Module 8_Week 8_Corporations, Debtor-Creditor Relations, and Business Regulation_American Business Law

Module 8

Corporations, Debtor-Creditor Relations, and Business Regulation

A. Nature, Formation, and Powers

A corporation is an entity created by law whose existence is distinct from that of

the individuals whose initiative, property, and management enable it to function. The

corporation is the dominant form of business organization in the United States,

accounting for 85 percent of the gross revenues of all business entities. Approximately 6

million domestic corporations, with annual revenues approaching $30 trillion and assets

of approximately $85 trillion, are currently doing business in the United States.

The principal attributes of a corporation are as follows: (1) it is a legal entity; (2)

it owes its existence to a State, which also regulates it; (3) it provides limited liability to

its shareholders; (4) its shares of stock are freely transferable; (5) its existence may be

perpetual; (6) its management is centralized; and it is considered, for some purposes, (7) a

person and (8) a citizen. A corporation is a legal entity and therefore is liable out of its

own assets for its debts. Generally, the shareholders have limited liability for the

corporation’s debts—their liability does not extend beyond the amount of their

investment— although, as discussed later in this chapter, under certain circumstances, a

shareholder may be personally liable. The limitation on liability, however, will not affect

the liability of a shareholder who committed the wrongful act. A shareholder is also liable

for any corporate obligations personally guaranteed by the individual member or

manager.

Corporations may be classified as public or private, profit or nonprofit, domestic

or foreign, publicly held or closely held, Subchapter S, and professional. As will be seen,

these classifications are not mutually exclusive. For example, a corporation may be a

closely held, professional, private, profit, domestic corporation. A public corporation is

one that is created to administer a unit of local civil government, such as a county, city,

town, village, school district, or park district, or one created by the United States to

conduct public business, such as the Tennessee Valley Authority or the Federal Deposit

Insurance Corporation. A public corporation usually is created by specific legislation,

which determines the corporation’s purpose and powers. Many public corporations are

also referred to as municipal corporations. A private corporation is founded by and

composed of private persons for private purposes and has no government duties. A

private corporation may be for profit or nonprofit.

A profit corporation is one founded for the purpose of operating a business for

profit from which payments are made to the corporation’s shareholders in the form of

dividends. Although a nonprofit (or not-for-profit) corporation may make a profit, the

profit may not be distributed to members, directors, or officers but must be used

exclusively for the charitable, educational, or scientific purpose for which the corporation

was organized. Examples of nonprofit corporations include private schools, library clubs,

athletic clubs, fraternities, sororities, and hospitals. Most States have special

incorporation statutes governing nonprofit corporations, most of which are patterned after

the Model Nonprofit Corporation Act. A benefit corporation, public benefit corporation,

or B-corporation is a type of for-profit corporate entity, authorized in at least twenty-eight

States, that includes positive impact on society and the environment in addition to profit

as its legally defined goals.

A corporation is a domestic corporation in the State in which it is incorporated. It

is a foreign corporation in every other State or jurisdiction. A corporation may not do

business, except for acts in interstate commerce, in a State other than the State of its

incorporation without the permission and authorization of the other State. Every State,

however, provides for the issuance of certificates of authority that allow foreign

corporations to do business within its borders and for the taxation of such foreign

businesses. Obtaining a certificate (called “qualifying”) usually involves filing certain

information with the Secretary of State, paying prescribed fees, and designating a resident

agent. Doing or transacting business within a particular State makes the corporation

subject to local litigation, regulation, and taxation.

A publicly held corporation is one whose shares are owned by a large number of

people and are widely traded. There is no accepted minimum number of shareholders, but

any corporation required to register under the Federal Securities and Exchange Act of

1934 is considered to be publicly held. In addition, corporations that have issued

securities subject to a registered public distribution under the Federal Securities Act of

1933 usually are also considered publicly held. The Federal securities laws are discussed

in Chapter 43. To distinguish publicly held corporations from other corporations, the

Revised Act was amended to define the term public corporation as “a corporation that has

shares listed on a national securities exchange or regularly traded in a market maintained

by one or more members of a national securities association.”

A promoter is a person who brings about the “birth” of a corporation by arranging

for capital and financing; assembling the necessary assets, equipment, licenses,

personnel, leases, and services; and attending to the actual legal formation of the

corporation. Upon incorporation, the promoter’s organizational task is finished. In

addition to procuring subscriptions and preparing the incorporation papers, promoters

often enter into contracts in anticipation of the creation of the corporation. The contracts

may be ordinary agreements necessary for the eventual operation of the business, such as

leases, purchase orders, employment contracts, sales contracts, or franchises. If the

promoter executes these contracts in her own name and there is no further action, the

promoter is liable on such contracts; the corporation, when created, is not liable.

Moreover, a preincorporation contract made by a promoter in the name of the corporation

and on its behalf does not bind the corporation. The promoter, in executing such

contracts, may do so in the corporate name even if incorporation has yet to occur. Before

its formation, a corporation has no capacity to enter into contracts or to employ agents or

representatives.

A preincorporation subscription is an offer to purchase capital stock in a

corporation yet to be formed. The offeror is called a “subscriber.” Courts traditionally

have viewed subscriptions in one of two ways. The majority regards a subscription as a

continuing offer to purchase stock from a nonexisting entity, incapable of accepting the

offer until it exists. Under this view, a subscription may be revoked at any time prior to

its acceptance. In contrast, a minority of jurisdictions treats a subscription as a contract

among the various subscribers, rendering the subscription irrevocable except with the

subscribers’ unanimous consent. Most incorporation statutes have adopted an

intermediate position making preincorporation subscriptions irrevocable for a stated

period without regard to whether they are supported by consideration. For example, the

Revised Act provides that a preincorporation subscription is irrevocable for six months,

unless the subscription agreement provides a different period or all of the subscribers

consent to the revocation. Section 6.20. If the corporation accepts the subscription during

the period of irrevocability, the subscription becomes a contract binding on both the

subscriber and the corporation.

Although the procedure involved in organizing a corporation varies somewhat

from State to State, typically the incorporators execute and deliver articles of

incorporation to the Secretary of State or another designated official. The Revised Act

provides that after incorporation, the board of directors named in the articles of

incorporation shall hold an organizational meeting for the purpose of adopting bylaws,

appointing officers, and carrying on any other business brought before the meeting.

Section 2.05. After completion of these organizational details, the corporation’s officers

and board of directors manage its business and affairs. Several States require that a

corporation have a minimum amount of capital, usually $1,000, before doing any

business. The Revised Act and most States have eliminated this requirement.

The incorporators are the persons who sign the articles of incorporation, which

are filed with the Secretary of State of the State of incorporation. Although they perform

a necessary function, in many States, their services as incorporators are perfunctory and

short-lived, ending with the organizational meeting. Furthermore, modern statutes have

greatly relaxed the qualifications of incorporators and also have reduced the number

required. The Revised Act and all States provide that only one person need act as the

incorporator or incorporators, though more may do so. Section 2.01. The Revised Act and

most States permit artificial entities to serve as incorporators. For example, the Revised

Act defines a person to include individuals and entities, with an entity defined to include

domestic and foreign corporations, not-for-profit corporations, profit and not-for-profit

unincorporated associations, business trusts, estates, partnerships, and trusts.

Although modern incorporation statutes have greatly simplified incorporation

procedures, defective incorporations do occur. The possible consequences of a defective

incorporation include the following: (1) the State brings an action against the association

for involuntary dissolution, (2) the associates are held personally liable to a third party,

(3) the association asserts that it is not liable on an obligation, or (4) a third party asserts

that it is not liable to the association. Corporate statutes addressing this issue have taken

an approach considerably different from that of the common law. Under the common

law, a defectively formed corporation was, under certain circumstances, accorded

corporate attributes. The courts developed a set of doctrines granting corporateness to de

jure (of right) corporations, de facto (of fact) corporations, and corporations by estoppel

but denying corporateness to corporations that were too defectively formed

While the common law approach to defective incorporation is cumbersome both

in theory and in application, incorporation statutes now address the issue more simply.

