I. Agency

Restatement Definitions (see Restatement 2nd of Agency § 1)

Agency: The fiduciary relation which results form the manifestation of consent by one person to another that the other shall act on his own behalf and subject to his control, and consent by the other so to act.

Principal: The person for whom action is to be taken.

Agent: The person who acts or is to act on behalf of the principal.

Servant: A type of agent who is subject to the detailed control of his principal (his “master”). Most employees fall into this category.

Master: A type of principal who controls the details of her agent’s acts. Most employers fall into this category as they relate to their employees.

Louisiana Crazy Cajun Code:

Representation: A person may represent another person in legal relations as provided by law or juridical act. This is called a representation. LCC art. 2985.

Creation of the Agency Relationship:

Consent

1. The agency relationship requires the consent of both the principal and agent. The agent must agree to act of behalf of, and subject to control by, the principal

2. No consideration is required.3. Consent can be express or implied. The course of prior dealings between the parties can

imply consent to create an agency.

By Operation of Law

An agency by operation of law is usually created by statute and may not require consent of the parties.

By Estoppel

This is not a true agency because the alleged agent has no real authority. However, the “principal” is held liable as though there were an agency. The underlying theory is that his conduct has been such that it would now be unjust to permit him to deny the agency.

Agency by estoppel is created and proven by establishing:1. Apparent authority: P allows, or is negligent in allowing, A to hold himself

out to T as P’s agent;2. Reasonable reliance: T reasonably relies on the holding out;3. Change of position: T changes his position to his detriment.

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Test for Agency relationship:

1. Was there a fiduciary relationship?2. Was the principal in control of the other person?3. Did the other person act primarily on behalf of and for the benefit of the principal.

Three elements of agency relationship:1. Consent of the Principal and Agent2. Control of the Agent by the Principal3. Agent’s Acting on Behalf of Principal

Authority v. Power

R § 7 defines authority as “the power of an agent to affect the legal relations of the principal by acts done in accordance with the principal’s manifestations of consent to him.”

R § 6 defines power as “an ability on the part of a person to produce a change in a given legal relationship by doing or not doing a given act.”

Directors of a publicly held corporation only have authority when acting together; not alone.

CEO is an agent (CEO has control); much apparent authority.

Duties

“Unless otherwise agreed, an agent is subject to a duty to his principal to act solely for the benefit of the principal in all matters connected with his agency.” R § 387.

Master; Servant; Independent Contractor

A master is a principal who employs an agent to perform service in his affairs and who controls or has the right to control the physical conduct of the other in the performance of the service. R §2

A servant is an agent employed by a master to perform service in his affairs whose physical conduct in the performance of the service is controlled or is subject to the right to control by the master. R §2

e.g servant agents: corporate officers, truck drivers, interns in hospitals, janitors

An independent contractor is a person who contracts with another to do something for him, but who is not controlled by the other nor subject to the other’s right to control with respect to his physical conduct in the performance of the undertaking. He may or may not be an agent. R §2

e.g. independent contractors (non servant) agents: real estate agents and brokers, attorneys at law, and stock brokers.

e.g. independent contractors who are not agents: general contractors who enter a building contract for an owner, a taxi driver.

A principal is responsible for torts of servant agents but not non-servant agents.

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The corporate directors are not agents of the corporation or the shareholders. They are not controlled by or subject to the control of the corporation or the shareholders.

Disclosed Principal; Partially Disclosed Principal; Undisclosed Principal

If, at the time of a transaction conducted by an agent, the other party thereto has notice that the agent is acting for a principal and of the principal’s identity, the principal is a disclosed principal. R §4

If the other party has notice that the agent is or may by acting for a principal but has no notice of the principal’s identity, the principal for whom the agent is acting is a partially disclosed principal. R §4

If the other party has no notice that the agent is acting for a principal, the one for whom he acts is an undisclosed principal. R §4.

Apparent Authority

For the doctrine of apparent authority to apply:1. the apparent principal must act to manifest the agent’s ostensible authority to an

innocent third party.2. The manifestation must reach the third party.3. The third party must be reasonably caused to believe that the apparent principal has

authorized the agent to act for her/him. 4. The third party is thus caused to act or not act to her/his detriment.

II. Business Associations

Types

Sole ProprietorshipPartnership (general and limited)Limited Liability Company (LLC)Registered Limited Liability Company (RLLC)Corporation

Limited Liability

In a corporation, a shareholder’s liability is normally limited to the amount he has invested.

The liability of partners is a partnership depends upon the whether the partnership is “general” or “limited.”

In a general partnership, all partners are individually liable for the obligations of the partnership.

