of partnerships, LLPs retain pass-through taxation treatment.

The main function of an LLP is to insulate its partners from vicarious liability for certain partnership obligations, such as liability arising from the malpractice, or negligent or wrongful conduct, of another partner. Partners in an LLP usually have unlimited liability for their own malpractice.

State LLP statutes are not uniform, however. Most statutes provide that liability will be limited at least for debts and obligations arising from the malpractice of other partners. However, a few states, such as Minnesota and New York, protect partners from commercial liabilities (such as trade debt) as well. 2  This expanded protection further narrows the distinction between an LLP and a limited liability company.

19-5: LIMITED PARTNERSHIPS

A  limited partnership  is a special type of partnership consisting of general partners and limited partners.  General partners  of a limited partnership remain jointly and severally liable for partnership obligations (just like partners in a general partnership), and they are responsible for the management of the partnership. In contrast,  limited partners  assume no liability for partnership debts beyond the amount of capital they have contributed, and they have no right to participate in the management of the partnership.

Limited partnerships are often used to raise capital— the limited liability for limited partners makes them attractive to investors. Returning to the Rad Waves example, suppose the general partners wish to raise capital to finance a sportswear line to promote their other products. To do so, they restructure their partnership as a limited partnership with Abigail and Caroline remaining as general partners. They can now offer an investor a limited partnership interest in the business, renamed Rad Waves, L.P. If Olivia contributes $1,000 to the partnership, she becomes a limited partner in Rad Waves (assuming compliance with the relevant state statute), and her personal liability for Rad Waves’ obligations is limited to her $1,000 investment.

This ability to attract investors with the assurance of limited liability is the main advantage of a limited partnership. A limited partnership is more difficult to create than a general partnership. Unlike a general partnership, a limited partnership does not come into existence until a certificate of limited partnership has been filed with the appropriate state agency. Moreover, courts generally take a strict approach to the formal requirements of limited partnership status. If a partnership runs afoul of those requirements, courts will treat it as a general partnership instead.

19-6: MASTER LIMITED PARTNERSHIPS

The  master limited partnership (MLP)  is a business structure that is currently available to a select group of entities, primarily “mineral or natural resource companies.” The MLP has been described as a “type of corporation that is able to raise money on public exchanges and doesn’t pay income tax at the corporate level.” 3  It is thus a pass-through entity, like a partnership, but it “acts” like a corporation. Over time, IRS rulings and tax law provisions have widened the types of businesses that qualify, resulting in an “elastic” application of the “mineral or natural resource” definition—for example, “it is not just income from coal that qualifies; money made from rolling stock that carries coal on railways qualifies too.” 4  The estimated value of MLPs exceeds $1 trillion, and they account for nearly 10% of listed companies. 5

MLPs have been termed “distorporations”  6 —structures that avoid corporate taxes (the partnership structure requires earnings to be distributed) but that retain certain characteristics of a corporation. For example, investors are insulated from liability, and they can publicly trade their shares (typically called units). The general partner has a relatively free hand in running the company, while investors have few rights compared with shareholders in a C corporation (discussed next). 7  The tax implications of MLPs for an individual investor can be complex, and various laws prohibit or limit certain entities, such as mutual funds, from investing.

19-7: CORPORATIONS

A  corporation  is an organization authorized by state law to act as a legal entity distinct from its owners. A corporation has its own name and operates with specified powers to achieve the specific purposes set out in its  corporate charter  (also called its  articles of incorporation  or  certificate of incorporation ). Most charters give corporations the broad power to engage in any lawful business. Corporations are owned by  shareholders  (also called stockholders), who have purchased an ownership stake in the business. The  board of directors , which is elected by the shareholders, has central decision-making authority. The board of directors typically employs officers to manage the day-to-day operations of the business.

One of the most attractive features of the corporation is that the liability of its shareholders is limited to their investments. Only the corporation itself is responsible for its liabilities. (An important exception to this general rule, the “piercing the corporate veil” theory, is discussed later in this chapter.) This cap on liability permits entrepreneurs and investors to undertake risky ventures without the worry that they will lose personal assets if things go badly.

Another benefit of a corporation is its ability to raise significant capital by selling transferable ownership shares of corporate stock (also known as equity) to investors. Finally, corporations have the advantage of perpetual life. Thus, if a key investor dies or decides to sell his or her interest in the business, the corporation as an entity continues to exist and to conduct business.

19-7a: C Corporations

The main disadvantage of the corporate form of organization is that it is usually subject to two levels of taxation: both corporate and shareholder, unless it is eligible for and elects S corporation status (discussed below). Any corporation not meeting the requirements for an S corporation is automatically a  C corporation  (so-named because it is taxed in accordance with the rules set forth in Subchapter C of the Internal Revenue Code). A C corporation pays tax on the income generated by the business, and the shareholders pay tax on that same income when it is distributed as dividends.

19-7b: S Corporations

Some closely held corporations (discussed in  Section 19-7d ) can avoid this double taxation by electing to be treated as S corporations under Subchapter S of the Internal Revenue Code. An  S corporation  is taxed as a pass-through entity. In other words, the corporation itself is not taxed on its income; rather, the shareholders pay tax on their pro rata shares of the corporation’s income. An election to be taxed under Subchapter S does not affect the status of the organization as a corporation for state corporate law purposes. Any corporation that has not elected to be an S corporation or that fails to continue to meet the requirements for an S corporation is automatically a C corporation.

To qualify for S corporation status, a corporation must satisfy the following requirements:

· 1. The corporation must have no more than one hundred shareholders, all of whom must be individuals who are citizens of the United States or U.S. resident aliens, or certain types of tax-exempt organizations, trusts, or estates.

· 2. The corporation must have only one class of stock.

· 3. The corporation must be domestic.

· 4. The corporation must file a timely election signed by all the shareholders to be treated as an S corporation.

· 5. The corporation must not be an ineligible corporation, which includes certain financial institutions, insurance companies, and domestic international sales corporations. 8

19-7c: Close Corporations

Some states have enacted laws that give close corporations extra operating flexibility. A  close corporation  is a corporation that (1) has elected in its charter to be treated as a close corporation and (2) has a “small” number of shareholders, typically no more than thirty. A corporation must elect to become a close corporation by stating in its certificate of incorporation that it is a close corporation; otherwise, regardless of the number of shareholders, the corporation will not be treated as a close corporation.

State close corporation laws permit significant departures from the formalities required of traditional corporations. 9  Under some state statutes, if a close corporation’s shareholders agree not to observe corporate formalities relating to meetings of directors or shareholders in connection with the management of its affairs, then the bypassing of these formalities may not be considered a factor in deciding whether to pierce the corporate veil and hold the shareholders personally liable. In addition, many statutes permit the shareholders of a close corporation to manage the corporation directly—instead of delegating that responsibility to the directors or officers—as long as a certain percentage of the shareholders agree to this in writing.

19-7d: Closely Held Corporations

It is important to distinguish between a close corporation— one that conforms to the rules set forth by the state of incorporation to legally qualify as such—and a closely held corporation. A  closely held corporation  typically has a small number of shareholders, and it is characterized by the absence of a market for its stock. 10  If a court characterizes a corporation as closely held, it will often impose a greater duty of loyalty and care on the corporation’s directors and majority shareholders. These impositions are not codified, however, and exist only in common law and traditional business practices. 11

19-8: LIMITED LIABILITY COMPANIES

A  limited liability company (LLC)  combines the tax advantages of a pass-through entity with the limited liability advantages of a corporation. Like corporations and limited partnerships, the LLC is a creature of state law. However, as discussed below, many LLC statutes give the founders and investors flexibility to shape their duties and responsibilities by contract. To form an LLC, a charter document must be filed with the appropriate state agency (usually the office of the secretary of state). This LLC charter document is typically called the  articles of organization  (as in California) or the  certificate of formation  (as in Delaware). The name of the business must include the initials L.L.C. or the words Limited Liability Company.

The owners of an LLC are called  members . The rights, obligations, and powers of the members, managers, and officers are set forth in an  operating agreement . The members elect the  managers , who, like a board of directors, are responsible for managing the business, property, and affairs of the company. The managers appoint the officers of the company.

Unless a business is organized as a corporation under state law or is publicly held, the IRS’s “check the box” regulations permit the founders to decide whether the entity is to be taxed as a corporation or a pass-through entity. State-law corporations and publicly traded entities are always taxed as corporations. Accordingly, LLCs are not taxed at the firm level unless they elect to be taxed as corporations.

An LLC offers the advantages of both the limited partnership and the S corporation without their respective drawbacks. Properly formed LLCs are taxed as partnerships, but unlike the general partners in limited partnerships, even the controlling members in LLCs can limit their liability to the amount invested. Moreover, all owners of an LLC can participate fully in the management of the business. Like a partnership, an LLC can have flexible allocations of profits and losses. The main advantage of the LLC form over the S corporation is the lack of restrictions on shareholders and the ability to have more than one class of securities. Specifically, in contrast to an S corporation, there is no limit on the number of members an LLC can have, and its investors can be corporations, partnerships, and foreigners.

Although standardized forms provide a good starting point for drafting the LLC operating agreement, it must be tailored to the individual company and the needs of its members. The courts have made it clear that the operating agreement “defines the scope, structure, and personality of limited liability companies.” 12

For example, the Delaware Limited Liability Company Act provides, “It is the policy of this chapter to give the maximum effect to the principle of freedom of contract and to the enforceability of limited liability company agreements.” 13  The members may not, however, enter into an agreement that contravenes any mandatory provisions of the Delaware LLC Act. These provisions are generally intended to protect third parties, not necessarily the contracting members. As Delaware Chancellor Chandler explained, “The allure of the limited liability company … would be eviscerated if the parties could simply petition this court to renegotiate their agreements when relationships sour.” 14

The LLC Act explicitly bars members from “eliminat[ing] the implied contractual covenant of good faith and fair dealing,” 15  but courts are loathe to interject duties not required by the act or to invalidate waivers of obligation set forth in the operating agreement, especially when all the members are sophisticated parties. Although the implied covenant of good faith and fair dealing “requires ‘a party in a contractual relationship to refrain from arbitrary or unreasonable conduct which has the effect of preventing the other party to the contract from receiving the fruits’ of the bargain,” 16  the mere exercise of contractual rights, without more, does not constitute a breach of the implied covenant of good faith and fair dealing. Thus, the implied covenant “is not a panacea for the disgruntled litigant” and should not be used to fill a gap in a contract with an implied term unless it is clear from the contract that the “parties would have agreed to that term had they thought to negotiate the matter.” 17  So, for example, the Delaware Court of Chancery upheld provisions in an operating agreement whereby the members waived their right to seek dissolution of the LLC or to appoint a receiver. 18

19-8a: Fiduciary Duties

The extent of managers’ fiduciary duties to the other members and the ability of members to eliminate those duties by contract vary by state. 19  Several examples follow.

Delaware

Section 18-1104 of the Delaware Limited Liability Company Act provides that unless the LLC agreement contains language to the contrary, the managers and controlling members of an LLC owe a fiduciary duty of care and loyalty to the LLC and its members. 20  Section 18-1101(c) further provides that “[t]o the extent that, … a member or manager … has duties (including fiduciary duties) to a limited liability company or to another member or manager … the member’s or manager’s … duties may be expanded or restricted or eliminated by provisions in the limited liability company agreement; provided, that the limited liability company agreement may not eliminate the implied contractual covenant of good faith and fair dealing.” 21

In the following case, the Supreme Court of Delaware explored the contours of the fiduciary duties imposed by the terms of an LLC operating agreement.

CASE 19.1: A CASE IN POINT: IN THE LANGUAGE OF THE COURT

Gatz Properties, LLC v. Auriga Capital Corporation

Supreme Court of Delaware 59 A.3d 1206 (Del. 2012).

FACTS

In 1997, Gatz Properties, LLC and Auriga Capital Corp., along with other minority investors, formed Peconic Bay, LLC to lease and develop a golf course on property owned by the Gatz family. Under Peconic Bay’s operating agreement, Gatz Properties was the manager of Peconic Bay, and William Gatz (Gatz) managed and controlled Gatz Properties. The Peconic Bay agreement provided that certain major decisions required the approval of 66 2/3% of the Class A membership interests and 51% of the Class B interests. The Gatz family controlled 85% of the Class A interests and 52% of the Class B interests.

The property was leased to Peconic Bay under a long-term lease. Peconic Bay borrowed $6 million for improvements and entered into a sublease with American Golf Corp. to operate the course. The operation was never profitable. Aware that American Golf would terminate the sublease, Gatz had the property appraised. The improved land was valued at $10.1 million, but the development value of the vacant land was $15 million.

A third party made an unsolicited offer to buy the property. Even though Gatz was not cooperative, the buyer submitted two offers, both of which Gatz disclosed to the members. The members rejected both. One member asked Gatz to inquire whether the potential buyer would offer $6 million. Gatz allegedly told the buyer that the offer had to be “well north of $6 million.” The bidder was, however, still interested and attempted to work out satisfactory price terms, but again Gatz did not cooperate. Meanwhile, Gatz made his own buyout offer to the Peconic Bay minority investors after misrepresenting to them the terms the outside buyer was willing to negotiate. After all the minority investors (except one) rejected the offer, Gatz had the property reappraised, but he did not provide the appraiser with the information needed to make an accurate appraisal. The appraised leasehold value was $2.8 million if used as a public course and $3.9 million if used as a private course.