All States provide that corporate existence begins either upon the filing of the articles of

incorporation or their acceptance by the Secretary of State. Moreover, the Revised Act

and most States provide that the filing or acceptance of the articles of incorporation by

the Secretary of State is conclusive proof that the incorporators have satisfied all

conditions precedent to incorporation, except in a proceeding brought by the State.

Section 2.03(b). This applies even if the articles of incorporation contain mistakes or

omissions.

If substantial compliance with the incorporation statute results in a de jure or de

facto corporation, the courts generally will recognize corporateness and its attendant

attributes, including limited liability. Nonetheless, the courts will disregard the corporate

entity when it is used to defeat public convenience, commit a wrongdoing, protect fraud,

or circumvent the law. Going behind the corporate entity to confront those seeking to

insulate themselves from personal accountability and the consequences of their

wrongdoing is known as piercing the corporate veil. Courts will pierce the corporate veil

where they deem such action necessary to remedy wrongdoing. However, there is no

commonly accepted test used by the courts. They have done so most frequently in regard

to closely held corporations and parentsubsidiary relationships. It should be noted that

piercing the corporate veil is the exception, and in most cases, courts uphold the

separateness of corporations.

All State incorporation statutes provide that a corporation may be formed for any

lawful purposes. The Revised Act permits a corporation’s articles of incorporation to

state a more limited purpose. Many State statutes, but not the RMBCA, require that the

articles of incorporation specify the corporation’s purposes although they usually permit

a general statement that the corporation is formed to engage in any lawful purpose.

Because a corporation has authority to act only within its powers, any action or contract

that is not within the scope and type of acts which the corporation is legally empowered

to perform is ultra vires. The doctrine of ultra vires is less significant today because

modern statutes permit incorporation for any lawful purpose, and most articles of

incorporation do not limit corporate powers. Consequently, far fewer acts are ultra vires.

A corporation is liable for the torts its agents commit in the course of their

employment. The doctrine of ultra vires, even in those jurisdictions where it is permitted

as a defense, does not apply to wrongdoing by the corporation. The doctrine of

respondeat superior imposes full liability upon a corporation for the torts its agents and

employees commit during the course of their employment. For example, Robert, a truck

driver employed by the Webster Corporation, negligently runs over Pamela, a pedestrian,

while on a business errand. Both Robert and the Webster Corporation are liable to

Pamela in her action to recover damages for the injuries she sustained. A corporation also

may be found liable for fraud, false imprisonment, malicious prosecution, libel, and other

torts, though some States hold the corporation liable for punitive damages only if it

authorized or ratified the agent’s act.

B. Financial Structure

Capital is necessary for any business to function. Two principal sources for

corporate financing involve debt and equity investment securities. While equity securities

represent an ownership interest in the corporation and include both common and

preferred stock, corporations finance most of their operations through debt securities.

Debt securities, which include notes and bonds, do not represent an ownership interest in

the corporation but rather create a debtor-creditor relationship between the corporation

and the bondholder. The third principal way in which a corporation may meet its

financial needs is through retained earnings. All States have statutes regulating the

issuance and sale of corporate shares and other securities. Popularly known as blue-sky

laws, these statutes typically have provisions prohibiting fraud in the sale of securities. In

addition, a number of States require the registration of securities, and some States also

regulate brokers, dealers, and others who engage in the securities business.

The Revised Act provides that every corporation has the power “to make

contracts and guarantees, incur liabilities, borrow money, issue its notes, bonds, and other

obligations (which may be convertible into or include the option to purchase other

securities of the corporation), and secure any of its obligations by mortgage or pledge of

any of its property, franchises, or income.” Section 3.02. The board of directors may

issue bonds without the authorization or consent of the shareholders.

Debt securities can be classified into various types according to their

characteristics. The variants and combinations possible within each type are limited only

by a corporation’s ingenuity. Debt securities are typically issued under an indenture or

debt agreement, which specifies in great detail the terms of the loan. The Federal Trust

Indenture Act of 1939 applies to indentures covering bonds issued for $10 million or

more. In addition, a high-yield bond (non-investment-grade bond or junk bond is a bond

that is rated below investment grade at the time of purchase. These bonds have a greater

risk of default than investment-grade bonds but typically pay higher yields than

investment-grade bonds to make them attractive to investors.

The State of incorporation regulates the issuance of shares by determining the

type of shares that may be issued, the kinds and amount of consideration for which shares

may be issued, and the rights of shareholders to purchase a proportionate part of

additionally issued shares. Moreover, the Federal government and each State in which the

shares are issued or sold regulate the issuance and sale of shares. Once the amount of

shares that the corporation is authorized to issue has been specified in the charter, it

cannot be increased or decreased without amending the articles of incorporation. This

means that the shareholders, who must approve any amendment to the articles of

incorporation, have residual authority over increases in the amount of authorized capital

stock. Consequently, articles of incorporation commonly specify more shares than are to

be issued initially.

A shareholder’s proportionate interest in a corporation can be changed by either a

disproportionate issuance of additional shares or a disproportionate reacquisition of

outstanding shares. In either transaction, management owes both the shareholder and the

corporation a fiduciary duty. Moreover, when additional shares are issued, a shareholder

may have the preemptive right to purchase a proportionate part of the new issue.

Preemptive rights are used far more frequently in closely held corporations than in

publicly traded corporations. Without such rights, a shareholder may be unable to prevent

a dilution of his ownership interest in the corporation. For example, Leonard owns two

hundred shares of stock of the Fordham Company, which has a total of one thousand

shares outstanding. The company decides to increase its capital stock by issuing one

thousand additional shares of stock. If Leonard has preemptive rights, he and every other

shareholder will be offered one share of the newly issued stock for every share they own.

If he accepts the offer and buys the stock, he will have four hundred shares out of a total

of two thousand outstanding, and his relative interest in the corporation will be

unchanged. Without preemptive rights, however, he would have only two hundred out of

the two thousand shares outstanding; instead of owning 20 percent of the stock, he would

own 10 percent.

Corporations are generally authorized by statute to issue different classes of stock,

which may vary with respect to their rights to dividends, their voting rights, and their

right to share in the assets of the corporation upon liquidation. The usual classifications

of stock are common and preferred shares. Although the Revised Act has eliminated the

terms preferred and common, it permits the issuance of shares with different preferences,

limitations, and relative rights. Section 6.01. The Revised Act explicitly requires that the

charter authorize “(1) one or more classes of shares that together have unlimited voting

rights, and (2) one or more classes of shares (which may be the same class or classes as

those with voting rights) that together are entitled to receive the net assets of the

corporation upon dissolution.” Section 6.01(b). In most States, however, even nonvoting

shares may vote on certain mergers, share exchanges, and other fundamental changes

which affect that class of shares as a class.

Several legal restrictions limit the amount of distributions a board of directors

may declare. Though all States have statutes restricting the funds that are legally

available for dividends and other distributions of corporate assets, lenderimposed

contractual restrictions often limit the declaration of dividends and distributions even

more stringently. States restrict the payment of dividends and other distributions to

protect creditors. All States impose the equity insolvency test, which prohibits the

payment of any dividend or other distribution when the corporation either is insolvent or

would become so through the payment of the dividend or distribution. Insolvent in the

equity sense indicates the inability of a corporation to pay its debts as they become due in

the usual course of business.

In addition, almost all States impose further restrictions regarding the funds that

are legally available to pay dividends and other distributions. These additional restrictions

are based upon the corporation’s assets or balance sheet, whereas the equity insolvency

test is based upon the corporation’s cash flow.

The declaration of dividends and other distributions is within the discretion of the

board of directors and may not be delegated. If the charter clearly and expressly provides

for mandatory dividends, however, the board must comply with the provision.

Nonetheless, such provisions are extremely infrequent, and shareholders cannot usurp the

board’s power in any other way, although it is in their power to elect a new board.

Moreover, the board cannot discriminate in its declaration of dividends among

shareholders of the same class.