In limited partnership, the general partners are personally liable but the limited partners are liable only up to the amount of their capital contribution. (But a limited partner will lose this limit on his liability if he actively participates in the management of the partnership.)

In Louisiana, each partner is liable for his viral share.

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Management

Corporations follow the principle of centralized management.

In partnerships, management is usually not centralized. In a general partnership, all partners have an equal voice (unless they otherwise agree). In a limited partnership, all general partners have an equal voice unless they otherwise agree, but the limited partners may not participate in management.

Perpetual Existence

A corporation has “perpetual existence.” In contrast, a general partnership dissolves upon the death or withdrawal of a general partner. A limited partnership is dissolved by the withdrawal or death of a general partner, but not a limited partner.

Transferability

Ownership interests in a corporation are readily transferable (the shareholder just sells the stock). A partnership interest, by contrast, is not readily transferable (all partners must consent to the admission of a new partner).

Federal Income Tax

The Corporation is taxed as a separate entity. This may lead to “double taxation” (a corporate-level tax on corporate profits, followed by a shareholder-level tax on the dividend.)

Partnerships, by contrast, are not separately taxable entities. The partnership files an information return, but the actual tax is paid by each individual. Also, a partner can use losses from the partnership to shelter income form other sources.

If the owner/stockholders of a corporation would like to be taxed approximately as if they were partners in a partnership, they can often do this by having their corporation elect to be treated as Subchapter S corporation. An “S” corporation does not get taxed at the corporate level, instead each shareholder pays a tax on his portion of the corporation’s profits.

Summary:

Corporation Superior:1. where owners want to limit their liability;2. where free transferability of interests in important;3. where centralized management is important (i.e., large number of owners);4. where continuity of existence in the face of withdrawal or death of an owner is important.

Partnership Superior:1. simplicity and inexpensiveness of creating and operating the enterprise are important; or2. the tax advantages are significant, such as avoiding double taxation and/or sheltering

other income.

Sole Proprietorship

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Sole proprietorship is simple to organize and subject to a minimum of governmental regulation. It is centrally managed and freely transferable, but unstable because of death, retirement, disability or bankruptcy of the owner may terminate it.

The owner has unlimited personal responsibility for business debts and cannot easily separate her/his business assets from personal ones.

The proprietor is taxed on his business profits as an individual.

Partnership

General or Ordinary Partnership

A “general partnership” is any association of two or more people who carry on a business as co-owners. A general partnership can come into existence by operation of law, with no formal papers signed or filed. Any partnership is a “general” one unless the special requirements for limited partnerships are complied with.

In LA, a partnership is a legal entity that generally must sue and be sued in its own name. CC Art 2801 requires:

1. contract between two or more persons (including legal persons such as corps, partnerships, etc.).

2. to combine their efforts in determined proportions (if none stated then equal).3. To collaborate at mutual risk (sharing losses) for their common profit…

Under the UPA, the partnership is not an entity but rather an aggregate of members.

Under RUPA, the partnership is an entity.

In LA, each partner is also personally liable for his virile share (by heads) of the partnership debts and thus secondarily liable.

At common law, partners are either jointly liable or jointly and severally liable for partnership obligations depending upon specific state law and sometimes the type of liability such as tort or contract.

In LA, a member can cease to be a partner without terminating the entity, unless the partners are reduced to one thereby. Termination of the entity can also occur by unanimous consent of partners, by judgment of termination, by expiration of the term, and by the bankruptcy of the entity.

At common law and under UPA, dissolution is when the partners cease to carry on the going concern. Winding up is the series of transactions thereafter to bring a end to and settle the partnership affairs. Termination is when all affairs have been wound up.

RUPA provides two paths for termination. On path leads to buy out of a partner (business continues). The other is the winding up of the business itself.

Under UPA and RUPA, a partnership is dissolved by the death or bankruptcy of a partner, by expelling a partner, ….

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Partnership (written) agreement

A partnership need not be in writing unless the entity as such is to own real estate.

Unless stipulated otherwise, unanimity is required to amend the partnership agreement, admit new partners, terminate the partnership, or allow withdrawal of a partner.

Even though the advantages of a written agreement are undeniably substantial, it should be recognized that many successful partnerships have operated for years without a written agreement. Hamilton.

Advantages of written Partnership agreement:1. avoid future discrepancies about the agreement;2. a written agreement is readily proved in court;3. allocate tax burdens;4. make a contingency for death or retirement;5. clearly identify loans from equity investments by partners;6. cover statute of frauds for real estate.