Gatz then offered to buy 25% of the minority members’ capital account balances. He also retained legal counsel, who advised the minority members that the majority members had the right to vote out the minority members “so long as a fair price is paid for the interests of the minority members.” Counsel further advised that, in light of the existing debt and the most recent appraisal, “that value is, at best, zero.”

Shortly thereafter, Gatz formally proposed to sell the property at auction and told the minority members that Gatz Properties would bid. The proposal was approved, because the Gatz family had majority voting power. Gatz used an auction company with no experience in golf courses that “specialized in ‘debt-related’” sales. He ended up being the only bidder. He purchased the property for $50,000 and assumed the outstanding debt; the minority investors received $20,985 in the aggregate.

The minority members later instituted suit, and the Delaware Court of Chancery awarded them almost $800,000 in damages, as well as half of their attorney fees. Gatz appealed.

ISSUE PRESENTED

Did the individual controlling the manager of an LLC violate the fiduciary duties to the LLC and its minority members set forth in the operating agreement when he misrepresented certain information to the minority members and engineered an auction at which he was the sole bidder?

OPINION

PER CURIAM

III.

A

The pivotal legal issue presented … is whether Gatz owed contractually-agreed-to fiduciary duties to Peconic Bay and its minority investors. Resolving that issue requires us to interpret Section 15 of the LLC Agreement, which both sides agree is controlling. Section 15 pertinently provides that:

Neither the Manager nor any other Member shall be entitled to cause the Company to … enter into any additional agreements with affiliates on terms and conditions which are less favorable to the Company than the terms and conditions of similar agreements which could then be entered into with arms-length third parties, without the consent of a majority of the non-affiliated Members….

The Court of Chancery determined that Section 15 imposed fiduciary duties in transactions between the LLC and affiliated persons. We agree…. [W]e construe its operative language as an explicit contractual assumption by the contracting parties of an obligation subjecting the manager and other members to obtain a fair price for the LLC in transactions between the LLC and affiliated persons. Viewed functionally, the quoted language is the contractual equivalent of the entire fairness equitable standard of conduct and judicial review.

… There having been no majority-of-the-minority approving vote in this case, the burden of establishing the fairness of the transaction fell upon Gatz. That burden Gatz could easily have avoided. If (counterfactually) Gatz had conditioned the transaction upon the approval of an informed majority of the nonaffiliated members, the sale of Peconic Bay would not have been subject to, or reviewed under, the contracted-for entire fairness standard.

. …

Entire fairness review normally encompasses two prongs, fair dealing and fair price. “However, … [a]ll aspects of the issue must be examined as a whole since the question is one of entire fairness.” … [The Court of Chancery] also properly considered the “fairness” of how Gatz dealt with the minority “because the extent to which the process leading to the self-dealing either replicated or deviated from the behavior one would expect in an arms-length deal bears importantly on the price determination.” The court further held that “in order to take cover under the contractual safe harbor of Section 15, Gatz bears the burden to show that he paid a fair price to acquire Peconic Bay.” We agree.

The trial judge found facts … that firmly support his conclusion that Gatz breached his contracted-for duty to the LLC’s minority members…. [T]he court found that “Peconic Bay was worth more than what Gatz paid.” … The Court … also properly relied on Auriga’s expert witness’s discounted cash flow analysis, which valued Peconic Bay at approximately $8.9 million.

… [T]he court relied on the fact that Gatz had rebuffed [the outside buyer’s] interest in discussing a deal “well north of $6 million.” …

… [T]he Court of Chancery did not “view the Auction process as generating a price indicative of what Peconic Bay would fetch in a true arms-length negotiation.” Indeed, the court found, the Auction was a “sham,” “the culmination of Gatz’s bad faith efforts to squeeze out the Minority Members.” … “Gatz manufactured a situation of distress to allow himself to purchase Peconic Bay at a fire sale price at a distress sale.”

… The Court of Chancery properly concluded “that the Auction was not a process that anyone acting with minimal competency and in good faith would have used to obtain fair value for Peconic Bay.”

. …

B

… Section 16, permits both exculpation and indemnification of Peconic Bay’s manager in specified circumstances….

. …

Gatz was not entitled to exculpation because the Court of Chancery properly found that he had acted in bad faith and had made wilful misrepresentations in the course of breaching his contracted-for fiduciary duty. Consequently, Section 16 of the LLC Agreement provides no safe harbor….

. …

Further, the court correctly found that Gatz’s offer to Peconic Bay’s minority members … “contained incomplete and misleading information [about the outside offer].” Gatz “intentionally [misled] the Minority Members when accurate information concerning third-party offers would have been material to their decision whether to accept Gatz’s own offer….”

. …

The trial court determined that if Gatz had engaged with [the outside buyer] … as Gatz’s contracted-for entire fairness duty required, Peconic Bay could probably have been sold at a price that returned to the minority investors both their initial capital ($725,000) plus a 10% aggregate return ($72,500)….

… The damages award was based on conscience and reason, and we uphold it.

E

“Under the American Rule, absent express statutory language to the contrary, each party is normally obliged to pay only his or her own attorneys’ fees.” … Our courts have, however, recognized bad faith litigation conduct as a valid exception to that rule….

… The court did not abuse its discretion in awarding attorneys’ fees.

RESULT

The Supreme Court of Delaware affirmed the judgment in favor of the minority investors, finding the manager had breached his fiduciary duties.

CRITICAL THINKING QUESTIONS

1.

Why wasn’t the fact that no one else bid at the auction proof of the fairness of the price bid by Gatz?

2.

Would the result have been the same if Gatz had given the appraiser sufficient information to perform an accurate appraisal?

New York

Section 409(a) of the New York Limited Liability Company Law provides that “[a] manager shall perform his or her duties as a manager … in good faith and with that degree of care that an ordinarily prudent person in a like position would use under similar circumstances.” New York courts have held that managers of an LLC have a fiduciary duty to the limited liability company (breaches of which can be addressed in a derivative action brought on behalf of the company) 22  and may also owe a fiduciary duty directly to the other members of the LLC. 23  For example, one court held that the managing member of a New York LLC had a fiduciary duty to a co-member to make full disclosure of all material facts. 24

California

The California Revised Uniform Limited Liability Company Act (RULLCA) 25  provides that the operating agreement may not eliminate the duty of loyalty or the obligation of good faith and fair dealing. It also may not unreasonably reduce the duty of care. The agreement can, however, specify the types of behavior that will not violate the duty of loyalty, if not “manifestly unreasonable.” It may also specify the standards under which the performance of good faith and fair dealing will be measured, also if not “manifestly unreasonable.” 26

19-9: BENEFIT CORPORATIONS

The  benefit corporation (B corporation)  is a for-profit corporation that uses the power of business to solve social and environmental problems. 27  B corporations are required to “have a purpose of creating general public benefit” in addition to their other corporate purposes. 28  Benefit corporations must distribute to shareholders an annual benefit report providing information about their social and environmental performance benchmarked against a third-party standard. As of August 2014, twenty-six states (including California, Delaware, Florida, New York, and Virginia) and the District of Columbia had enacted benefit corporation legislation, and legislation has been introduced in a number of other states. 29

Unlike directors of most for-profit corporations, directors of B corporations have no duty to maximize shareholder value even when there is a change of control. Instead, they are required to consider the effects of any action on (1) the ability of the corporation to accomplish its benefit purpose; (2) the corporation’s shareholders; (3) the employees and workforce of the corporation and its suppliers; (4) customers; (5) the community; (6) the environment; and (7) “the short-term and long-term interests of the benefit corporation, including benefits that may accrue to the benefit corporation from its long-term plans and the possibility that these interests may be best served by the continued independence of the benefit corporation.” 30  The directors may also take other factors into account, such as the intent and conduct of any potential acquirer. Importantly, directors of a B corporation have no duty to give priority to the interests of any one group over the interests of another unless the certificate of incorporation so provides.

19-10: LOW-PROFIT LIMITED LIABILITY COMPANIES

A somewhat similar new type of entity with both business and charitable or educational purposes is the  low-profit limited liability company (L3C) . The L3C has been described as “a for-profit company with a ‘nonprofit soul,’” meaning that it can distribute its profits to investors while serving a philanthropic purpose. 31  As of February 2014, eight states and one Native American tribe had adopted L3C legislation. 32

19-11: INCOME TAX CONSIDERATIONS

The discussion that follows is concerned solely with federal income tax consequences under the Internal Revenue Code of 1986, as amended and in force as of January 1, 2014. Many state income tax provisions follow the federal rules, but there can be substantial differences. Because provisions in the tax laws change often, it is more important to understand the general issues than to strive for a detailed knowledge of the tax laws for any given year.

19-11a: Comparing Taxable Entities with Pass-Through Entities

The tax treatment of C corporations is different from that of pass-through entities (such as partnerships, S corporations, and LLCs) in several respects. Each may have favorable or unfavorable tax consequences, depending on the circumstances.

Property Transfers

Because a C corporation is a separate taxable entity, a transfer of cash or any other kind of property between the corporation and its owners is a taxable transaction unless it comes within one of the statutory exceptions in Subchapter C. It is easier to transfer property to and from a partnership or an LLC on a tax-free basis than it is with either a C corporation or an S corporation. For example, a transfer of property to either type of corporation in exchange for stock is tax-free only if the persons transferring the property own, immediately after the transaction, 80% or more of the stock of the corporation to which the property is transferred. In contrast, an exchange of property for a share in a partnership is tax-free regardless of the transferor’s percentage share in the partnership.

Similarly, property that has appreciated in value may be more easily distributed tax-free from a partnership or an LLC than from a corporation. Neither the partnership nor the LLC is subject to tax on the appreciated property, and the partner receiving the property is not taxed until he or she subsequently sells it. This can be particularly important for venture capital funds, which often make distributions of illiquid stock in the portfolio companies in which the fund has invested. If the fund is organized as a partnership or an LLC, these securities can be distributed to the partners or members tax-free, with no tax due until the partner or member sells the securities. In contrast, a corporation will be taxed on the appreciation in value at the time of the transfer just as if it had sold the property for cash, and the shareholders will be taxed on the fair market value of the property they have received. Thus, with a C corporation, there will be both a corporate-level tax and a shareholder-level tax on the distribution. For an S corporation, the taxable income is passed through and will be taxed only at the shareholder level.

Cash Distributions

The income of a C corporation is taxed at the corporate level when earned, and it is taxed again at the individual level when it is distributed. This double taxation does not occur with the other forms of business organizations. This difference alone may make a pass-through entity preferable to a C corporation as the chosen form of business organization.

Double taxation can be reduced in two ways. First, the tax liability of the corporation can be reduced to the extent that corporate income can be offset by tax-deductible payments to shareholders. For example, if personal services are a major source of the corporation’s income, payment of employee compensation to shareholders active in the business will reduce the corporation’s taxable income. If capital investment is a major source of income, payment of interest or rent to shareholders may provide similar relief. Second, the tax liability of the shareholders can be reduced to the extent that the business income is retained by the corporation and not distributed to shareholders. However, the accumulated earnings of a corporation may be taxed if they are not being retained for a legitimate corporate business purpose (the “accumulated earnings tax”).

Cash distributions from partnerships and S corporations are tax-free to the recipients up to the amount of their previous capital contributions less any income previously passed through to them. Distributions from C corporations, on the other hand, generally result in taxable dividend income to the shareholders.

Operating Losses

If the business operations of a C corporation produce a loss, as is frequently the case with start-up companies and real estate investments in their early years, the operating loss will be recognized at the corporate level. This means that the shareholders receive no tax benefits from the operating loss, and the corporation receives no benefit until it has operating income against which its prior losses can be deducted.

In contrast, if the same business is operated by a partnership, LLC, or S corporation, then the operating loss each year will be passed through to the individual partners or shareholders. They may, if certain tax law requirements are satisfied, deduct the operating loss from their other income. Under the limits on passive losses, only owners who materially participate in the business may deduct its losses from their other ordinary income (such as wages or interest). Passive investors may not deduct such losses from ordinary income, but they can use passive losses to offset passive gains (such as capital gains on the sale of stock).

Capitalization

The tax laws impose no restrictions on a C corporation’s capitalization. As business needs require, the corporation may issue common stock, preferred stock, bonds, notes, warrants, options, and other instruments. These instruments may confer the right to varying degrees of control and varying shares of earnings and may be convertible, redeemable, or callable. The tax treatment of each type of capital instrument may differ from its classification by the corporation, however. For example, shareholder debt may be treated as stock if the corporation has too little equity capital—that is, capital received in exchange for shares in the ownership of the corporation. As a consequence, tax-deductible “interest” payments may be recast as nondeductible “dividends” that are taxable to the shareholders.

Allocation of Losses

Items of partnership (or LLC) income or loss generally can be allocated to specific partners (or members) at specific times as long as these allocations have a substantial economic effect apart from tax considerations. Thus, an LLC can allocate a disproportionate amount of losses or depreciation to a particular member in the early years and allocate a disproportionate amount of later income to the same member until the loss is recovered. This form of allocation may generate a valuable tax deferral for that member.

No comparable allocation can be made by a C corporation, except to a limited extent by capitalizing the corporation with different classes of stock and debt. An S corporation is even more limited in this regard. It may have only one class of stock, and all income and losses must be allocated strictly in proportion to stock ownership.