The Revised Act imposes personal liability upon the directors of a corporation

who vote for or assent to the declaration of a dividend or other distribution of corporate

assets contrary to the incorporation statute or the articles of incorporation. Section

8.33(a). The measure of damages is the amount of the dividend or distribution in excess

of the amount that the corporation lawfully may have paid. A director is not liable if she

acted in accordance with the relevant standard of conduct: in good faith, with reasonable

care, and in a manner she reasonably believed to be in the best interests of the

corporation. Sections 8.30 and 8.33. (This standard of conduct will be discussed in the

next chapter.)

In discharging this duty, a director is entitled to rely in good faith upon financial

statements presented by the corporation’s officers, public accountants, or finance

committee. Such statements must be prepared on the basis of “accounting practices and

principles that are reasonable in the circumstances or on a fair valuation or other method

that is reasonable in the circumstances.” Section 6.40(d). According to the Comments to

this section, generally accepted accounting principles are always reasonable in the

circumstances; other accounting principles may be acceptable under a general standard of

reasonableness.

C. Management Structure

The corporate management structure, as required by State incorporation statutes,

is pyramidal. At the base of the pyramid are the shareholders, who are the residual

owners of the corporation. Basic to their role in controlling the corporation is the right to

elect representatives to manage the ordinary business matters of the corporation and the

right to approve all extraordinary matters. The board of directors, as the shareholders’

elected representatives, are delegated the power to manage the business of the

corporation. Directors exercise dominion and control over the corporation, hold positions

of trust and confidence, and determine questions of operating policy. Because they are

not expected to devote their time completely to the affairs of the corporation, directors

have broad authority to delegate power to agents and to officers who hold their offices at

the will of the board and who, in turn, hire and fire all necessary operating personnel and

run the day-to-day affairs of the corporation.

The shareholder’s right to vote is fundamental both to the corporate concept and

to the corporation’s management structure. In most States, a shareholder is entitled to one

vote for each share of stock that she owns, unless the articles of incorporation provide

otherwise. In addition, incorporation statutes generally permit the issuance of one or more

classes of nonvoting stock, so long as at least one class of shares has voting rights.

Section 6.01. The articles of incorporation may provide for more or less than one vote for

any share. For example, in Providence & Worcester Co. v. Baker, 378 A.2d 121 (Del.

1977), the court upheld articles of incorporation which provided that each shareholder

was entitled to one vote per share for each of fifty or fewer shares that he owned and one

vote for every twenty shares in excess of fifty, but no shareholder was entitled to vote

more than one-fourth of the whole number of outstanding shares.

Most States have enacted statutory provisions granting shareholders the right to

inspect for a proper purpose books and records in person or through an agent and to make

extracts from them. The right generally covers all records relevant to the shareholder’s

legitimate interest. The Revised Act extends the right to copy records to include, if

reasonable, the right to receive copies made by photographic, xerographic, or other

means. Section 16.03. The Act provides that every shareholder is entitled to examine

specified corporate records upon prior written request if the demand is made in good

faith, for a proper purpose, and during regular business hours at the corporation’s

principal office.

Many States, however, limit this right to shareholders who own a minimum

number of shares or to those who have been shareholders for a specified minimum time.

For example, the MBCA requires that a shareholder either must own 5 percent of the

outstanding shares or must have owned his shares for at least six months; a court,

however, may order an inspection even when neither condition is met. A proper purpose

for inspection is one that is reasonably relevant to a shareholder’s interest in the

corporation. Proper purposes include determining the financial condition of the

corporation, the value of shares, the existence of mismanagement or improper

transactions, or the names of other shareholders in order to communicate with them about

corporate affairs.

The Revised Act and the statutes of many States provide that “[a]ll corporate

powers shall be exercised by or under the authority of, and the business and affairs of the

corporation managed under the direction of, its board of directors, subject to any

limitation set forth in the articles of incorporation.” Section 8.01(b). In some

corporations, the members of the board all are actively involved in the management of

the business. In these cases, the corporate powers are exercised by the board of directors.

On the other hand, in publicly held corporations, most board members are unlikely to be

actively involved in management.

Here, the corporate powers are exercised under the authority of the board, which

formulates major management policy and monitors management’s performance but does

not involve itself in day-to-day management. In publicly held corporations, the directors

who are also officers or employees of the corporation are inside directors while the

directors who are not officers or employees are outside directors. Outside directors who

have no business contacts with the corporation are unaffiliated directors; outside directors

who do have such contacts with the corporation—such as investment bankers, lawyers,

and suppliers—are affiliated directors.

The incorporation statute, articles of incorporation, and bylaws determine the

qualifications essential for those who would be directors of the corporation. They also

determine the election, number, tenure, and compensation of directors. Only individuals

may serve as directors. Although they are powerless to bind the corporation when acting

individually, directors can exert this power when acting as a board. Nevertheless, the

board may act only through a meeting of the directors or with the written, unanimously

signed consent of the directors if written consent without a meeting is authorized by the

statute and not contrary to the charter or bylaws.

In most States, the officers of a corporation are appointed by the board of

directors to hold the offices provided in the bylaws, which set forth the respective duties

of each officer. Statutes generally require as a minimum that the officers consist of a

president, one or more vice presidents as prescribed by the bylaws, a secretary, and a

treasurer. A person may hold more than one office, with the exception that the same

person may not hold the office of president and secretary at the same time. The Revised

Act and other modern statutes permit every corporation to designate whatever officers it

wants. Although the Act specifies no particular number of officers, one of them must be

delegated responsibility for preparing the minutes of directors’ and shareholders’

meetings and authenticating corporate records. The Revised Act permits the same

individual to hold all of the offices of a corporation.

D. Fundamental Changes

Certain extraordinary changes exert such a fundamental effect on a corporation by

altering the corporation’s basic structure that they fall outside the authority of the board

of directors and require shareholder approval. Such fundamental changes include charter

amendments, mergers, consolidations, compulsory share exchanges, dissolution, and the

sale or lease of all or substantially all of the corporation’s assets, other than those in the

regular course of business. Although each of these actions is authorized by State

incorporation statutes, which impose specific procedural requirements, they are also

subject to equitable limitations imposed by the courts. In 1999, substantial revisions were

made to the Revised Act’s treatment of fundamental changes.

Shareholders do not have a vested property right resulting from any provision in

the articles of incorporation. Section 10.01(b). Accordingly, incorporation statutes grant

the authority to amend corporate charters if specified procedures are followed. The

amended articles of incorporation, however, may contain only those provisions that the

articles of incorporation might lawfully contain at the time of the amendment.

Acquiring all or substantially all of the assets of another corporation or

corporations may be both desirable and profitable. A corporation may accomplish this

through (1) purchase or lease of other corporations’ assets, (2) purchase of a controlling

stock interest in other corporations, (3) merger with other corporations, or (4)

consolidation with other corporations. A few States have and the 1999 amendments to the

Revised Act contain provisions authorizing a corporation to merge into another type of

business organization, such as a limited partnership (LP), a limited liability company

(LLC), or a limited liability partnership (LLP).

Although a corporation may have perpetual existence, its life may be terminated

in a number of ways. Incorporation statutes usually provide for both voluntary dissolution

and involuntary dissolution. Dissolution does not in itself terminate the corporation’s

existence but does require that the corporation wind up its affairs and liquidate its assets.

Voluntary dissolution may be brought about through a board resolution approved by the

affirmative vote of the holders of a majority of the corporation’s shares entitled to vote at

a shareholders’ meeting duly called for this purpose.

Although shareholders who object to dissolution usually have no right to dissent

and recover the fair value of their shares, the Revised Act grants dissenters’ rights in

connection with a sale or exchange of all or substantially all of a corporation’s assets not

made in the usual or regular course of business, including a sale in dissolution.

Nevertheless, the Act excludes such rights in sales by court order and sales for cash on

terms requiring that all or substantially all of the net proceeds be distributed to the

shareholders within one year. Section 13.02(a)(3). In addition, in many States, but not the

Revised Act, dissolution without action by the directors may be effected by unanimous

consent of the shareholders.