IN BRIEF: Choice of Business Entity: Pros and Cons

The following chart lists the principal considerations in selecting the form of business entity and applies them to the C corporation, S corporation, general partnership, limited partnership, limited liability company, and limited liability partnership. The considerations are listed in no particular order, in part because their importance will vary depending on the nature of the business, its sources of financing, and the plan for providing financial returns to the owners (for example, distributions of operating income, a public offering, or a sale of the business). Other factors that are not listed will also influence the choice of entity. In addition, the “yes” or “no” format oversimplifies the applicability of certain attributes.

	C Corporation	S Corporation	General Partnership	Limited Partnership	Limited Liability Company	Limited Liability Partnership
Limited liability	Yes	Yes	No	Yes a	Yes	Yes b
Flow-through taxation	No	Yes	Yes	Yes	Yes	Yes
Simplicity/low cost	Yes	Yes	No	No	No	No
Limitations on eligibility	No	Yes	No	No	No	No
Limitations on capital structure	No	Yes	No	No	No	No
Ability to take public	Yes	Yes c	No d	No d	No d	No d
Flexible charter documents	No	No	Yes	Yes	Yes	Yes
Ability to change structure without tax	No	No	Yes	Yes	Yes	Yes
Favorable employee incen- tives (including incentive stock options)	Yes	Yes/No e	No f	No f	No f	No f
Qualified small business stock exclusion for gains	Yes g	No	No	No	No	No
Special allocations	No	No	Yes	Yes	Yes	Yes
Tax-free in-kind distributions	No	No	Yes	Yes	Yes	Yes

a. Limited liability for limited partners only; a limited partnership must have at least one general partner with unlimited liability.

b. Partners in LLPs generally are protected from liability for malpractice and other wrongful conduct of fellow partners; states are split on whether LLP partners can be held individually liable for other partnership liabilities, such as commercial debt.

c. An S corporation would convert to a C corporation upon a public offering because of the number of shareholders.

d. Although the public markets are generally not available for partnership offerings, partnerships (including LLPs) and LLCs can be incorporated without tax and then taken public.

e. Although an S corporation can issue incentive stock options, the inability to have two classes of stock limits favorable pricing of the common stock offered to employees.

f. Although partnership and LLC interests can be provided to employees, they are poorly understood by most employees. Moreover, tax-favored incentive stock options are not available.

g. A special low capital gains rate is available for stock of U.S. C corporations with not more than $50 million in gross assets at the time the stock is issued if the corporation is engaged in an active business and the taxpayer holds the stock for at least five years. Certain types of corporations are disqualified from participation.

Ability to Raise Venture Capital

Although pass-through entities (such as partnerships, LLCs, and S corporations) offer many tax advantages, they are rarely used for a business that intends to raise money from venture capitalists. Instead, the C corporation is usually used, for two reasons. First, most venture capital firms raise money from large institutional investors, such as pension funds, university endowments, and the like. Nonprofit entities such as these can invest in securities and receive their income and capital gains tax-free only if the issuer of the securities is not a pass-through entity. Otherwise, the nonprofits will be deemed to have received unrelated business income, which is fully taxable. Second, most start-ups want the ability to sell securities to outside investors at a significantly higher price than was paid by the founders at the outset. To justify the price differential, and avoid having some of the value of the founders’ shares treated as employee compensation, companies issue two classes of stock: common stock to the founders and preferred stock to the outside investors. Because an S corporation cannot have more than one class of stock, the C corporation is usually the easiest vehicle to use.

19-12: AGENCY LAW AND LIMITED LIABILITY

As discussed in  Chapter 5 , it is critical for individuals acting on behalf of any business entity to make it clear whether they are acting on their own or as agents of a separate legal entity. Failure to do this can result in personal liability for the manager involved. For example, if a person signs a contract in his or her own name, without indicating the name of the business entity on behalf of which he or she is acting, then the person is personally liable if the undisclosed principal fails to perform its obligations. In addition, owners of a limited liability entity who are active in the operation of the business can be held directly liable for their own tortious acts. 33

19-13: PARTNERSHIP MECHANICS

This section describes how partnerships are formed, operated, and terminated.

19-13a: Formation of a General Partnership

A general partnership can be created with nothing more than a handshake and a general understanding between the partners. For example, students agree to work together on a business plan; a baker and a chef agree to open a restaurant together; an engineer and a mechanic agree to design bicycles together—in each case, a partnership is formed. The intention of one party alone, however, cannot create a partnership. There must be a meeting of the minds. Hence, in the Rad Waves example from the beginning of the chapter, if Caroline viewed her agreement with Abigail as forming a partnership, but Abigail contemplated a mere employee–employer relationship, then there would be no partnership.

INTERNATIONAL SNAPSHOT

Before a business is organized abroad, its management should consult a lawyer in the country in which the entity is to be created to be advised of the country’s laws governing tax, labor, and governance issues. Parties contemplating a partnership or joint venture should note that civil law jurisdictions usually do not recognize common law–style general partnerships. Instead, they look through the partnership to the partners and view the partners as the legal owners.

A partnership does not require a minimum amount of capital for formation. Partners usually contribute cash or property, or agree to provide personal services, to the partnership. In some instances, a partnership interest may be received as a gift. The partnership need not be given a name. There may or may not be a written partnership agreement.

Without a Written Agreement

If there is no written partnership agreement, the laws of the state where the parties are doing business will determine whether the relationship will be treated as a partnership or some other relationship, such as an agency. If the relationship is recognized as a partnership, state partnership laws will govern the partnership and prescribe the rights of the partners if there is no written agreement. Some provisions of those laws could lead to undesirable business results.

In the Rad Waves example, Abigail and Caroline could form a partnership with a simple oral agreement. Under state partnership law, however, Abigail and Caroline will be required to share the profits and losses equally. Furthermore, until the partnership is terminated, neither partner may withdraw capital without the consent of the other. If they admit a third partner, his or her death could terminate the partnership even if Abigail and Caroline preferred to continue it. These are just a few examples of the dangers of forming a partnership without a written partnership agreement.

In the following case, the Court of Appeal of California considered whether a partnership existed between two women who had discussed a business idea but never drafted documents expressly creating a partnership.

CASE 19.2: A CASE IN POINT: IN THE LANGUAGE OF THE COURT

Holmes v. Lerner

Court of Appeal of California 88 Cal. Rptr. 2d 130 (Ct. App. 1999).

FACTS

Sandra Lerner was a successful entrepreneur and an experienced businessperson. She invested her money, in part, in a venture capital limited partnership called “& Capital Partners.”

Patricia Holmes met Lerner in late 1993, when Lerner visited Holmes’s horse-training facility to arrange for the training and boarding of two horses Lerner was importing from England. In 1995, Lerner and Holmes traveled to England to make arrangements to ship the horses to the United States. On this trip, Lerner decided that she wanted to celebrate her fortieth birthday by going pub crawling in Dublin. Lerner was wearing what Holmes termed “alternative clothes” and black nail polish. Because Holmes did not like black nail polish, Lerner gave her a manicure kit and told her to see if she could find a color she liked. Holmes tried different colors and eventually developed her own purple shade by layering a raspberry color over black nail polish. Lerner also found the color attractive.

On July 31, 1995, the two women returned from England and stayed at Lerner’s West Hollywood condominium while they waited for the horses to clear quarantine. While sitting at the kitchen table, they discussed nail polish colors. Lerner and Holmes worked with the colors in a nail kit for more than an hour to try to recreate the purple color Holmes had made in England in a liquid form.

Lerner said to Holmes: “This seems like a good [thing], it’s something that we both like, and isn’t out there. Do you think we should start a company?” Holmes responded: “Yes, I think it’s a great idea.” Lerner told Holmes that they would have to do many things, including market research and determining how to have the polishes produced. Lerner said: “We will hire people to work for us. We will do everything we can to get the company going, and then we’ll be creative, and other people will do the work, so we’ll have time to continue riding the horses.” Holmes agreed. They did not separate out which tasks each of them would do, but planned to do everything together.

Lerner then called David Soward, the general partner of & Capital and her personal business consultant. Holmes heard her say, “Please check Urban, for the name, Urban Decay, to see if it’s available and if it is, get it for us.” Holmes was certain from the tone of Lerner’s voice that she was serious about the new business. The telephone call to secure the trademark for Urban Decay confirmed in Holmes’s mind that they were forming a business based on the concepts they had originated in England and at the kitchen table that day.

Holmes knew that she would be taking the risk of sharing in losses as well as potential success, but the two friends did not discuss the details at that time. Lerner’s housekeeper heard Lerner tell Holmes, “It’s going to be our baby, and we’re going to work on it together.” After Holmes left, the housekeeper asked Lerner what gave her the idea to go into the cosmetics business, given that her background was in computers. Lerner replied: “It was all Pat’s idea over in England, but I’ve got the money to make it work.” Lerner told her housekeeper that she hoped to sell Urban Decay to Estée Lauder for $50 million.

Lerner and Holmes began work on their idea immediately. They met frequently in August and September at Lerner’s home and experimented with nail colors. Prior to the first meeting in August, Holmes told Lerner she was concerned about financing the venture. Lerner told her not to worry because Lerner thought they could convince Soward that the nail polish business would be a good investment. Holmes and Lerner discussed their plans for the company and agreed that they would attempt to build it up and then sell it. They discussed the need to visit chemical companies and to hire people to handle the daily operations of the company. However, the creative aspect, ideas, inspiration, and impetus for the company would come from Holmes and Lerner.

The participants in these meetings referred to them as “board meetings,” even though there was no formal organizational structure and, technically, no board. Soward reluctantly agreed to commit $500,000 to the project. Urban Decay was financed entirely by & Capital, the venture capital partnership comprising Soward as general partner and Lerner and her husband as the only limited partners. Neither Lerner nor Holmes invested any of their individual funds.

Lerner and Soward visited Kirker Chemical Company later in August 1995 to learn about manufacturing nail polish colors. Lerner discouraged Holmes from accompanying them. At a board meeting in late August, Soward introduced Wendy Zomnir, a friend of his former fiancée, as an advertising and marketing specialist. At the conclusion of the September board meeting, after Holmes had left, Lerner and Soward secretly made Zomnir an offer of employment, which included a percentage ownership interest in Urban Decay. Holmes did not learn of the terms of the offer until later, when Lerner or Soward referred to Zomnir as the “chief operating officer” of Urban Decay.

In early October, after Holmes learned of the secret offer to Zomnir, she asked Lerner to define her role at Urban Decay. Lerner responded, “Your role is anything you want it to be.” When Holmes asked to discuss the issue in more detail, Lerner turned and walked away.

In December 1995, Urban Decay Cosmetics LLC was organized. Holmes asked for a copy of the articles of organization but was given only two pages showing the name and address of the company. On December 31, Holmes sent a fax to Lerner asking: “What are my responsibilities and obligations, and what are my rights or entitlements?” and “What are my current and potential liabilities and assets?” She requested that Lerner provide the information in writing.

Soward intercepted the fax and called Holmes, asking: “What’s going on?” When Holmes explained that she wanted a written agreement, Soward noted that no one in the company had a written statement of their percentage interest in the company yet. Soward then asked: “What do you want, 1 percent, 2 percent?” When Holmes did not respond, he told her that 5% was high for an idea. Holmes told him: “I’m not selling an idea. I’m a founder of this company.” Soward exclaimed: “Surely you don’t think you have fifty percent of this company?” Holmes told him that it was a matter between Lerner and her and said that Soward should speak to Lerner, which he agreed to do.

During January and February of 1996, an early press release approved by Lerner stated: “The idea for Urban Decay was born after Lerner and her horse trainer, Pat Holmes, were sitting around in the English countryside.” Also in February, the San Francisco Examiner published an article with the following quote from Lerner: “Since we couldn’t find good nail polish, in cool colors there must be a business opportunity here. Pat had the original idea. Urban Decay was my spin.”

In March 1996, Holmes received a document from Soward offering her a 1% ownership interest in Urban Decay. Soward explained that Urban Decay had been formed as a limited liability company, which was owned by its members. For the first time, Holmes realized that she was now being asked to become a minor partner.

Holmes sued Lerner and others claiming the existence of an oral contract making them partners. The trial court found in favor of Holmes, and Lerner appealed.

ISSUE PRESENTED

What types of actions and words are sufficient to create a general partnership without any formal documentation?

OPINION

MARCHIANO, J., writing for the Court of Appeal of California:

Holmes testified that she and Lerner did not discuss sharing profits of the business during the July 31 “kitchen table” conversation. Throughout the case, Lerner and Soward have contended that without an agreement to share profits, there can be no partnership…. [The] statutory predecessor of the Uniform Partnership Act (UPA) defined a partnership as: “ … the association of two or more persons, for the purpose of carrying on business together, and dividing its profits between them.” 34  …

The … version of the UPA [in effect in 1995 and 1996] … omitted the language regarding division of profits and defined a partnership as: “an association of two or more persons to carry on as co-owners a business for profit.” When the legislature enacts a new statute, replacing an existing one, and omits express language, it indicates an intent to change the original act. We can only conclude that the omission of the language regarding dividing profits from the definition of a partnership was an intentional change in the law….

. …

Lerner and Soward argue that the agreement between Lerner and Holmes was too indefinite to be enforced. The cases they rely on do not support the argument…. “The parties’ outward manifestations must show that the parties all agreed ‘upon the same thing in the same sense.’” If there is no evidence establishing a manifestation of assent to the ‘same thing’ by both parties, then there is no mutual consent to contract and no contract formation. “The terms of a contract are reasonably certain if they provide a basis for determining the existence of a breach and for giving an appropriate remedy.” …

. …

… “There is no requirement, the intention to form a joint venture being otherwise present, that the parties must agree upon the post-acquisition management and operation of the property.” In addition, there is nothing unusual about a partnership in which one party supplies an idea which the other party brings into a substantive form. “Many businesses and great industrial organizations have sprouted from the germ of an idea in the mind of some man. When the idea is reduced to concrete form and put into action in the form of a business enterprise, an invention, a book, an opera or a theatrical production, the results of the idea are subject to private ownership.”

The agreement between Holmes and Lerner was to take Holmes’ idea and reduce it to concrete form. They decided to do it together, to form a company, to hire employees, and to engage in the entire process together….

RESULT

The Court of Appeal of California affirmed the trial court’s finding that Lerner and Holmes had created a general partnership.

CRITICAL THINKING QUESTIONS

1.

How could Lerner and Holmes have avoided this dispute?

2.

Did Lerner behave ethically?

With a Written Agreement

A written partnership agreement can override many of the provisions of partnership statutes that could turn out to be undesirable to the partners. It can prevent future misunderstandings and also provide for a dispute resolution mechanism, such as arbitration.

A partnership agreement usually includes (1) the term of the partnership’s existence, (2) the capital characteristics of the partnership, (3) the division of profits and losses between the partners, (4) partnership salaries or withdrawals, (5) the duties of the partners, and (6) the consequences to the partnership if a partner decides to sell his or her interest in the partnership or becomes incapacitated or dies. Also included are the name of the partnership, the names and addresses of the partners, the type of business to be conducted, and the location of the business.

Drafting a partnership agreement focuses the partners’ attention on matters that they might not consider if they made less formal arrangements. 35  For example, will all partners have an equal voice in management? What limits will be placed on the managing partners? How will disputes be settled? May a partner be expelled? May new partners be admitted? If so, by what process?

19-13b: Operation of a General Partnership

Unlike a corporation, which has a centralized board of directors and hired executives for decision making, a general partnership is characterized by direct owner management and control of the business. Each partner’s assets are vulnerable to the poor business decisions of the fellow partners. It is therefore important that each partner have a voice in the business decisions of the partnership.

A partnership may choose to cede managerial control of the business to one or more of its partners. Unless the partners expressly agree otherwise, however, partnership law requires unanimous agreement of all partners on all but the most ordinary matters. If the partners in an informal partnership cannot agree on a decision, they may disband the partnership, distribute its assets, and terminate it.

Each partner is an agent of the partnership for the purpose of its business unless the partnership has filed with the secretary of state a statement specifying that certain named partners have authority for entering into certain transactions on behalf of the partnership, as specified in sections 105 and 303 of the Revised Uniform Partnership Act (RUPA) of 1997. Each partner in a general partnership is liable for the debts incurred by another partner acting in the name of the partnership if that partner had express authority to incur the debt or was carrying on the business of the partnership in the usual way.

For example, if Abigail and Caroline form Rad Waves as a general partnership, each will be responsible for the full amount of any liabilities incurred by the partnership or by either partner acting within the scope of her authority as a partner. Hence, Caroline’s personal assets can be seized if Rad Waves’ partnership assets are insufficient to satisfy a judgment against Rad Waves. Caroline’s personal assets might also be seized if Rad Waves breaches a contract entered into by Abigail on behalf of the partnership.

19-13c: Fiduciary Duty

Partners owe one another certain fiduciary duties—in particular, a duty of loyalty and a duty of care. Partners must also discharge their duties to the partnership and to one another in accordance with the obligation of good faith and fair dealing.

Among the duty of loyalty obligations listed in the RUPA are (1) accounting to the partnership and holding as trustee for it any property, profit, or benefit; (2) refraining from dealing with the partnership as or on behalf of a party having an interest adverse to the partnership; and (3) refraining from engaging in grossly negligent or reckless conduct, intentional misconduct, or a knowing violation of the law.

Although some states, such as Delaware, have adopted the RUPA in its entirety, many states have chosen to tailor their own version, creating subtle differences that can be significant. For example, the California Uniform Partnership Act implies a higher fiduciary duty than the RUPA.

19-13d: Dissolution, Winding Up, and Termination of a General Partnership

Dissolution  of a general partnership occurs when the partners no longer carry on the business together. A partnership may be dissolved for many reasons. The agreed term for the partnership may expire, or the partners may decide to dissolve the partnership prior to the expiration of the agreed term. A particular undertaking specified in the partnership agreement may be completed. One or more partners may desire to withdraw from the partnership, or a partner may die or go bankrupt. (Unless there is an agreement to the contrary, withdrawal or death of a general partner results in the dissolution of the partnership.) A partner may be expelled, and the remaining partners may thereafter agree to terminate the partnership.

A partnership will also be dissolved if the business for which the partnership was formed becomes unlawful—for example, if there is a war between the countries of two or more of the partners. In such a case, the partnership will be dissolved regardless of the wishes of the partners. In other situations, a court may issue a decree of dissolution if a partner becomes disabled, insane, or otherwise unable to perform as a partner. Courts also have the power to dissolve a partnership when a partner willfully breaches the agreement or performs in such a manner as to make it impractical to carry on the partnership. Because the purpose of partnerships is to make a profit, a partnership may be dissolved by court decree if it becomes apparent that the partnership is unprofitable and lacks any real prospect of success. If the partnership has reasonable prospects of earning money in the future, however, it may not be dissolved by court decree despite recent losses.

On dissolution, all of the partners’ authority ceases except their authority to complete transactions begun but not yet finished and to wind up the partnership.  Winding up  involves settling the accounts and liquidating the assets of the partnership for the purpose of making distributions and terminating the concern. The liabilities and obligations of the partners do not end at dissolution; the partnership continues throughout the winding-up period. During the winding-up process, the partners’ fiduciary duties to one another continue. The winding-up partners may not run the business for their own benefit but must account as trustees to the withdrawing partners or to the estate of a deceased partner.

Termination  occurs when all the partnership affairs are wound up and the partners’ authority to act for the partnership is completely extinguished. A dissolved partnership may terminate or may be continued by a new partnership formed by the remaining partners (including perhaps the estate or heirs of a deceased partner).

19-14: LIMITED PARTNERSHIP REQUIREMENTS

Many of the basic rules that govern formation, operation, and termination of general partnerships apply to limited partnerships as well. Some additional requirements are placed on limited partnerships, however.

19-14a: Formal Requirements

In addition to the requirement that a certificate of limited partnership be filed with the appropriate state authority, most state statutes require that the partnership agreement clearly designate the limited partners as such. Any partnership that does not substantially meet this and other statutory requirements will be treated as a general partnership, with mutual liability and apparent authority attaching to each partner. A person who intended to be only a limited partner may face unlimited personal liability for the partnership’s debts if there has not been substantial compliance in good faith with the formal requirements.

The Uniform Limited Partnership Act provides that persons who contributed capital to a business erroneously believing that they were becoming limited partners in a limited partnership will not be liable as general partners if, upon ascertaining the mistake, they promptly renounce their interest in the profits of the business. 36  A person who believed in good faith that he or she had become a limited partner is liable only to third parties that both transacted business with the purported limited partnership before the certificate of limited partnership was filed (or before an amended certificate or certificate of withdrawal was filed) and reasonably believed that the person was a general partner at the time of the transaction. 37

19-14b: Limited Participation

A limited partner’s liability is limited unless he or she takes part in the control of the business. Thus, if limited partners have a voice in the business decisions of the partnership, they are opening themselves up to the possibility of liability beyond their original capital investment. Furthermore, limited partners may contribute money or property to the partnership, but generally not services. Hence, in the Rad Waves example, if limited partner Olivia assists in designing the sportswear line, in most states her liability could exceed her original $1,000 capital contribution. Therefore, limited partners should not take part in any partnership activity beyond monitoring the progress of their investment and exercising such statutory rights as the right to vote on the removal of a general partner. Moreover, the limited partner’s name cannot appear in the name of the partnership without the limited partner’s incurring unlimited liability.

19-15: INCORPORATION

Incorporation  is the process by which a corporation is formed. The corporate statutes of each state set forth the steps that must be taken to establish a corporation in that state. Many state statutes are based in whole or in part on the Model Business Corporation Act, an annotated uniform statute prepared by academics and practitioners. The state under whose laws a corporation is formed is called the corporation’s  corporate domicile . A corporation is not limited to doing business in its corporate domicile. It can conduct business as a  foreign corporation  in other states. Typically, to do so, it must file a statement of foreign corporation with the appropriate secretary of state and state taxing authority.

19-15a: Where to Incorporate

Corporations may incorporate in any state; it need not be the state in which most of their business is located. Two important factors affect the decision of where to incorporate: (1) the costs of incorporation in a given state and (2) the relative advantages and disadvantages of that state’s corporation laws. If the corporation is privately held and its business will be conducted largely within one state, incorporation in that state is probably the best choice. If the corporation will be large from the outset or will be engaged in substantial interstate business, however, then incorporation in a jurisdiction with the most advantageous corporate statutes and case law should be considered.

Corporation laws may be favorable either to management or to the shareholders. Some states, such as Delaware, are considered to be pro-management because their statutes and court decisions tend to give control on a wide range of issues to the directors and officers. Other states, such as California, make it difficult for corporate managers to take certain actions without the approval and participation of the shareholders. These states are regarded as pro-shareholder.

Since the mid-1930s, Delaware has been considered the preeminent state for incorporation. More than 50% of the companies on the New York Stock Exchange, Nasdaq, and other U.S. exchanges are incorporated in Delaware; 64% of Fortune 500 companies are Delaware companies. 38  Consequently, Delaware corporate law is considered the standard in America and much of the world.

The Delaware General Corporation Law is a dynamic statute designed to give corporations maximum flexibility in ordering their affairs. The Delaware Court of Chancery, established in 1792, hears (without juries) all cases involving corporate law issues and has rendered thousands of written opinions interpreting virtually every provision of the Delaware General Corporation Law. 39

An examination of the Delaware statute helps highlight some of the key corporate governance choices. The power to elect the board of directors is the primary mechanism whereby shareholders exercise control, and all jurisdictions provide for it. Delaware permits, but does not require, cumulative voting (discussed further below), which allows minority shareholders greater opportunity to elect a representative to the board. Delaware also permits a  staggered  (or  classified )  board , whereon directors serve for specified terms, usually three years, with only a fraction of them up for reelection at any one time. Delaware prohibits the removal of directors on a classified board without cause, unless the certificate of incorporation provides otherwise. Thus, a classified board makes it more difficult to replace the entire board at once, which can be important in a change-of-control contest. Although classified boards used to be the norm in Delaware, institutional investors have successfully pressured many large Delaware corporations to declassify their boards. 40

Any corporation incorporated in California, except publicly traded companies, must have cumulative voting and cannot have a staggered board. In addition, as explained further in  Chapter 20 , California permits fewer limitations on directors’ personal monetary liability than Delaware.

The primary reason a company would choose to incorporate in California, or any other state rather than Delaware, is cost. When deciding whether to incorporate in the local state or Delaware, entrepreneurs must weigh the advantages Delaware provides for managers against the expense of paying Delaware corporate franchise taxes, the expense of hiring lawyers familiar with Delaware law, and the possibility of having to defend a lawsuit in Delaware. Businesses incorporated in their local state often reincorporate in Delaware once they have grown large enough to justify the effort and expense of reincorporation.

19-15b: How to Incorporate

To create a corporation, one or more incorporators must prepare the certificate or articles of incorporation (or the corporate charter). This document must be filed with the appropriate state governmental agency, usually the secretary of state for the jurisdiction that will become the corporate domicile.

The certificate of incorporation is generally very short. For example, the Pennsylvania Business Corporation Law specifies that the certificate need only set forth the name of the corporation, the location and mailing address of the corporation’s registered office in Pennsylvania, a brief statement of the purpose of the corporation, the term for which the corporation is to exist (which may be perpetual), the total number of shares that the corporation is authorized to issue, the name and mailing address of each of the incorporators, and a statement of the number of shares to be purchased by each.

A comment to the Pennsylvania Business Corporation Law indicates that while “[n]ew corporations are [generally] deemed to have all-purpose charters,” a statement may be included that “the corporation shall have unlimited power to engage in and to do any lawful act concerning any or all lawful business for which corporations may be incorporated.” 41  Pennsylvania’s corporate law goes on to specify corporate powers, so there is no need to have a long purpose clause in the certificate of incorporation. Indeed, to do so invites trouble, because one might inadvertently exclude an activity in which the corporation may later want to engage.

After the certificate of incorporation is filed, the incorporators adopt the  bylaws —that is, the rules governing the corporation (including the number of authorized directors)—and elect the initial board of directors. This can be done either at an organizational meeting or by unanimous written consent. The incorporators are exclusively empowered to place the directors in office. After electing the board of directors, the incorporators sign a written resignation. The directors then have an organizational meeting at which they (1) ratify the adoption of the bylaws by the incorporators or adopt new bylaws, (2) appoint officers, (3) designate a bank as depository for corporate funds, (4) authorize the sale of stock to the initial shareholders, and (5) determine the consideration to be received in exchange for such shares—cash, other property, or past services rendered to the corporation.  Exhibit 19.1  outlines the steps required to form a corporation.