Dissolution, as mentioned, requires that the corporation devote itself to winding

up its affairs and liquidating its assets. After dissolution, the corporation must cease

carrying on its business except as is necessary to wind up. Section 14.05. When a

corporation is dissolved, its assets are liquidated and used first to pay the expenses of

liquidation and its creditors according to their respective contract or lien rights. Any

remainder is distributed proportionately to shareholders according to their respective

contract rights; stock with a liquidation preference has priority over common stock.

Voluntary liquidation is carried out by the board of directors, who serve as trustees; a

court-appointed receiver may conduct involuntary liquidation.

E. Secured Transactions and Suretyship

Neither a borrower nor a lender be”—Shakespeare’s well-known line in Hamlet—

reflects an earlier view of debt, for today borrowed funds are both essential and

honorable under our economic system. In fact, the absence of loans would severely

restrict the availability of goods and services and would greatly limit consumers in the

quantities they would be able to purchase. A lender typically incurs two basic collection

risks: the borrower may be unwilling to repay the loan even though he is able to, or the

borrower may prove to be unable to repay the loan. In addition to the remedies dealing

with the first of these risks, the law has developed several devices to maximize the

likelihood of repayment. These devices, which are discussed in this chapter, include

consensual security interests (also called secured transactions) and suretyships.

Article 9 governs a secured transaction in personal property in which the debtor

consents to provide a security interest in personal property to secure the payment of a

debt. A security interest in property cannot exist apart from the debt it secures, and

discharging the debt in any manner terminates the security interest in the property. Article

9 also applies to the sales of certain types of collateral (accounts, chattel paper, payment

intangibles, and promissory notes). Article 9 does not apply to nonconsensual security

interests that arise by operation of law, such as mechanics’ or landlords’ liens, although it

does cover nonpossessory statutory agricultural liens. A common type of consensual

secured transaction covered by Article 9 occurs when a person wanting to buy goods has

neither the cash nor a sufficient credit standing to obtain the goods on open credit, and

the seller, to secure payment of all or part of the price, obtains a security interest in the

goods. Alternatively, the buyer may borrow the purchase price from a third party and pay

the seller in cash. The thirdparty lender may then take a security interest in the goods to

secure repayment of the loan.

Although most of the provisions of Article 9 apply to all kinds of personal

property, some provisions state special rules that apply only to particular kinds of

collateral. Under the UCC, collateral is classified according to its nature and its use. The

classifications according to nature are (1) goods, (2) indispensable paper, and (3)

intangibles. Proceeds include whatever is received upon the sale, lease, license, exchange,

or other disposition of collateral; whatever is collected on, or distributed on account of,

collateral; or other rights arising out of collateral. Section 9-102(a)(64). For example, an

automobile dealer grants a security interest in its inventory to the automobile

manufacturer that sold the inventory. When the dealer sells a car to Henry and receives

from Henry a used car and the remainder of the purchase price in a monetary payment,

both the used car and the money are proceeds from the sale of the new car. Unless

otherwise agreed, a security agreement gives the secured party (the manufacturer in this

example) the rights to proceeds. Section 9-203(f ). Additional types of collateral include

timber to be cut, minerals, motor vehicles, mobile goods (goods used in more than one

jurisdiction), and money. Article 9 also includes the following kinds of collateral:

commercial tort claim, letter-ofcredit rights, and deposit accounts (a demand, savings,

time, or similar account maintained with a bank). In consumer transactions, however,

deposit accounts may not be taken as original collateral.

Attachment is the UCC’s term to describe the creation of a security interest that is

enforceable against the debtor. Attachment is also a prerequisite to rendering a security

interest enforceable against third parties, though in some instances, attachment in itself is

sufficient to create such enforceability. Perfection, which provides the greatest

enforceability against third parties who assert competing interests in the collateral, is

discussed in the next section. Until a security interest “attaches,” it is ineffective against

the debtor.

The elusive concept of the debtor’s rights in collateral is not specifically defined

by the UCC. As a general rule, the debtor is deemed to have rights in collateral that she

owns or is in possession of as well as in those items that she is in the process of acquiring

from the seller. For example, if Adrien borrows money from Richard and grants him a

security interest in corporate stock that she owns, then Adrien had rights in the collateral

before entering into the secured transaction. Likewise, if Sally sells goods to Benjamin on

credit and he provides Sally a security interest in the goods, Benjamin will acquire rights

in the collateral upon identification of the goods to the contract. In addition, Section 9-

203(b)(2) adds the words “or the power to transfer rights in the collateral to a secured

party.” The comments to this section state “however, in accordance with basic personal

property conveyancing principles, the baseline rule is that a security interest attaches only

to whatever rights a debtor may have, broad or limited as those rights may be.”

To be effective against third parties who assert competing interests in the

collateral (including other creditors of the debtor, the debtor’s trustee in bankruptcy, and

transferees of the debtor), the security interest must be perfected. Perfection of a security

interest occurs when it has attached and when all the applicable steps required for

perfection have been satisfied. Section 9-308(a). If these steps precede attachment, the

security interest is perfected at the time it attaches. Once a security interest becomes

perfected, it “may still be or become subordinate to other interests … [h]owever, in

general, after perfection the secured party is protected against creditors and transferees of

the debtor and, in particular, against any representative of creditors in insolvency

proceedings instituted by or against the debtor.” Section 9-308, Comment 2. Thus, in

most instances, a perfected secured party will prevail over a subsequent perfected

security interest, a subsequent lien creditor or a representative of creditors (e.g., a trustee

in bankruptcy), and subsequent buyers of the collateral.

As previously noted, a security interest must be perfected to be most effective

against the debtor’s other creditors, her trustee in bankruptcy, and her transferees.

Nonetheless, perfection of a security interest does not provide the secured party with a

priority over all third parties with an interest in the collateral. On the other hand, even an

unperfected but attached security interest has priority over a limited number of third

parties and is enforceable against the debtor. Article 9 establishes a complex set of rules

that determine the relative priorities among these parties.

Because the UCC does not define or specify what constitutes default, general

contract law or the agreement between the parties will determine when a default occurs.

After default, the security agreement and the applicable provisions of the UCC govern the

rights and remedies of the parties. In general, the secured party may reduce his claim to

judgment, foreclose, or otherwise enforce the claim, security interest, or agricultural lien

by any available judicial procedure. Section 9-601(a)(1). If the collateral consists of

documents, the secured party may proceed against the documents or the goods they

cover. Section 9-601(a)(2). These rights and remedies of the creditor are cumulative.

The Restatement provides that if the secondary obligor is identified as a

guarantor, the creditor may hold the guarantor liable as soon as the principal debtor

defaults. The creditor need not proceed first against the principal debtor. In contrast, a

secondary obligor who is identified as a guarantor of collection is liable only when the

creditor exhausts his legal remedies against the principal debtor. Section 15. Thus, a

conditional guarantor of collection is liable if the creditor first obtains, but is unable to

collect, a judgment against the principal debtor. A secondary obligor who is identified as

a surety is jointly and severally liable with the principal debtor to perform the obligation

set forth in the contract. Two or more secondary obligors bound for the same debt of a

principal debtor are cosureties.

Upon default by the principal debtor, the creditor may proceed against the surety

to enforce the surety’s undertaking. A surety or guarantor usually has no right to compel

the creditor to collect from the principal debtor or to take action on collateral provided by

the principal debtor. Sections 15 and 51. Nor is the creditor required to give the surety

notice of the principal debtor’s default unless the contract of suretyship provides

otherwise. A guarantor of collection, on the other hand, has no liability until the creditor

exhausts his legal remedies of collection against the principal debtor, including taking

action on collateral provided by the principal debtor. Up to the amount of each surety’s

undertaking, cosureties are jointly and severally liable for the principal debtor’s default.

The creditor may proceed against any or all of the cosureties and collect from any of

them the amount that the surety has agreed to guarantee, up to and including the entire

amount of the principal debtor’s obligation.