EXHIBIT 19.1: Steps Required to Form a Corporation

· 1. Select a corporate name and agent for service of process.

· 2. File the certificate of incorporation (also known as articles of incorporation or charter in some jurisdictions) signed by the incorporator(s).

· 3. Sign action by the incorporator(s) that:

· • Adopts by laws.

· • Specifies initial directors.

· 4. Obtain written resignation of the incorporator(s).

· 5. Hold first directors’ meeting or take action by unanimous written consent of the directors to:

· • Ratify the adoption of the bylaws by the incorporator(s) or the adoption of new bylaws.

· • Elect officers.

· • Authorize issuance of stock.

· • Authorize corporate bank account.

19-15c: Bylaw Amendments

Boards of directors generally have broad discretion in amending bylaws. In Boilermakers Local 154 Retirement Fund v. Chevron Corporation, 42  for example, the Delaware Court of Chancery ruled that the directors of Chevron Corporation, a Delaware corporation, had the authority under the Delaware General Corporation Law (DGCL) to amend the corporate bylaws to require that all shareholder derivative suits, fiduciary duty suits, and other suits under the DGCL relating to the “internal affairs” of the corporation—that is, “matters peculiar to the relationships among or between the corporation and its current officers, directors, and shareholders”—be brought in the Delaware courts. The court explained that Section 109(b) of the Delaware General Corporation Law (DGCL) 43  provides that the bylaws may contain any provision “not inconsistent with law or with the certificate of incorporation” that relates to the “business of the corporation, the conduct of its affairs, and its rights or powers or the rights or powers of its stockholders, directors, officers or employees.” Section 109(a) provides that the power to “adopt, amend or repeal bylaws shall be in the stockholders entitled to vote,” unless the corporation’s certificate of incorporation “confer[s] the power to adopt, amend or repeal bylaws upon the directors.”  44  The certificate of incorporation of Chevron gave this power to its board.

The board asserted that it had adopted the bylaws to avoid inefficient and costly “multiforum litigation,” in which a corporation might have to defend itself against the same complaint in more than one court at the same time. The board argued that it is ultimately the stockholder who bears the cost of litigation instituted by “dispersed stockholders in different forums.”

The court rejected as “cramped” the claim that the bylaws regulated an “external” matter, not an internal matter. The bylaws regulated where a shareholder suit could be filed; they did not regulate the type of suit that could be filed, nor did they dictate a remedy. Furthermore, they did not apply to external claims, such as a tort lawsuit, even if a shareholder brought such a suit.

The court also rejected plaintiffs’ assertion that a board cannot modify bylaws in a way that “diminishes or divests pre-existing shareholder rights absent stockholder consent.” When a stockholder buys stock in a Delaware corporation, he or she “contractually assent[s]” to being bound by bylaws that are valid under the DGCL and is thus “on notice” that the board can unilaterally act to adopt bylaws within the scope of the DGCL. Accordingly, the “contemporaneous assent” of the stockholders was not required to adopt the bylaws.

The court noted that Delaware corporate law must grow and change. Thus, the mere fact that the DGCL did not specifically reference forum selection in its provisions governing the subject matter of bylaws did not mean that forum selection was precluded.

The court pointed out, however, that “because the DGCL gives stockholders an annual opportunity to elect directors, stockholders have a potent tool to discipline boards who refuse to accede to a stockholder vote repealing a forum selection clause.”

In 2014, in ATP Tour, Inc. v. Deutscher Tennis Bund, 45  the Supreme Court of Delaware held that a bylaw adopted by the directors of a non-stock corporation that shifted attorneys’ fees and costs to unsuccessful plaintiffs in intracorporate litigation was not invalid per se and could be valid and enforceable under Delaware law. The court noted that the common law does not prohibit fee-shifting bylaws; that contracting parties may agree to modify the “American Rule,” under which each party pays its own litigation costs; and that enforceability of the bylaw provision would depend on whether it was adopted using appropriate corporate procedures and for a proper corporate purpose.

19-15d: Defective Incorporation

Because a corporation exists only by statute, not by common law, any defect in the incorporation process can have the effect of denying corporate status. A business organization that was intended to function as a corporation but that has failed to comply with the statutory requirements is in fact a partnership or, if there is only one shareholder, a sole proprietorship. The owners will not enjoy the protection of limited liability and can be held personally responsible for all debts of the enterprise. The courts have, however, developed several doctrines to avoid this result if it would be unfair.

De Jure Corporation

When incorporation has been done correctly, a  de jure  corporation  is formed. This means that the entity is a corporation by right and cannot be challenged. Most jurisdictions will find de jure corporate status as long as the incorporators have substantially complied with the incorporation requirements. For example, substantial compliance will be found even if the incorporators failed to obtain a required signature or submitted an improper notarization.

De Facto Corporation

If the incorporators cannot show substantial compliance, a court may treat the entity as a  de facto  corporation —that is, as a corporation in fact even though it is not technically a corporation by law. For the court to find a de facto corporation, the incorporators must demonstrate that they were unaware of the defect and that they made a good faith effort to incorporate correctly. For example, if a clerk for the secretary of state delayed filing the certificate of incorporation, the business would not be a corporation de jure, but it would probably be a corporation de facto.

Corporation by Estoppel

An entity that is neither a de jure nor a de facto corporation may be a  corporation by estoppel . If a third party, in all of its transactions with the enterprise, acts as if it were doing business with a corporation, the third party is prevented, or estopped, from claiming that the enterprise is not a corporation. 46  It is considered unfair to permit the third party to reach shareholders’ personal assets when all along it believed it was dealing with a corporation whose shareholders had limited liability.

19-16: PIERCING THE VEIL OF A CORPORATION OR LIMITED LIABILITY COMPANY

The corporation is built around the central premise of limited liability. Under certain circumstances, however, courts will deny this central premise and hold the shareholders liable for claims against the corporation. A court will  pierce the corporate veil  in this way if necessary to prevent the evasion of statutes, the perpetration of fraud, or other activities against public policy. The need to pierce arises only if the corporation is unable to pay its own debts.

There are two legal approaches to piercing the corporate veil. The  alter ego theory  applies when the owners of a corporation have so mingled their own affairs with those of the corporation that the corporation does not exist as a distinct entity—instead, it is an alter ego of its owners. The  undercapitalization theory  applies when the corporation is a separate entity, but its deliberate lack of adequate capital allows it to skirt potential liabilities.

Courts usually apply some combination of these theories. A court is more inclined to pierce the corporate veil when it suspects wrongdoing or bad faith on the part of shareholders. Because a publicly traded corporation generally does not have one controlling shareholder, attempts to pierce the veil of such corporations are rare. Usually, the cases involve small, closely held corporations or subsidiaries of larger corporations.

Courts have used the same approach to decide whether to pierce the veil of a limited liability company (LLC) and hold its members personally liable. For example, the Court of Appeal of Louisiana held that Insulation Sales and Service, Inc. (ISS), the majority owner of AAI Ventures, L.L.C., was liable for monies owed under a contract between AAI and Patrick Hamilton, an individual hired to provide general management services to AAI in connection with its subcontract to remove asbestos from a casino. 47  AAI, which was formed to do the asbestos removal work at the casino, was undercapitalized; the separate corporate existence of AAI and its affiliated companies was disregarded; individuals associated with the casino project were unsure of coworkers’ job titles or the employers of record; employees of one organization were housed at the offices of other organizations; and AAI had no employees—its accounting was handled by employees of ISS. The discussion that follows applies to both corporations and LLCs.

19-16a: Alter Ego Theory

A court will consider several factors when deciding whether a corporation is merely the alter ego of a shareholder.

Domination by Controlling Shareholder

If an individual or another corporation owning most of the stock of the corporation exerts so much control that the standard corporate decision-making mechanisms are not in operation, the court may find that the corporation has no separate mind, will, or existence of its own.

Commingling of Assets

The courts will also examine whether the books and funds of the corporation and of the controlling shareholder have been commingled—for example, whether the shareholder uses company checks to make personal purchases or payments.

Bypassing of Formalities

If an action that requires approval by the board proceeds without a board meeting being held, or if other procedural rules (such as the requirement of an annual shareholders’ meeting) are consistently broken, the courts will be inclined to view the corporation as the instrument of the controlling shareholder unless the corporation qualifies as a statutory close corporation under the law of the state of incorporation. As noted earlier, the bypassing of these formalities is not a factor in deciding whether to pierce the veil of a close corporation.

19-16b: Undercapitalization Theory

In certain states, including California, a court may ignore the corporate form and hold the owners of an under-capitalized corporation personally liable for its debts and liabilities. When deciding whether a corporation is under-capitalized, a court will consider whether the founders should have reasonably anticipated that the corporation would be unable to pay the debts or liabilities it would incur. (Of course, the amount of capital invested does not have to guarantee business success—if it did, all failed businesses would be deemed undercapitalized.)

It is often difficult for a court to decide how much capital is enough. Two judges examining the same facts may reach different conclusions. Judges may also disagree as to whether undercapitalization alone is sufficient grounds to pierce the corporate veil. Factors a judge may consider include whether the undercapitalization was an intentional device to avoid responsibility for acts that were likely to occur during the operation of the business, and thus constituted fraud.

Tort Versus Contract

Many courts are more sympathetic to a tort victim who faces an undercapitalized corporate defendant than to a plaintiff seeking to pierce the corporate veil in a breach of contract case. Why should someone who voluntarily contracted to provide credit to a weakly capitalized corporation, perhaps charging a premium interest rate in so doing, later be entitled to reach the owner’s personal assets? After all, the creditor had, or could have negotiated, access to the corporation’s financial statements. The voluntary decision to do business with the undercapitalized company contrasts quite sharply with the plight of a party who is a victim of a tort committed by an officer or employee of the corporation and whose contact with the corporation may have been completely involuntary. If, however, a shareholder misrepresents the financial condition of the corporation when negotiating a contract, then courts will pierce the corporate veil.

19-16c: Reverse Piercing

Under certain circumstances, some jurisdictions permit  reverse piercing , whereby a corporation may be held liable for the debts of a shareholder. For example, in what the California Court of Appeal called “[p]erhaps the oldest reverse piercing case,” 48  Kingston Dry Dock Co. v. Lake Champlain Transportation Co., 49  the U.S. Court of Appeals for the Second Circuit held, as a matter of federal law, that a parent corporation may be liable for the acts of its subsidiary when the parent directly intervened in the transaction, “ignoring the subsidiary’s paraphernalia of incorporation, directors and officers.” 50

19-17: MANAGEMENT OF THE CORPORATION

Corporate control is apportioned among the directors, officers, and shareholders. The directors are the overall managers and guardians of the corporation. The officers are the day-to-day managers. The shareholders, as the residual owners of the corporation, do not participate directly in management, but they elect the directors. The shareholders also must approve certain major transactions.

19-17a: Directors

Most state statutes provide that the business and the affairs of the corporation shall be managed, and all corporate powers shall be exercised by, or under the direction of, the board of directors. The board typically delegates the management of the day-to-day operations of the business of the corporation to the officers or, less often, to a management company. A member of the board may also serve as an officer. Such a person is called an  inside director . A director who is not also an officer is called an  outside director  or  independent director . An understanding of the dynamics between the board and the officers is essential to comprehend the workings of a corporation.

Although boards of directors do not have responsibility for managing the day-to-day risk of a company, they do have a responsibility to see that the company has an appropriate system in place to manage risk. Federal laws require certain bank holding companies with assets in excess of $10 billion, as well as some other entities, to have risk committees. 51  In addition, SEC disclosure rules require proxy statements to include information about the board’s role in risk oversight and how the company’s compensation regime relates to risks that may have a material adverse effect on the company. 52

19-17b: Officers

Officers are chosen by the board and serve at the pleasure of the board. If an officer is terminated in violation of an employment contract, the officer cannot sue to get his or her job back but can sue for damages. An officer may resign at any time on written notice to the corporation. The corporation can sue for damages if an officer’s resignation breaches his or her employment contract.

The officers are agents of the corporation and have the power to act on its behalf. A corporation will normally have a chief executive officer (often called president), a secretary, a chief financial officer, and other officers as designated in the bylaws or determined by the board. Any number of offices may be held by the same person unless the relevant state statute or the corporation’s articles or bylaws provide otherwise.

19-17c: Shareholders

Shareholders are virtually never involved in the day-today operations of a corporation. As discussed more fully in  Chapter 20 , shareholders’ main “power” in the corporation is their right to elect directors who will run the company in their stead.

Voting Rights

The shareholders elect the directors. In some states, directors can be removed by the shareholders with or without cause at any time. In other states, such as Delaware, a director who is elected to a staggered or classified board may not be removed without cause, unless the certificate of incorporation provides otherwise. The shareholders might be able to accomplish the same result by first eliminating the charter or bylaw provision requiring the staggered board and then voting to remove the directors, however. In addition, certain transactions, such as a merger or the sale of substantially all of the corporation’s assets, can be approved only by a vote of the shareholders.