Upon the principal debtor’s default, the surety has a number of rights against the

principal debtor, third parties, and cosureties. These rights include (1) exoneration, (2)

reimbursement, (3) subrogation, and (4) contribution. Section 18. These rights may, by

agreement, be augmented, modified, or limited. The ordinary expectation in a suretyship

relation is that the principal debtor will perform the obligation and the surety will not be

required to perform. Therefore, the surety has the right to require that her principal debtor

perform the underlying obligation when that obligation is due. Section 21. This right of

the surety against the principal debtor, called the right of exoneration, is enforceable at

equity. If the principal debtor fails to pay the creditor when the debt is due, the surety

may obtain a decree ordering the principal debtor to pay the creditor. The remedy of

exoneration against the principal debtor does not, however, impair the creditor’s right to

proceed against the surety. Unless otherwise agreed, collateral supplied by the principal

debtor to secure the duty to reimburse the surety also secures the principal debtor’s duty

of exoneration to the surety to perform the underlying obligation.

The defenses available only to a principal debtor are known as the personal

defenses of the principal debtor. For example, the principal debtor’s incapacity due to

infancy or mental incompetency may serve as a defense for the principal debtor but not

for the surety. If, however, the principal debtor disaffirms the contract and returns the

consideration he received from the creditor, the surety is discharged from his liability to

the extent the value of the consideration equals the principal debtor’s underlying

obligation. Section 34. A discharge of the principal debtor’s obligation in bankruptcy

does not discharge the surety’s liability to the creditor on that obligation. The principal

obligor may assert a claim against the creditor unrelated to the underlying obligation to

the extent permitted under the law governing setoffs. Subject to several exceptions

discussed later, the surety may not use as a setoff any unrelated claim that the principal

debtor has against the creditor.

F. Bankruptcy

A debt is an obligation to pay money owed by a debtor to a creditor. Debts are

created daily by countless purchasers of goods at the consumer level; by retailers of

goods in buying merchandise from a manufacturer, wholesaler, or distributor; by

borrowers of funds from various lending institutions; and through the issuance and sale of

bonds and other types of debt securities. Multitudes of business transactions are entered

into daily on a credit basis. Commercial activity would be restricted greatly if credit were

not readily obtainable or if needed funds were unavailable for lending.

The most important method of protecting creditor rights and granting debtor relief

is Federal bankruptcy law, which is largely statutory and involves court supervision. U.S.

bankruptcy law serves a dual purpose: (1) to effect a quick, equitable distribution of the

debtor’s property among her creditors and (2) to discharge the debtor from her debts,

enabling her to rehabilitate herself and start afresh. Other purposes are to provide uniform

treatment of similarly situated creditors, preserve existing business relations, and stabilize

commercial usages.

More than 99 percent of all bankruptcy petitions are filed voluntarily. Any person

eligible to be a debtor under a given bankruptcy proceeding may file a voluntary petition under

that chapter and need not be insolvent to do so. Commencing a voluntary case by filing a

petition constitutes an automatic order for relief. The petition must include a list of all creditors

(secured and unsecured), a list of all property the debtor owns, a list of property that the debtor

claims to be exempt, and a statement of the debtor’s affairs. The 2005 Act added a requirement

that all individual debtors receive credit counseling from an approved nonprofit budget and

credit counseling agency within the 180-day period before filing the petition. This requirement

does not apply to a debtor who (1) is exempted by the court or (2) resides in a district for which

the U.S. trustee or the bankruptcy administrator determines that approved nonprofit budget

and credit counseling agencies are not reasonably able to provide adequate services to the

additional individuals who would seek required credit counseling. The role of the credit

counseling agencies is to analyze the client’s current financial condition, the factors that caused

the financial distress, and how the client can develop a plan to respond to these problems.

The Bankruptcy Code defines a creditor as any entity having a claim against the

debtor that arose at the time of or before the order for relief. A claim means a “right to

payment whether or not such right is reduced to judgment, liquidated, unliquidated, fixed,

contingent, matured, unmatured, disputed, undisputed, legal, equitable, secured, or

unsecured.” The debtor has the option of using either the exemptions provided by the

Bankruptcy Code or those available under State law. Nevertheless, a State may by

specific legislative action limit its citizens to the exemptions provided by State law. More

than three-quarters of the States have enacted such “opt out” legislation. The 2005 Act

specifies that a debtor’s exemption is governed by the law of the State where the debtor

was domiciled for 730 days immediately before filing. If the debtor did not maintain a

domicile in a single State for the 730-day period, then the governing law is of the State

where the debtor was domiciled for 180 days immediately preceding the 730-day period

(or for a longer portion of such 180-day period than in any other State).

Under the means test, abuse is presumed (i.e., the debtor is not eligible for

Chapter 7 unless the debtor can prove special circumstances) for an individual debtor

whose net current monthly income is greater than the State median income and if (1) the

debtor has available net income (income after deducting allowed expenses) for repayment

to creditors over five years totaling at least $12,850 or (2) the available net income for

repayment to creditors over five years is between $7,700 and $12,850 and such available

net income is at least 25 percent of nonpriority unsecured claims.

Reorganization is the process of correcting or eliminating factors responsible for

the distress of a business enterprise, thereby preserving both the enterprise and its value

as a going concern. Chapter 11 of the Bankruptcy Code governs reorganization of eligible

debtors, including individuals, partnerships, and corporations, and permits the

restructuring of their finances. A number of large corporations have made use of Chapter

11, including WorldCom, Enron, Kmart, Texaco, A.H. Robins, Johns-Manville, Allied

Stores, Global Crossing, Pacific Gas and Electric, CIT Group, Conseco, Lehman

Brothers, American Airlines, MF Global, Washington Mutual, Circuit City, Linens ’n

Things, General Motors, and Chrysler. The main objective of a reorganization proceeding

is to develop and carry out a fair, equitable, and feasible plan of reorganization.

When a debtor fails to pay a debt, the creditor may file suit to collect the debt

owed. The objective is to obtain a judgment against the debtor and ultimately to collect

on that judgment. Because litigation takes time, a creditor attempting to collect on a claim

through the judicial process will almost always experience delay in obtaining judgment.

To prevent the debtor from meanwhile disposing of his assets, the creditor may use, when

available, certain prejudgment remedies. The most important of these is attachment, the

process of seizing property, by virtue of a writ, summons, or other judicial order, and

bringing the property into the custody of the court to secure satisfaction of the judgment

ultimately to be entered in the action. At common law, the main objective of attachment

was to coerce the defendant debtor into appearing in court; today the writ of attachment is

statutory and is used primarily to seize the debtor’s property in the event a judgment is

rendered. Most States limit attachment to specified grounds and provide the debtor an

opportunity for a hearing before a judge prior to the issuance of a writ of execution

The creditor’s pursuit of a judgment on which she can collect and the debtor’s

quest for relief inherently give rise to conflicts among (1) the right of diligent creditors to

pursue their claims to judgment and to satisfy their judgments by sale of property of the

debtor, (2) the right of unsecured creditors who have refrained from suing the debtor, and

(3) the social policy of affording relief to a debtor who has contracted debts beyond his

ability to pay and who therefore may bear a lifetime burden. Various nonbankruptcy

compromises provide relief to debtors. Certain compromises, such as those offered by

credit agencies and adjustment bureaus, are relatively informal. Some, such as

compositions and assignments, are founded in common law and involve simple contract

and trust principles; others, such as statutory assignments, are statutory. Some, such as

equity receiverships, involve the intervention of a court and its officers, while others do

not.

G. Protection of Intellectual Property

Intellectual property (IP) is an economically significant type of intangible

personal property that includes trade secrets, trade symbols, copyrights, and patents.

These interests are protected from infringement, or unauthorized use, by others. Such

protection is essential to the conduct of business. For example, a business would be far

less willing to invest considerable resources in research and development if the resulting

discoveries, inventions, and processes were not protected by patents and trade secrets.

Similarly, a company would not be secure in devoting time and money to marketing its

products and services without laws that protect its trade symbols and trade names.

Moreover, without copyright protection, the publishing, entertainment, and computer

software industries would be vulnerable to piracy, both by corporate competitors and by

the general public. This chapter discusses the law protecting (1) trade secrets; (2) trade

symbols, including trademarks, service marks, certification marks, collective marks, and

trade names; (3) copyrights; and (4) patents.

Every business has secret information. Such information may include customer

lists or contracts with suppliers and customers; it also may comprise formulas, processes,

and production methods that are vital to the successful operation of the business. A

business may disclose a trade secret in confidence to an employee with the understanding

that the employee will not reveal the information to others. To the extent the owner of the

information obtains a patent on it, it is no longer a trade secret but is protected by patent

law. Some businesses, however, choose not to obtain a patent because it provides

protection for only a limited time, whereas trade secret law protects a trade secret as long

as it is kept secret. Moreover, if the courts invalidate a patent, the information will have

been disclosed to competitors without the owner of the information obtaining any benefit.

One of the earliest forms of unfair competition was the fraudulent marketing of

one person’s goods as those of another. Still common, this unlawful practice is

sometimes referred to as “passing off” or “palming off.” Basically the process of

“cashing in” on the goodwill, good name, and reputation of a competitor and of his

products, this fraudulent marketing deceives the public and deprives honest businesses of

trade. Section 43(a) of the Federal Trademark Act (the Lanham Act) prohibits a person

from using a false designation of origin in connection with any goods or services in

interstate commerce. This section also prohibits a person from making a false or

misleading description or representation of fact which misrepresents the nature,

characteristics, qualities, or geographic origin of her own goods, services, or commercial

activities. In 1988, this section was amended to prohibit misrepresentations of another

person’s goods, services, or commercial activities. As a result, Section 43(a) also forbids

“reverse palming off,” by which a producer misrepresents someone else’s goods as his

own. Accordingly, James would violate Section 43(a) by passing off his product as

Sally’s or by reverse passing off Sally’s product as his. A violator of Section 43(a) is

liable in a civil action to any person who is, or is likely to be, injured by the violation.

The remedies are (1) injunctive relief, (2) an accounting for profits, (3) damages, (4)

destruction of infringing articles, (5) costs, and (6) attorneys’ fees in exceptional cases.

works, which, under Section 102 of the Copyright Act, include literary, musical, and

dramatic works; pantomimes; choreographic works; pictorial, graphic, and sculptural

works; motion picture and other audiovisual works; sound recordings; and architectural

works. This listing is illustrative, not exhaustive, as the Act extends copyright protection

to “original works of authorship in any tangible medium of expression, now known or

later developed.” Section 102(a). Moreover, in 1980, the Copyright Act was amended to

extend copyright protection to computer programs. Furthermore, the Semiconductor Chip

Protection Act of 1984 extended protection for ten years to safeguard mask works

embodied in a semiconductor chip product.

Through a patent, the Federal government grants an inventor a monopolistic right

to make, use, or sell an invention to the absolute exclusion of others for the period of the

patent. The patent owner may also profit by selling the patent or by licensing others to

use the patent on a royalty basis. The patent may not be renewed, however: upon

expiration, the invention enters the “public domain,” and anyone may use it.

H. Antitrust

The economic community is best served by free competition in trade and industry.

It is in the public interest that quality, price, and service in an open, competitive market

for goods and services be determining factors in the business rivalry for the customer’s

dollar. Nevertheless, in lieu of competing, businesses would prefer to eliminate their

rivals and consequently gain a position from which they could dictate both the price of

their goods and the quantity they produce. Although to eliminate competition by

producing a better product is the goal of a business, some businesses try to effect this

elimination through illegitimate means, such as fixing prices and allocating exclusive

territories to certain competitors within an industry. The law of antitrust prohibits such

activities and attempts to ensure free and fair competition in the marketplace.

Section 1 of the Sherman Act prohibits contracts, combinations, and conspiracies

that restrain trade, while Section 2 prohibits monopolies and attempts to monopolize.

Failure to comply with either section is a criminal felony and subjects the offender to fine

or imprisonment or both. As amended by the Antitrust Criminal Penalty Enhancement

and Reform Act of 2004, the Sherman Act subjects individual offenders to imprisonment

of up to ten years and fines up to $1 million, while corporate offenders are subject to

fines of up to $100 million per violation. Moreover, under the Federal Alternative Fines

Act, the maximum fine may be increased to twice the amount the conspirators gained

from the illegal acts or twice the money lost by the victims of the crime, if either of those

amounts is over $100 million. In addition, the Sherman Act empowers the Federal district

courts to issue injunctions restraining violations, and anyone injured by a violation is

entitled to recover in a civil action treble damages (i.e., three times the amount of the

actual loss sustained).

In 1914, Congress strengthened the Sherman Act by adopting the Clayton Act,

which was expressly designed “to supplement existing laws against unlawful restraints

and monopolies.” The Act is intended to stop trade practices before they become

restraints of trade or monopolies forbidden by the Sherman Act. The Clayton Act

provides only for civil actions, not for criminal penalties. Private parties may bring civil

actions in Federal court for treble damages and attorneys’ fees. In addition, the Justice

Department and the FTC are authorized to bring civil actions, including proceedings in

equity, to prevent and restrict violations of the Act.

In 1914, through the enactment of the Federal Trade Commission Act, Congress

created the FTC and charged it with the duty to prevent “unfair methods of competition

in commerce, and unfair or deceptive acts or practices in commerce.” To this end, the

five-member commission is empowered to conduct appropriate investigations and

hearings and to issue against violators “cease-and-desist” orders enforceable in the

Federal courts.

I. Consumer Protection

Consumer transactions have increased enormously since World War II. As of the

end of 2015, total consumer indebtedness was more than $12 trillion, nonmortgage

consumer debt was over $3.75 trillion, and total consumer mortgage debt was $8.25

trillion. Although the definition varies, a consumer transaction generally involves goods,

credit, services, or land acquired for personal, household, or family purposes.

Historically, consumers were subject to the rule of caveat emptor—let the buyer beware.

In recent years, however, the law has largely abandoned this principle and now provides

consumers greater protection. Most of this protection takes the form of statutory

enactments at both the State and Federal levels, and a number of government agencies are

charged with enforcing these statutes. This enforcement varies enormously. In some

cases, only government agencies may exercise enforcement rights, which they impose

through criminal penalties, civil penalties, injunctions, and cease-and-desist orders. In

other cases, in addition to the government’s enforcement rights, consumers may privately

seek the rescission of contracts and damages for harm resulting from violations of

consumer protection laws. Finally, under certain consumer protection statutes such as

State “lemon laws,” consumers alone may exercise enforcement rights. This chapter

examines State and Federal consumer protection agencies and consumer protection

statutes.

Through the enactment of laws and regulations, legislatures and administrative

bodies at the Federal, State, and local levels all actively seek to shield consumers from an

enormous range of harm. The most common abuses in consumer transactions involve the

extension of credit, deceptive trade practices, unsafe products, and unfair pricing.

Whenever a consumer purchases a product or obtains a service, certain rights and

obligations arise. The extent to which these rights and obligations apply to all contracts is

discussed more fully in Chapters 9 through 18; the extent to which they apply to a sale of

goods under the Uniform Commercial Code (UCC) is discussed in Chapters 21 through

25. Although a number of consumer protection laws have been enacted in recent years,

they still leave large areas of a consumer’s rights and duties to State contract law. In

particular, Article 2 of the UCC provides the basic rules governing when a contract for

the sale of goods is formed, what constitutes a breach of contract, and what rights an

innocent party has against a party who commits a breach. While many consumer

protection laws provide for rights the UCC does not address, they still use its principles

as building blocks. For example, the Magnuson-Moss Warranty Act builds upon the

perceived inadequacy of the UCC in permitting sellers to disclaim or modify warranties.