ETHICAL CONSIDERATION

Edward Hall and Harry Hall were 50% owners of Hall Contractors and the corporation’s only directors. Edward died, leaving all of his assets to his widow. Harry (the only surviving director at that point) appointed his own wife to fill the vacancy on the board. Initially, Harry and his wife refused to call a shareholder meeting. Even when one was called, Harry simply did not show up to vote. As a result, Edward’s widow could never generate a quorum for a shareholder vote to replace Harry’s wife with an impartial director. The corporation never paid dividends to Edward or his widow and did not intend to pay dividends in the future. As a result, Edward’s widow’s stock in the corporation became worthless. Did Harry and his wife have a legal right to do what they did? a  Were they acting ethically? Would the answer be different if the case involved a corporation like IBM or Google?

a. Hall v. Hall, 506 S.W.2d 42 (Mo. Ct. App. 1974).

Shareholders can act by voting at a meeting or by written consent. A shareholder who cannot be present at a meeting can vote by  proxy —that is, by a written authorization for another person to vote on his or her behalf. Only  shareholders of record —that is, persons whose names appear on the corporation’s shareholder list on a specified date— are entitled to vote.

No action can be taken at a shareholders’ meeting unless there is a  quorum ; the quorum requirements are set forth in each state’s corporate statute. In most jurisdictions, there is no quorum unless the holders of at least 50% of the outstanding shares are present in person or by proxy.

Plurality and Majority Voting

Management proxy statements typically give shareholders two choices when voting for directors: “For” and “Withhold Authority.” Until the early 2000s, most corporations used a  plurality standard , whereby a director could be elected as long as he or she received a plurality of the votes cast for any nominee, without regard to the number of votes withheld. This means that if there are no contested seats, a director can be elected with only one vote for that nominee. More recently,  majority voting , whereby a director must receive a majority of the shares voted to be elected, has become more prevalent. A study of the 2013 proxy season indicated that 84% of S&P 500 companies had adopted some type of majority voting. 53  One popular variation—“plurality-plus”—provides that directors who fail to receive a majority of the votes cast must tender their resignations, which the board must then decide whether to accept. 54  In a true majority voting system, a director must receive a majority of the votes cast to be elected.

Cumulative Voting Versus Straight Voting

Certain states permit, and some require,  cumulative voting , whereby each shareholder may cast all of his or her votes for one nominee or allocate them among the nominees as the shareholder sees fit. A shareholder’s total number of votes is thus equal to the number of directors to be elected multiplied by the number of shares owned by the shareholder. Cumulative voting gives minority shareholders a greater likelihood of electing at least one director.

In an election permitting cumulative voting, the number of shares, x, required to elect a given number of directors, y, can be calculated by the following formula:

x = y × z1 + d  + 1

where z is the total number of shares voting and d is the total number of directors to be elected. 55

To illustrate, assume a shareholder wants to elect three directors (y = 3) to a board with five members up for election (d = 5). The corporation has 100 shares outstanding, and they are all voted (z = 100). Then

x = 3 × 1001 + 5  + 1 x = 51 

With cumulative voting, a shareholder would need 51 shares to elect three directors.

In contrast, with  straight voting , a shareholder can cast one vote for each share the shareholder owns for each nominee. Thus, a shareholder who owns 51 shares can cast 51 votes for each vacant director position. Consequently, a shareholder who controls more than half the voting stock of a corporation can effectively elect the entire board of directors.

Class Voting

Class voting  occurs when the charter or applicable corporate law requires one class of stock, usually preferred, to approve a given proposal voting separately from the holders of the other classes of stock. For example, a charter might require all mergers and sales of substantially all of the assets to be approved by both a majority of the common shares voting as a class and a majority of the preferred shares voting as a class. Class voting is often sought by investors attempting to protect their control of certain key decisions even if they lose majority control of the corporation’s voting equity.

Courts generally will enforce class-voting provisions but tend to construe them quite literally. In Benchmark Capital Partners IV, L.P. v. Vague, 56  the Delaware Court of Chancery reaffirmed its position that a class-voting provision should be narrowly construed even if it appears that a majority shareholder crafted a transaction to avoid triggering the provision. Thus, a group of shareholders who were guaranteed the right to vote as a class on any change in the corporate charter that would dilute their rights or holdings in the corporation had no right to a class vote on a merger that might dilute their equity interest.

Including Shareholder Proposals in the Company’s Proxy Statement

The Securities and Exchange Commission (SEC) requires publicly traded companies to include certain shareholder proposals in the proxy statement the board sends to shareholders to solicit proxies for the election of directors. Shareholder activists have used shareholder proposals extensively to raise social, political, and corporate governance issues. Early examples included proposals for companies to stop doing business in South Africa to protest the policy of apartheid (mandated segregation of blacks and whites). More recently, shareholder proposals have focused on corporate governance issues, such as eliminating classified boards and giving shareholders a right to vote on executive compensation (so-called Say on Pay). 57  As discussed in  Chapter 20 , the Dodd–Frank Wall Street Reform and Consumer Protection Act gave shareholders of public companies the right to vote on advisory (that is, nonbinding) resolutions regarding executive compensation and severance agreements (so-called golden parachutes).

In the wake of the Supreme Court’s decision in Citizens United  58  expanding corporations’ ability to directly fund political advertising and indirectly support individual candidates, shareholders in a number of companies have proposed enhanced disclosure of the board’s policies and procedures for spending corporate funds on electioneering. As of April 2014, 127 companies, including Comcast, Merck, and Microsoft, had voluntarily agreed to provide such disclosure. 59  Although the Securities and Exchange Commission had previously indicated that it might consider promulgating a rule requiring publicly traded companies to disclose their political spending, the matter was not included in its 2014 agenda. 60

Shareholders have also focused on nanotechnology, energy sustainability, and the economic and environmental effects of climate change. 61  For example, the SEC ruled that (1) ExxonMobil could not omit a request that the board establish a committee to study and report to shareholders on how the company can become a leader in developing environmentally sustainable technology to make the United States energy independent and (2) General Electric could not omit a request that the board prepare a global warming report. 62

SEC Rule 14a–8 under the Securities Exchange Act of 1934 allows companies to exclude proposals that relate to the “ordinary business” of the company. The SEC staff has advised corporations that they may not omit any of the following types of shareholder proposals from proxy materials: (1) requests that the board seek shareholder approval prior to adopting a “poison pill” antitakeover device (discussed in  Chapter 20 ), (2) limits on the compensation of nonemployee directors, (3) compensation for senior officers, (4) a reduction in pension benefits, (5) requests that the company dissociate itself from any “offensive” advertising, (6) increased retirement benefits, and (7) a dividend increase. 63  Corporations also may not exclude proposals relating to board structure, voting procedures, nominating procedures, or qualifications of directors. 64  In addition, corporations must include, under certain circumstances, shareholder proposals that seek to establish a procedure in the company’s governing documents for the inclusion of one or more shareholder director nominees in the company’s proxy materials. 65

Shareholder Nomination of Directors

As discussed earlier, corporate law proceeds on the assumption that the shareholders will elect the directors, who in turn are responsible for overseeing management. In practice, the CEO is often also the chair of the board and significantly influences both the selection of directors and the board’s agenda. 66  As a result, the board may fail to exercise the necessary oversight.

The corporate excesses of recent years have led to renewed calls for greater director independence. In public companies, a separate, independent committee of directors is charged with nominating directors for election. In 2003, the SEC adopted rules that require companies to disclose more information about the nomination process, including whether the company pays a third party to help find suitable directors and the company’s minimum requirements for its director nominees. 67

In 2010, the SEC adopted Rule 14a–11, the so-called proxy access rule, which made it possible for shareholders who have held at least 3% of a public company’s stock for at least three years to nominate candidates for the board and solicit proxies without having to go through the considerable expense of commencing a costly proxy contest. 68  The rule required management to include certain shareholder nominations in management’s proxy statement and on its proxy voting card. In 2011, the U.S. Court of Appeals for the District of Columbia Circuit vacated the rule, 69  finding that the SEC had not considered whether the rule would “promote efficiency, competition, and capital formation” as required by section 3(f) of the Securities Exchange Act of 1934. 70  Thus, the rule was arbitrary and capricious.

Shareholder Inspection Rights and Access to the Shareholder List

Shareholders have a common law right to inspect the corporate books and records, including the stock register and/or shareholder list, the minutes of board meetings and shareholder meetings, the bylaws, and books of account. In making the examination, shareholders are permitted the assistance of an accountant, lawyer, or other expert.

In most states, the right of inspection is limited by the requirement that the inspection be conducted for a “proper purpose.” States vary in their interpretation of this limit. Some jurisdictions construe “proper purpose” liberally, leaving shareholder inspection rights virtually unfettered. These states reason that inspection rights should be broad because everything that affects a corporation eventually has an effect on its shareholders. Other states, more concerned with the potential for the inspection right to be an abusive tool, protect against “fishing expeditions” by requiring more than a vague allegation of mismanagement to establish a proper purpose.

In one of the most famous cases in American corporate history, the Minnesota Supreme Court ruled that a shareholder of Honeywell, Inc. who opposed the Vietnam War and sought to persuade Honeywell to cease producing antipersonnel fragmentation bombs for use in the war, did not have a right to Honeywell’s shareholder list or the corporate records dealing with weapons and munitions manufacture. 71  The court explained: “‘Considering the huge size of many modern corporations and the necessarily complicated nature of their bookkeeping, it is plain that to permit their thousands of stockholders to roam at will through their records would render impossible … the proper carrying on of their businesses.’” Because “the power to inspect may be the power to destroy,” the court ruled that Delaware law (which governed the case because Honeywell was incorporated in Delaware) requires the shareholder to assert some concern with investment return. In this case, the shareholder’s avowed purpose in buying Honeywell stock was to place himself in a position to try to impose his social and political opinions upon Honeywell’s management and its other shareholders. Such an interest, the court concluded, could hardly be deemed a proper purpose germane to his economic interest as a shareholder.

Many of the most intense shareholder inspection battles involve access to the list of shareholders. Shareholders seeking to change a corporate policy or gain control of the board of directors want to identify and target their message to the holders of large blocks of stock. To do this, the insurgents need a copy of the shareholder list. Precisely because the list is so valuable to management’s shareholder critics, incumbent managers are likely to resist efforts to obtain it.

Acknowledging that access to the shareholder list can be vital to a successful corporate power struggle, some jurisdictions allow such access without requiring a proper purpose, provided that the shareholder owns a substantial block of shares. For example, the California Corporations Code provides that any 5% shareholder (or a 1% shareholder who files the specified form with the applicable regulatory agency) can inspect and copy the record of shareholders’ names and addresses and shareholdings during usual business hours upon five business days’ written notice, or obtain a list of such information from the transfer agent (the company that transfers ownership of shares when they are bought or sold and keeps the official shareholder list) upon written demand and payment of the appropriate fee. 72

Proxy contests , whereby insurgents propose their own slate of directors or rally to oppose a board proposal by sending out their own proxy statement and soliciting proxies for their candidates or position, continue to be an important technique for obtaining control of a publicly traded company or opposing a particular transaction proposed by the incumbent board of directors. 73  Under the SEC’s regulation for the solicitation of proxies, publicly traded companies must either mail the proxy materials for the insurgents seeking to elect their own directors or  provide a shareholder list. Most companies elect to mail the materials, so insurgents often rely on state inspection statutes to gain access to shareholder lists. 74

ETHICAL CONSIDERATION

In 2003, Hewlett-Packard (HP) and Compaq were involved in the largest high-tech merger in history. Walter Hewlett, son of the company’s founder and an HP director, commenced a proxy contest to oppose the merger. On the day the stockholders were to vote, Deutsche Asset Management, a division of Deutsche Bank, suddenly changed most of its votes from opposing the merger to approving it. The investment giant’s sudden turnaround accounted for 17 million HP shares, nearly 1% of the company’s stock. What Walter Hewlett did not know at the time was that HP’s directors, who were in favor of the merger, had secretly hired Deutsche Bank and agreed to pay it $1 million to advise HP concerning the merger. Deutsche Bank was to receive another $1 million on the successful completion of the merger. a  The merger was approved by a margin of roughly 2% of the company’s stock. Was Deutsche Bank’s conduct legal? Ethical?

a. In re Deutsche Asset Mgmt., Inc., Investment Advisers Act of 1940 Release No. 2160, 80 SEC Docket 2714 (Aug. 19, 2003); see also Susan Beck, Proxy Wars, AM. LAW., May 2002.

Shareholder Suits

Shareholders generally have a right to sue individually and directly for specific harm done to them. However, shareholders alleging corporate mismanagement leading to harm to the corporation as a whole must usually sue derivatively in the name of the corporation in a shareholder derivative action. In such a case, the recovery is paid to the corporation, not to any individual shareholder.

To determine whether a claim is direct or derivative, Delaware courts focus on “(1) who suffered the alleged harm (the corporation or the suing stockholders, individually); and (2) who would receive the benefit of any recovery or other remedy (the corporation or the stockholders, individually).” 75  Also relevant is whether the plaintiffs have demonstrated that they can prevail without showing an injury to the corporation, which depends in part on the identity of the person or entity to whom a duty was owed.

As discussed further in  Chapter 20 , before bringing a shareholder derivative action, the plaintiff shareholder must first demand that the directors bring suit on behalf of the corporation or prove that such a demand would be futile. Often, companies will set up a special litigation committee to decide whether a suit is warranted. Because the would-be defendants are often fellow directors, a court may not honor the committee’s decision not to sue unless the committee was truly independent. 76

Impact of the Shareholders’ Religious Beliefs on the Obligations of a Corporation

As discussed in  Chapter 4 , corporations have free-speech rights, including the right to use treasury funds to pay for political advertising. 77  In the following case, the Supreme Court considered whether family-owned for-profit corporations may refuse to provide certain health insurance coverage required by federal law on the grounds that it would violate their shareholders’ personal religious beliefs.