Similarly, many States have passed so-called lemon laws to provide additional contract

cancellation rights to dissatisfied automobile purchasers. In 2012, the American Law

Institute began a new project: the Restatement of the Law of Consumer Contracts. This

new project focuses on the rules of contract law that treat consumer contracts differently

from commercial contracts. It includes regulatory rules that are prominently applied in

consumer protection law. The project covers common law as well as statutory and

regulatory law.

A consumer credit transaction is customarily defined as any credit transaction

involving subject matter to be used by one of the parties for personal, household, or

family purposes. The following are illustrative: Atkins borrows $600 from a bank to pay

a dentist bill or to take a vacation; Bevins buys a refrigerator for her home from a

department store and agrees to pay the purchase price in twelve equal monthly

installments; Carpenter has an oil company credit card that he uses to purchase gasoline

and tires for his family car.

A primary concern of creditors involves their rights should a debtor default or

become tardy in payment. When the credit charge is precomputed, the creditor may

impose a delinquency charge for late payments, subject to statutory limits for such

charges. If instead of being delinquent the consumer defaults, the creditor may declare

the entire balance of the debt immediately due and payable and may sue on the debt. The

other courses of action to which the creditor may turn depend upon his security. Security

provisions included in consumer credit contracts may require a cosigner, an assignment

of wages, a security interest in the goods sold, a security interest in other real or personal

property of the debtor, and a confession of judgment clause (i.e., an agreement by the

debtor giving the creditor the authority to enter judgment against the debtor).

J. Employment Law

Though in general the common law governs the relationship between employer

and employee in terms of tort and contract duties (rules that are part of the law of agency;

see Chapter 19), this common law has been supplemented—and in some instances

replaced—by statutory enactments, principally at the Federal level. In fact, government

regulation now affects the balance and working relationship between employers and

employees in three areas. First, the general framework in which management and labor

negotiate the terms of employment is regulated by Federal statutes designed to promote

both labor-management harmony and the welfare of society at large. Second, Federal law

prohibits employment discrimination based upon race, sex, religion, age, disability, or

national origin. Finally, Congress, in response to the changing nature of American

industry and the tremendous number of industrial accidents, has mandated that employers

provide their employees with a safe and healthy work environment. Moreover, all of the

States have adopted workers’ compensation acts to provide compensation to employees

injured during the course of employment.

Traditionally, labor law opposed concerted activities by workers (such as strikes,

picketing, and refusals to deal) to obtain higher wages and better working conditions. At

various times, such activities were found to constitute criminal conspiracy, tortious

conduct, and violation of antitrust law. As subjecting union workers to criminal sanctions

became publicly unpopular, employers began to resort to civil remedies in an attempt to

halt unionization. The primary tool in this campaign was the injunction. Eventually,

public pressure opposing such action forced Congress to intervene.

A number of Federal statutes prohibit discrimination in employment on the basis

of race, sex, religion, national origin, age, disability, and genetic information. The

cornerstone of Federal employment is Title VII of the 1964 Civil Rights Act, but other

statutes and regulations also are significant, including two subsequently enacted

discrimination laws: the Civil Rights Act of 1991 and the Americans with Disabilities

Act of 1990 (ADA). The Equal Employment Opportunity Commission (EEOC) is the

enforcement agency for Federal laws that makes it illegal to discriminate against a job

applicant or an employee because of race, sex, religion, national origin, age, disability,

and genetic information. The EEOC has interpreted Title VII’s prohibition of sex

discrimination as forbidding any employment discrimination based on gender identity or

sexual orientation. In addition, most States have enacted similar laws prohibiting

discrimination based on race, sex, religion, national origin, disability, and genetic

information. The Civil Rights Act of 1991 extended the coverage of both Title VII and

the ADA to include U.S. citizens working for U.S.-owned or U.S.-controlled companies

in foreign countries.

Employees are accorded a number of job-related protections. These include a

limited right not to be unfairly dismissed, a right to a safe and healthy workplace,

compensation for injuries sustained in the workplace, and some financial security upon

retirement or loss of employment. This section discusses (1) employee termination at

will, (2) occupational safety and health, (3) employee privacy, (4) workers’

compensation, (5) Social Security and unemployment insurance, (6) the Fair Labor

Standards Act (FLSA), (7) employee notice of termination or layoff, and (8) family and

health leave.

K. Securities Regulation

The primary purpose of Federal securities regulation is to foster public confidence

in the securities market by preventing fraudulent practices in the sale of securities.

Federal securities law consists principally of two statutes: the Securities Act of 1933,

which focuses on the issuance of securities, and the Securities Exchange Act of 1934,

which deals mainly with trading in issued securities. These “secondary” transactions

greatly exceed in number and dollar value the original offerings by issuers. The 1933 Act

has two basic objectives: (1) to provide investors with material information concerning

securities offered for sale to the public and (2) to prohibit misrepresentation, deceit, and

other fraudulent acts and unfair practices in the sale of securities, whether or not they are

required to be registered.

The 1933 Act prohibits the offer or sale of any security through the use of the

mails or any means of interstate commerce unless a registration statement for the

securities being offered is in effect or the issuer secures an exemption from registration.

Section 5. The purpose of registration is to adequately and accurately disclose financial

and other information upon which investors may appraise the merits of the securities.

Registration does not, however, insure investors against loss—the SEC does not judge the

financial merits of any security. Moreover, the SEC does not guarantee the accuracy of

the information presented in a registration statement.

In addition to exempting specific types of securities, the 1933 Act also exempts

issuers from the registration requirements for certain kinds of transactions. These exempt

transactions for issuers include (1) private placements (Rule 506), (2) limited offers not

exceeding $5 million (Rule 505), (3) limited offers not exceeding $1 million (Rule 504),

and (4) limited offers solely to accredited investors (Section 4(a)(5)). Except for some

issuances under Rule 504, these exemptions from registration apply only to the

transaction in which the securities are issued; therefore, any resale must be made by

registration, unless the resale qualifies as an exempt transaction. Moreover, these

transactions are not exempt from the anti-fraud, civil liability, or other provisions of the

Federal securities laws.

The 1933 Act requires registration for any sale by any person (including

nonissuers) of any nonexempt security unless a statutory exemption can be found for the

transaction. The Act, however, provides a transaction exemption for any person other

than an issuer, underwriter, or dealer. Section 4(a)(1). In addition, the Act exempts most

transactions by dealers and brokers. Sections 4(a)(3) and 4(a)(4). These three provisions

exempt from the registration requirements of the 1933 Act most secondary transactions;

that is, the numerous resales that occur on an exchange or in the over-the-counter market.

Nevertheless, these exemptions do not extend to some situations involving resales

by nonissuers, in particular to (1) resales of restricted securities acquired under

Regulation D (Rules 506, 505, or 504) or Sections 4(a)(5) and (2) sales of restricted or

nonrestricted securities by affiliates. Such sales must be made pursuant to registration,

Rule 144, or Regulation A, subject to the limited exception provided to some issuances

by Rule 504. An affiliate is a person who controls, is controlled by, or is under common

control with the issuer. Control is the direct or indirect possession of the power to direct

the management and policies of a person through ownership of securities, by contract, or

otherwise.

To implement the statutory objectives of providing full disclosure and preventing

fraud in the sale of securities, the 1933 Act imposes a number of sanctions for

noncompliance with its requirements. These sanctions include administrative remedies by

the SEC, civil liability to injured investors, and criminal penalties. The 1995 Reform Act

provides “forward-looking” statements (predictions) a “safe harbor” under the 1933 Act

from civil liability based on an untrue statement of material fact or an omission of a

material fact necessary to make the statement not misleading.

The safe harbor applies only to issuers required to report under the 1934 Act. The

safe harbor eliminates civil liability if a forward-looking statement is (1) immaterial, (2)

made without actual knowledge that it was false or misleading, or (3) identified as a

forward-looking statement and is accompanied by meaningful cautionary statements

identifying important factors that could cause actual results to differ materially from

those predicted. “Forward-looking statements” include projections of revenues, income,

earnings per share, capital expenditures, dividends, or capital structure; management’s

plans and objectives for future operations; and statements of future economic

performance. The safe harbor provision, however, does not cover statements made in

connection with an IPO, a tender offer, a going private transaction, or offerings by a

partnership or an LLC.