CASE 19.3: A CASE IN POINT: SUMMARY

Burwell v. Hobby Lobby Stores, Inc.

Supreme Court of the United States

134 S. Ct. 2751 (2014).

FACTS

Hobby Lobby Stores, Inc. is a chain that sells craft supplies. It operates more than five hundred stores and employs more than thirteen thousand individuals. Mardel is an affiliated chain of thirty-five Christian bookstores with almost four hundred employees. Hobby Lobby is a closely held for-profit family business organized as an S corporation, and Mardel is operated on a for-profit basis as well. Both organizations are owned by members of the Green family, who hold strong religious beliefs that impact their business activities—their stores are closed on Sundays, they take out newspaper ads “inviting people to ‘know Jesus as Lord and Savior,’” and they do not participate in business activities involving alcohol.

The Greens believe that “human life begins when sperm fertilizes an egg” and that it is “immoral for them to facilitate any act” that would cause the death of a human embryo. Therefore, they believe that requiring the corporations they own to provide certain forms of contraception (such as intrauterine devices and morning-after pills), as mandated by regulations adopted by the Department of Health and Human Services pursuant to the Patient Protection and Affordable Care Act (ACA), violates their religious beliefs. The corporations instituted suit, claiming that requiring them to provide this coverage of contraceptives violated the Religious Freedom Restoration Act of 1993 (RFRA), among other laws. RFRA provides that the “[g]overnment shall not substantially burden a person’s exercise of religion even if the burden results from a rule of general applicability” unless the government shows that application of the burden is “the least restrictive means” to further a “compelling governmental interest.” 78

ISSUE PRESENTED

Does RFRA permit family-owned for-profit corporations to deny their employees insurance coverage for certain types of contraceptives mandated by the ACA because of the religious beliefs of their shareholders?

SUMMARY OF OPINION

The U.S. Supreme Court noted that RFRA does not define the term “person,” so it consulted the Dictionary Act, 79  which governs “the meaning of any Act of Congress, unless the context indicates otherwise.” The act provides that the word “person” includes “corporations, companies, associations, firms, partnerships, societies, and joint stock companies, as well as individuals.”

The Court rejected the argument

that the owners of the companies forfeited all RFRA protection when they decided to organize their businesses as corporations rather than sole proprietorships or general partnerships. The plain terms of RFRA make it perfectly clear that Congress did not discriminate in this way against men and women who wish to run their businesses as for-profit corporations in the manner required by their religious beliefs. 80

Instead, the Court explained, Congress provided protection for individuals like the Greens

by employing a familiar legal fiction: It included corporations within RFRA’s definition of “persons.” But it is important to keep in mind that the purpose of this fiction is to provide protection for human beings. A corporation is simply a form of organization used by human beings to achieve desired ends. An established body of law specifies the rights and obligations of the people (including shareholders, officers, and employees) who are associated with a corporation in one way or another. When rights, whether constitutional or statutory, are extended to corporations, the purpose is to protect the rights of these people. 81

The Court also rejected the argument that the for-profit status of the corporations involved precluded their exercise of religious rights, noting that modern corporation statutes permit the organization of a for-profit corporation for any lawful purpose:

While it is certainly true that a central objective of for-profit corporations is to make money, modern corporate law does not require for-profit corporations to pursue profit at the expense of everything else, and many do not do so. For-profit corporations, with ownership approval, support a wide variety of charitable causes, and it is not at all uncommon for such corporations to further humanitarian and other altruistic objectives. Many examples come readily to mind. So long as its owners agree, a for-profit corporation may take costly pollution-control and energy-conservation measures that go beyond what the law requires. A for-profit corporation that operates facilities in other countries may exceed the requirements of local law regarding working conditions and benefits. If for-profit corporations may pursue such worthy objectives, there is no apparent reason why they may not further religious objectives as well. 82

After concluding that RFRA applied to for-profit corporations, the Court concluded that even if the regulations requiring the coverage of all FDA-approved contraceptives served a compelling state interest, the means chosen were not narrowly tailored to meet that interest. For example, the government could provide the coverage itself or offer for-profit corporations the same alternative offered religious corporations—namely, have the insurance provider or administrator exclude coverage of the contraceptives from the employer’s group plan and pay the cost of the contraceptives directly.

RESULT

The regulations requiring the provision of insurance coverage for all FDA-approved contraceptives, as applied to family-owned for-profit corporations owned by shareholders who objected to providing such coverage because of their religious beliefs, violated RFRA. Neither Hobby Lobby nor Mardel was required to provide such coverage.

CRITICAL THINKING QUESTIONS

1.

How will the holding in this case affect the enforcement of other laws, such as the anti-discrimination provisions of the Civil Rights Act of 1964? 83

2.

Is attributing to a corporation the religious identity of its controlling shareholders consistent with corporate law? 84

19-18: STRUCTURAL CHANGES IN A CORPORATION

State laws establish mechanisms by which the fundamental structure of the corporation can be changed. These changes can range from a reorganization of the enterprise to the end of the corporation as a separate entity. Because structural changes have far-reaching consequences, they cannot be made easily.

State corporation law prohibits certain changes, such as a merger or the sale of substantially all of the corporation’s assets, unless they are approved by both the board of directors and the shareholders. Approval by the shareholders usually means approval by a simple majority of the outstanding shares, but the certificate of incorporation may require approval by a larger majority, such as two-thirds of the shareholders. Such a requirement for supermajority approval reflects the importance of structural changes.

As discussed in  Chapter 16 , companies contemplating acquisitions and mergers meeting the size requirements set forth in the Hart–Scott–Rodino Antitrust Improvements Act must file a premerger notification with the Federal Trade Commission and the Department of Justice. This notification enables the federal agencies to review the anticompetitive effects of the proposed merger before the combination occurs.

19-18a: Merger

A  merger  is the combination of two or more corporations into one. The disappearing corporation no longer maintains its separate corporate existence but becomes part of the  surviving corporation . The surviving corporation assumes—that is, becomes responsible for—all of the liabilities and debts of the disappearing corporation and automatically acquires all of its assets by operation of law. The new corporation may take on the name of one of the parties to the merger, or a new corporate name may be chosen.

An agreement of merger, negotiated between the two companies, will specify such crucial matters as who will comprise the management team of the new enterprise. A merger generally cannot occur unless the boards and the shareholders of both companies approve the transaction. Once the requisite approval is given, the agreement of merger is filed with the secretary of state.

In a noncash merger, the shares in the disappearing corporation are automatically converted into shares in the surviving corporation. Shareholders are required to surrender their old stock certificates for new certificates representing the stock of the surviving corporation. If a shareholder does not surrender the old certificate, it is deemed by operation of law to represent an equivalent number of shares of the surviving corporation.

In a cash merger, some shareholders (usually the public shareholders) are required to surrender their shares in the disappearing corporation for cash. They retain no interest in the surviving corporation. Hence, such a merger is also called a  freeze-out merger .

19-18b: Sale of Assets

A company may want to acquire the assets of another company, but not its liabilities. To achieve this goal, it can purchase all or most of the other company’s assets without merging with the other company. The proceeds of the asset sale can be distributed to the selling company’s shareholders as part of a dissolution of the corporation. Alternatively, the selling company may choose to continue its corporate existence and invest the proceeds of the asset sale in a new business.

A sale of all or substantially all of the assets of a corporation must be approved by both the board and the shareholders of the selling company. Most states consider a sale of 50% or more of the assets of a company to be a sale of substantially all of the assets. On the theory that the acquisition of assets is a routine management decision, in which the shareholders should not be involved, some states do not require that the transaction be approved by the shareholders of the acquiring company.

19-18c: Appraisal Rights

In a merger or a sale of assets,  dissenting shareholders — those who voted against the transaction—are frequently granted  appraisal rights , that is, the right to receive in cash the fair value of the shares they were forced to give up as a result of the transaction. This right is available only if the transaction was subject to shareholder approval and if the dissenting shareholder complies with certain statutory procedures.

In M.P.M. Enterprises, Inc. v. Gilbert, 85  the Delaware Supreme Court held that for purposes of calculating the amount due shareholders exercising appraisal rights, “fair value” is “the value of the company to the stockholder as a going concern, rather than its value to a third party as an acquisition.” Using projected revenue growth, terminal value in five years, and an appropriate discount rate, the court determined that the equity value of M.P.M. Enterprises was $156.33 million, even though Cookson Group PLC had agreed to buy M.P.M. for $65 million plus up to $73.6 million in subsequent payments, contingent on earnings.

19-19: TENDER OFFERS AND STOCK REPURCHASES

One company can gain control of another (the  target corporation ) by buying a majority of its voting shares, rather than by merging with it or purchasing its assets.

19-19a: Tender Offers

A  tender offer  is a public offer to all the shareholders of a target corporation to buy their shares at a stated price, usually higher than the market price. The party making the offer is called a  bidder  or sometimes a raider because of what is often the hostile nature of the bid. The bidder may offer either cash or other securities in exchange for the stock it seeks to acquire. The bidder is often a new corporation formed for the purpose of making the offer.

The shareholders are free to reject or accept the tender offer without the approval of the target corporation’s board. If shareholders sell sufficient stock to the bidder, it will acquire control of the corporation. Hence, this transaction is commonly described as a  takeover . Because a takeover is almost certain to result in substantial changes in the corporate structure of the target, tender offers are the subject of much regulation by federal statutes, as well as by the laws of the individual states. In addition, as discussed more fully in  Chapter 20 , the boards of many public companies have enacted defensive tactics designed to thwart hostile tender offers.

An example of a takeover that results in a major change in corporate structure is the  second-step back-end merger . The bidder first acquires more than 50% of the shares of a company through a tender offer and replaces the target company’s board of directors with its own people. The new board then approves the merger of the target company into a company owned by the bidder, with the shareholders of the target company receiving cash or securities for their stock. As the majority shareholder of the target company, the bidder can outvote any dissenters and provide the required shareholder approval. The remaining shareholders are thus frozen out of the new company, and the bidder ends up with all the equity.

The Delaware General Corporation Law prohibits publicly held corporations from engaging in certain business combinations, including mergers, with an interested stockholder (defined as the owner of 15% or more of the outstanding voting stock of the corporation) for a period of three years following the time the stockholder became interested unless (1) prior to that time the board of directors approved the transaction that resulted in the stockholder becoming an interested stockholder or the business combination, (2) the interested stockholder owns at least 85% of the corporation, or (3) the business combination is approved by the board of directors and authorized at an annual or special meeting of stockholders by the affirmative vote of at least 66 2/3% of the outstanding voting stock that is not owned by the interested stockholder. 86  A Delaware corporation can opt out of this rule by including a provision in its charter expressly electing not to be governed by this section.

19-19b: Leveraged Buyouts

Any tender offer or other stock purchase can be structured as a  leveraged buyout (LBO) —that is, a stock purchase financed by debt. In many LBOs, the group of investors seeking to gain control of a corporation includes members of corporate management. The debt financing an LBO is typically secured by the assets of the target company (such as real estate or plant and equipment), and it may take the form of a bond issuance, a commercial bank loan, or a loan from an investment bank. An LBO often results in a high debt load, which requires the company to make a series of substantial interest payments. As discussed in  Chapter 23 , LBOs can raise fraudulent conveyance issues.

19-19c: Self-Tender Offers and Going-Private Transactions

A corporation can offer to repurchase its own shares, either in a privately negotiated transaction or through a tender offer available to the public shareholders. A large-scale repurchase can result in the corporation’s  going private —that is, having fewer than three hundred shareholders and no longer being required to file public periodic reports under the Securities Exchange Act of 1934 (discussed further in  Chapter 21 ). A host of SEC rules regulates share repurchases and going-private transactions. 87  A number of small public companies have elected to go private (also known as “going dark”) to avoid the expense of complying with the record-keeping and certification requirements imposed by the Sarbanes–Oxley Act of 2002. A report by the Government Accountability Office found that “public companies with $75 million or less in market capitalization paid a median of $1.14 in audit fees for every $100 in revenue under the act, compared with just 13 cents for every $100 by companies with over $1 billion in market capitalization.” 88  Sometimes, a firm will go private to give the management team more breathing room to reorganize its business. For example, Michael Dell reportedly took Dell Computer private in 2013 to “give Dell the time and breathing room it needs, without having to explain to impatient shareholders every quarter why it hasn’t built a better [sic] iPad.” 89

 THE RESPONSIBLE MANAGER: CHOOSING THE APPROPRIATE BUSINESS ORGANIZATION

The individuals who participate in the creation of a business organization will often go on to become its managers. These managers have a strong incentive to maximize the new enterprise’s potential for success. To do this, several concerns must be addressed during the entity-selection process.

First, a founder should define and clarify the business goals of the enterprise in a business plan. For example, if the enterprise will need capital from a large number of individuals, it will be necessary to ensure limited liability for some or all of these investors. A general partnership would not be suitable, as there would be no limited liability for passive investors.

If several persons work together on an informal basis with a common business objective, and then one leaves, the  forgotten founder  problem can arise. The person who left may have ownership rights in the enterprise. Such rights can be based on the laws of intellectual property if the person leaving created a protectable piece of property, such as a patentable invention or computer software that is protected by copyright law. (Intellectual property is discussed in  Chapter 11 .) Even if a founder created no protectable intellectual property before leaving, he or she may have been a partner in an informal oral general partnership if the parties were sharing profits and losses. As such, that founder would be entitled to a share of the partnership assets.

One way to mitigate the forgotten founder problem is to incorporate early and issue shares that are subject to vesting over time. A common vesting schedule provides that if a person leaves in the first year, he or she forfeits all rights to any stock. Under this approach, called  cliff vesting , one-quarter of the stock is often vested at the end of the first year. The remainder is vested monthly over the next three to four years.

If early incorporation is not feasible or is otherwise undesirable, it is important to spell out in writing at the beginning of a joint project what will happen if someone leaves. Otherwise, those who remain could find themselves sued years later for a share of the company that finally is formed, a partnership interest, or royalties for use of intellectual property.

If a general partnership is chosen, there are additional concerns. For example, it is important to put the partnership agreement in writing. Even though a written partnership agreement is not always necessary to form a partnership, preparing one forces people to think through their business objectives and relationships before they begin working together.

Once an entity has been established, the founders will oversee the process of capitalization. To decide what percentages of debt and equity are to be used in financing the operation, managers should have a realistic idea of the existing demand and the distinct markets for both types of financing. In addition, managers must be aware of the rates at which the corporation can borrow money and the terms that debt and equity holders will require. Tax considerations are crucial to this process.

The final capital structure can take a variety of forms, and much creativity can be employed in this area. Entrepreneurs and investors will often seek assistance from attorneys specializing in finance and tax law, as well as from accountants and investment bankers. The more a manager understands about capitalization, however, the better the manager can utilize the information provided by lawyers, bankers, and accountants to achieve a suitable capital structure.

A MANAGER’S DILEMMA: PUTTING IT INTO PRACTICE: WHEN IS A PARTNER NOT A PARTNER?

In February 1990, Collette Bohatch was named a partner in the Washington, D.C. office of Butler & Binion, a Houston-based law firm. John McDonald was then the managing partner of the firm’s D.C. office, which worked almost exclusively for Pennzoil. Bohatch soon became privy to internal firm reports showing the number of hours each attorney worked, billed, and collected. After reviewing such reports, she became concerned that McDonald was overbilling Pennzoil.

On July 15, 1990, Bohatch met with Louis Paine, Butler & Binion’s managing partner, to report her concerns about McDonald’s billing practices. Paine told Bohatch he would investigate. The following day, McDonald met with Bohatch and told her that Pennzoil was not satisfied with her work and wanted her work to be supervised. Bohatch later testified that this was the first time she had ever heard criticism of her work for Pennzoil.

After looking into Bohatch’s complaint and discussing the allegations with Pennzoil’s in-house counsel, who said that Pennzoil believed the firm’s bills were reasonable, Paine informed Bohatch in August that he found no basis for her contentions. Paine also told her that she should begin looking for other employment. In June 1991, she was informed that June’s monthly partnership distribution would be her last. She was asked to leave by November.

Bohatch filed suit for breach of fiduciary duty and other claims in October 1991. The firm voted to expel her three days later. At trial, a jury found that the firm had breached its fiduciary duty to Bohatch. The court of appeals reversed, holding that the firm’s only duty to Bohatch was not to expel her in bad faith. Bohatch appealed. Did Butler & Binion fulfill its legal obligations to Bohatch? Did it act ethically? Should it matter whether Bohatch was correct about the overbilling? 90

 INSIDE STORY: Focus on Franchises

Although franchises are not a separate form of business entity in the traditional sense, they are a common business arrangement that is subject to regulation by both the Federal Trade Commission (FTC) and a number of states. It is estimated that approximately 750,000 franchises were operating in the United States in 2013 with more than $850 billion in annual revenue. 91  Well-known franchisors include McDonald’s, Century 21, Avis Rent-a-Car, Realty World America, and Dunkin’ Donuts.

A  franchise  is commonly understood to refer to a business arrangement whereby the franchisor receives cash up front, followed by monthly payments based on a reseller’s gross receipts, in exchange for granting the franchisee the right to use the franchisor’s trademarks, marketing plan, and other proprietary information. Certain state statutes define the term more broadly, however, and may bring within their ambit product distribution arrangements between manufacturers and dealers that many managers would not have considered to be franchises. 92  Because franchise laws can override the parties’ contractual arrangements (for example, by prohibiting termination of the relationship without good cause), manufacturers may find themselves constrained in their ability to alter their supply chains to take advantage of new distribution channels, such as the Internet. Absent a contrary statutory provision, however, franchise arrangements are generally governed by the contract between the franchisor and franchisee. 93

Advantages and Disadvantages of Franchising

On the one hand, a franchise offers individuals the opportunity to own their own business without having to start from scratch. Furthermore, a new franchisee can capitalize on the enormous capital inherent in large, established franchises. 94

On the other hand, the quality of customer service and the level of individual attention sometimes deteriorate as a result of the less flexible business plan imposed by the franchisor. Although there is a trend toward larger franchises, some franchisees are finding niches by encouraging their employees to spend more time with customers, responding more promptly to problems, and empowering sales representatives to make decisions on the spot. 95

Definition of “Franchise”

State franchise statutes tend to use either a marketing plan or a community of interest definition, with the marketing plan definition being more prevalent. The definition of “franchise” used by the FTC is broad enough to encompass relationships that would be included under either state definition.

Marketing Plan Definition

The California Business and Professions Code, which is representative, defines a franchise as a contract or agreement, either expressed or implied, whether oral or written, between two or more persons by which:

· (a) A franchisee is granted the right to engage in the business of offering, selling, or distributing goods or services under a marketing plan or system prescribed in substantial part by a franchisor; and

· (b) The operation of the franchisee’s business pursuant to that plan or system is substantially associated with the franchisor’s trademark, service mark, trade name, logotype, advertising, or other commercial symbol designating the franchisor or its affiliate; and

· (c) The franchisee is required to pay, directly or indirectly, a franchise fee. 96

The courts have construed the requirement for a marketing plan very liberally. It can be as little as a quota of copiers to sell in a specific territory, coupled with a requirement that the distributor’s personnel participate in mandatory product training, 97  or an agreement with a boat manufacturer specifying that the dealer was to advertise intensively, conduct a variety of promotions, and carry the boat manufacturer’s array of accessory sales devices. 98

Similarly, it takes very little to satisfy the requirement for a franchise fee. Although many states exclude payments for goods at a bona fide wholesale price, payments for videocassettes, posters, and brochures to promote the manufacturer’s product have been viewed as franchise fees when they were required by the manufacturer or recommended as essential for the successful operation of the business.

Community of Interest Definition

The New Jersey definition of “franchise” is representative of state statutes using the community of interest definition:

“Franchise” means a written arrangement for a definite or indefinite period, in which a person grants to another person a license to use a trade name, trade mark, service mark, or related characteristics, and in which there is a community of interest in the marketing of goods or services at wholesale, retail, by lease, agreement, or otherwise. 99

Some states, including Hawaii and Minnesota, also require payment of a franchise fee.

The supplier is deemed to have given the requisite license if the distributor has the right to identify itself as an authorized dealer even if the distributor does not have the right to use the supplier’s name as part of its own business name. A community of interest in the marketing of goods is also easily shown, and it is present in most supplier–dealer arrangements. For example, courts have found that a community of interest existed when (1) a “consultant” was required to pay an information services firm 1% of the proceeds received from each loan placed by the consultant using the information, and (2) a dealer made significant investments that were specific to the supplier’s goods or services and therefore were not fully recoverable upon termination of the relationship. 100

Venue for Resolving Disagreements

One major difficulty inherent to franchises is determining where they actually are located and therefore where disputes should be resolved. Should a single Wendy’s restaurant in Jersey City be considered to be located in New Jersey for purposes of lawsuits against the Wendy’s Corporation? To decide where a franchise is located, the Wisconsin Supreme Court has developed a nine-point, nonexclusive test that concentrates on the “substance” rather than the physical “location” of the franchise—in this case, a dealership. 101  State public policy leans toward forcing franchisors to settle disputes that arise in the state’s territory under the state’s laws. In 2000, California invalidated all clauses in franchise agreements that mandated non-California venues for dispute resolution. 102  If states did not force franchises to obey their laws, franchisors could simply pick and choose which states to be “from” so as to take advantage of franchisor-friendly legislation.

State Registration and Disclosure Requirements

Thirteen states (including California, Illinois, Indiana, New York, Virginia, and Wisconsin) require franchisors to register before they can sell franchises in that state and to provide presale disclosure to prospective franchisees in the form of a Uniform Franchise Offering Circular (UFOC). Two additional states (Michigan and Oregon) do not require registration or the filing of offering circulars but do require franchisors to provide presale disclosures. All fifteen states also have broad antifraud provisions, prohibiting any person from making any untrue statement of material fact, or a material omission, in connection with the offer or sale of a franchise in the state.

State Franchise Laws Prohibiting Termination Without Good Cause

In the 1960s and early 1970s, a number of state legislatures adopted laws to protect local businesses investing in franchises from the superior bargaining power of large franchisors. These statutes typically prohibit termination or nonrenewal except where there is good cause, such as (1) failure by the franchisee to comply with any material and reasonable obligation under the franchise agreement or (2) conduct by the franchisee that substantially impairs the franchisor’s trademark or trade name.

Although manufacturers may feel justified in terminating a distribution arrangement if the franchisee’s performance is “sub-par,” according to Thomas J. Collin of Thompson Hine LLP, “[c]ases finding that sub-par performance constitutes good cause for termination are scarcer than hen’s teeth….” 103  As a result, a franchisor who seeks to terminate a dealer for lack of market penetration or performance “faces a steep uphill climb.” 104  In some states, such as New Jersey and Indiana, the franchisor may not terminate the franchise even if it has bona fide business reasons for doing so, such as a desire to eliminate distributors’ exclusive territories or to terminate distributors in order to sell directly to end users.

FTC’s Franchise Rule

The Federal Trade Commission’s Franchise Rule requires franchisors to provide a prospective franchisee with a UFOC at least fourteen calendar days before the franchisee signs the contract with the franchisor or pays any money to the  franchisor. 105  The Franchise Rule incorporates, for the most part, the UFOC guidelines developed and administered by the North American Securities Administrators Association, thereby harmonizing to a large extent the federal rule with state franchise disclosure laws. Unlike the state rules, however, the Franchise Rule does not require disclosure of risk factors.

The Franchise Rule requires a franchisor to make material disclosures in five general categories:

(1) the nature of the franchisor and the franchise system; (2) the franchisor’s viability; (3) the costs involved in purchasing and operating a franchise; (4) the terms and conditions that govern the franchise relationship; and (5) the names and addresses of current franchisees who can share their experiences within the franchise system, thus helping the prospective franchisee to verify independently the franchisor’s claims. 106

In addition, franchisors must have a reasonable basis and substantiation for any earnings claims made to prospective franchisees and must disclose the basis and assumptions underlying any such earnings claims.

Presale disclosure is intended to enable prospective franchisees to conduct their own due diligence investigations and to ensure that franchisees understand the relationships they are entering into, including any product source restrictions and any right to protected territories. The FTC enforces the Franchise Rule, and there is no implied private right of action for its violation.

Franchise Relationship Issues

Many franchisees have criticized the FTC for not addressing what they consider to be the greatest problem in franchising today: post-sale “abusive franchise relationships.” They have urged the FTC to use its power under section 5 of the Federal Trade Commission Act to ban as unfair practices post-contract covenants not to compete, obligations to purchase supplies or inventory from specified providers when comparable items are available at cheaper prices from alternative suppliers, and encroachment on a franchisee’s market territory. Encroachment occurs when a franchisor sells a franchisee an outlet in a certain location, and then “place[s] a second franchise blocks away, siphoning off customers and revenue.” 107  The new establishment diverts customers and revenues away from the original franchisee, but the franchisor is often better off because it is receiving its percentage royalty from two stores. The term “cannibalization” is often used to describe the negative effect of encroachment on the franchisee. 108  Only a handful of states, including Indiana and Iowa, protect against encroachment by state law.

The FTC has argued that it has no authority to address these so-called abuses because (1) there is insufficient evidence to show that the various alleged franchisor abuses are prevalent or result in substantial injury when viewed from the standpoint of the franchising industry as a whole; (2) the benefits to consumers and existing franchisees flowing from the franchisor’s contractual terms outweigh complaints or allegations of “oppression” by individual franchisees; and (3) the contractual provisions that prospective franchisees voluntarily read, agree to, and sign are “reasonably avoidable.” 109  The FTC does, however, require (1) disclosure in the UFOC of whether the franchisor or an affiliate (a) has the right to make sales within the franchisee’s territory or (b) has used, or has the right to use, other channels of distribution, such as the Internet, catalog sales, or telemarketing; (2) a breakdown in the UFOC of how many company-owned outlets were acquired from franchisees or sold to franchisors during the preceding three years; (3) a warning in the UFOC when the franchisee is not granted an exclusive territory; (4) disclosure in the UFOC of all material lawsuits involving the franchise relationship in the last fiscal year filed by or against a franchisor; and (5) disclosure of a franchisor’s use of confidentiality clauses that prohibit or restrict existing or former franchisees from discussing their experiences with prospective franchisees. 110