L. Accountants' Legal Liability

An accountant is subject to potential civil liability arising from the professional

services he provides to his clients and third parties. This legal liability is imposed both by

the common law at the State level and by securities laws at the Federal level. In addition,

an accountant may violate Federal or State criminal law through the performance of his

professional activities. This chapter deals with accountants’ legal liability under both

State and Federal law. An accountant’s legal responsibility under State law may be based

upon (1) contract law, (2) tort law, or (3) criminal law. In addition, the common law

provides accountants with certain rights and privileges, in particular, the ownership of

their working papers and, in some States, a limited accountantclient privilege.

Accountants may be both civilly and criminally liable under provisions of the

Securities Act of 1933 and the Securities Exchange Act of 1934. (Chapter 43 contains a

more comprehensive discussion of the securities laws.) This liability is more extensive

and has fewer limitations than liability under the common law. SEC regulations require

that auditors be qualified and independent of their audit clients both in fact and in

appearance. Accordingly, Rule 2-01 of SEC Regulation S-X imposes restrictions on

financial, employment, and business relationships between an accountant and an audit

client and restrictions on an accountant providing certain nonaudit services to an audit

client.

M. Environmental Law

As technology has advanced and people have become more urbanized, their effect

on the environment has increased. Our air has become dirtier; our waters have become

more polluted. Although individuals and environmental groups have brought private

actions against some polluters, the common law has proved unable to control

environmental damage. Because of this inadequacy, the Federal and State governments

have enacted a variety of statutes designed to promote environmental concerns and

prevent environmental harm. Although in recent years certain industrial countries such as

the United States, have made significant progress in controlling pollutants, such is not the

case worldwide. Moreover, even as we have enjoyed some success in controlling some

pollutants, a new generation of environmental problems has arisen. One of the more

recent environmental issues is the regulation of high-volume horizontal hydraulic

fracturing (fracking) for oil and gas. In this chapter, we discuss both common law causes

of action for environmental damage and Federal regulation of the environment.

The term nuisance encompasses two distinct types of wrong: private nuisance and

public nuisance. A private nuisance involves an interference with a person’s use and

enjoyment of his land, while a public nuisance is an act that interferes with a public right.

To establish trespass to land, a plaintiff must show an invasion that interferes with the

plaintiff’s right of exclusive possession of the property and that is the direct result of an

action by the defendant. For example, entering or throwing trash on someone else’s land

without permission constitutes a trespass. Trespass differs from private nuisance in that

trespass requires an interference with the plaintiff’s possession of the land. Thus, sending

smoke or gas onto another’s property may constitute a private nuisance but does not

constitute a trespass.

While they generally base tort liability on fault, the courts may hold strictly liable,

that is, liable without fault, a person engaged in an abnormally dangerous activity. To

establish such strict liability, a plaintiff must show that the defendant is carrying on an

unduly dangerous activity in an inappropriate location and that the plaintiff has suffered

damage because of this activity. For example, a person who operates an oil refinery in a

densely populated area may be held strictly liable for any damage the refinery causes.

The requirement that the activity engaged in be (1) ultrahazardous and (2) inappropriate

for its locale has limited the number of strict liability actions brought against polluters.

Initially, the Federal government’s role in controlling air pollution was quite

limited. The States had primary responsibility for air pollution control, and the Federal

government merely supervised their efforts and offered technical and financial assistance.

When State efforts proved inadequate to alleviate the problem, Congress enacted the

Clean Air Act Amendments of 1970, greatly expanding the Federal role in antipollution

efforts. Major revisions to the Clean Air Act were enacted in 1977 and 1990. In March

2011, the EPA issued the Second Prospective Report that looked at the results of the

Clean Air Act from 1990 to 2020. According to this study, the direct benefits from the

1990 Clean Air Act Amendments are estimated to reach almost $2 trillion for the year

2020 and to prevent 230,000 early deaths.

As with air pollution control, the primary responsibility for controlling water

pollution fell initially to the States. When their efforts proved inadequate, Congress

fundamentally revised the nation’s water pollution laws in its 1972 amendments to the

Federal Water Pollution Control Act (subsequently renamed the Clean Water Act).

Substantially amended again in 1977, 1981, and 1987, the Act attempts comprehensively

to restore and maintain the chemical, physical, and biological integrity of the nation’s

waters.

Technological advances have enabled human beings to produce numerous

artificial substances, some of which have proven extremely hazardous to health. As the

potential and actual harm from these latter substances became clear, Congress responded

by enacting various hazardous substancesrelated statutes. In this section, we will consider

some of the most important Federal statutes governing hazardous substances: the Federal

Insecticide, Fungicide, and Rodenticide Act (FIFRA); the Toxic Substances Control Act

(TSCA); the Resource Conservation and Recovery Act (RCRA); the Comprehensive

Environmental Response, Compensation, and Liability Act (CERCLA, or the Superfund);

and the Superfund Amendments and Reauthorization Act of 1986 (SARA).

N. /International Business Law

In the twenty-first century, every aspect of business, including business law,

requires some understanding of international business practices. Since World War II, the

global economy has become increasingly interconnected. Many U.S. corporations now

have investments or manufacturing facilities in other countries, while an increasing

number of foreign corporations are conducting business operations in the United States.

Furthermore, whether a domestic corporation exports goods or not, it competes with

imports from many other countries. For example, U.S. firms face competition from

Japanese electronics and automobiles, Chinese electronics and textiles, Korean

automobiles and electronics, French wines and fashions, German machinery, and Indian

software programmers and call centers. To compete effectively, U.S. firms need to be

aware of international business practices and developments.

International law deals with the conduct and relations between nation-states and

international organizations, as well as some of their relations with persons. Unlike

domestic law, international law generally cannot be enforced. Nevertheless, although

international courts do not have compulsory jurisdiction to resolve international disputes,

they do have authority to resolve an international dispute if the parties to the dispute

accept the court’s jurisdiction over the matter. Furthermore, a sovereign nation that has

adopted an international law will enforce that law to the same extent as all of its domestic

laws. This section of the chapter examines some of the sources and institutions of

international law.

The act of state doctrine provides that a nation’s judicial branch should not

question the validity of the actions a foreign government takes within its own borders. In

1897, the U.S. Supreme Court described the act of state doctrine in terms that still remain

valid: “Every sovereign State is bound to respect the independence of every other

sovereign State, and the courts of one country will not sit in judgment on the acts of the

government of another done within its own territory.” In the United States, there are

several possible exceptions to the act of state doctrine. Some courts hold (1) that a

sovereign may waive its right to raise the act of state defense and (2) that the doctrine

may be inapplicable to commercial activities of a foreign sovereign. In addition, by

Federal statute, the courts will not apply the act of state doctrine to claims to property

based on the assertion that a foreign state confiscated the property in violation of the

principles of international law, unless the President of the United States determines that

the doctrine should be applied in a particular case.

Transacting business abroad may involve activities such as selling goods,

information, or services; investing capital; or arranging for the movement of labor.

Because these transactions may affect the national security, economy, foreign policy, and

interests of both the exporting and importing countries, nations have imposed measures to

restrict or encourage such transactions. This section examines the legal controls imposed

upon the flow of trade, labor, and capital across national borders.

The term multinational enterprise (MNE) refers to any business that engages in

transactions involving the movement of goods, information, money, people, or services

across national borders. Such an enterprise may conduct its business in any of several

forms: direct sales, foreign agents, distributorships, licensing, joint ventures, and wholly

owned subsidiaries. A number of considerations determine the form of business

organization that would be best for conducting international transactions. These factors

include financing, tax consequences, legal restrictions imposed by the host country, and

the degree to which the MNE wishes to control the business.

Module 8_Week 8_Corporations, Debtor-Creditor Relations, and Business Regulation_American Business Law

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