Sharing of profits and losses

In the absence of an agreement, profits and losses are shared (equally???) See UPA (1914) § 18(a), UPA (1994) § 401(b). Does it make any difference if partners contributed unequal amounts of capital?

About half of the states have enacted UPA 94.

Possible agreements as to profits and losses:1. flat percentage basis or partnership units;2. salaries;3. percentage of investment;4. percentage based on productivity.

A two tied structure consists of income partners and equity partners. Income partners are paid a salary that is not contingent on their firms’ profits. Equity partners are owners of their firms and share in the profits. Hamilton.

In general partnerships each partner is jointly (or jointly and severally) liable for the actions of all partners. …in a two tied firm equity (or capital) partners “are liable for the debts of the firm, whereas income partners normally are indemnified.” Hamilton.

Partnership – 100% liable for debts; UPA – personal liability for torts and contract (joint and severally); RUPA – joint and several for everything; LA – viral share (by heads).

“Joint and several” liability permits suit to be brought against one or more of the partners without suing the all. Hamilton.

Hypo: 1. partnership has 8 properties and wants to borrow but not make the partners personally

liable… However, most banks will make them sign a doc saying that partners are personally liable (guarantee).

Richert v. Handly (1958)

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Richert (P) and Handly (D) were associates in a logging venture. Richert (P) had contributed all of the capital which was invested in the enterprise. The business ultimately lost money, and a dispute arose concerning the proper allocation of the receipts and losses. Casenotes.

The court held in the absence of an express agreement to the contrary, each partner is liable for a partnership’s losses in an amount proportionate to his share of its profits. Casenotes

Not all cases accept the result of Richert; the leading case rejecting this approach is Kovacik v. Reed…. The problem in Richert potentially arises whenever partners make unequal contributions of capital and services and decide precisely how they will split up the profits but do not consider the possibility that the venture will result in a loss. … UPA (1994) does not address this issue. Hamilton.

Limited Liability Partnership

It is true, of course, that even under broad shield LLP statutes, individual partners who themselves commit acts of malpractice or negligence remain personally liable because of their own conduct. It is also possible that partners with oversight responsibility over other professionals may have personal responsibility for the malpractice or negligence of persons they supervise… Hamilton.

Management

National Biscuit Co. v. Stroud (1959)

Stroud (D) and Freeman entered into a general partnership to sell groceries under the name of Stroud’s Food Center. Both partners apparently had an equal right to manage the business. The partnership periodically ordered bread from National Biscuit Company (P). Eventually, however, Stroud (D) notified National (P) that he would not be responsible for any additional bread which the company (D) sold to Stroud’s Food Center. Nevertheless, National (P) sent, at Freeman’s request, additional bread of a total value of $171.04. On the day of the last delivery, Stroud (D) and Freeman dissolved their partnership. Most of the firm’s assets were assigned to Stroud (D), who agreed to liquidate the assets of the partnership and to discharge its liabilities. National (P) eventually sued Stroud (D) to recover the value of the bread which had been delivered but never paid for. Stroud (D) denied liability for the price of the bread, contending that his notice to the company (P) that he would not be responsible for further deliveries had relieved him of any obligation to pay for the bread. The trial court rendered judgment in favor of National (P), and Stroud (D) appealed. Casenotes

The court held that acts of a partner, if performed on behalf of the partnership and within the scope of its business, are binding upon all copartners. Casenotes.

According to the UPA, all partners are jointly and severally liable for all obligations incurred on behalf of the partnership. Casenotes.

The rule adopted by UPA is consistent with traditional principles of agency law. In the absence of a contrary provision in the parties’ partnership agreement, each partner acts as the agent of the partnership and of each other partner… Casenotes.

Smith v. Dixon (1965)

Smith (D), manager of a partnership consisting of his family members (D), agreed to sell land to Dixon (P). The other members (D) of the partnership later refused to convey the property.

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The court held that the acts of a partner are binding upon the partnership if he acted within the scope, or apparent scope, of his authority. Casenotes.

Lesson – never take title without signatures of all partners. Rousseau.

Each partner is liable for any injury to a third person caused by a partner’s wrongful acts committed within the scope of the partnership business and in furtherance of the business. Professor Series.

Rouse v. Pollard (1941)

Fitzsimmons (D), a partner in a prestigious law firm, promised to invest Mrs. Rouse’s (P) money for her but in fact converted it to his own use. The court held partners are liable for the acts of their co-partners only if those acts are within the scope of the partnership’s business. Casenotes.

The rule of Rouse is consistent with the weight of authority. A partner is, in effect, the agent of the partnership and of the other partners. Thus, the rule of this case is a logical corollary to the proposition that a principle is liable for all acts of his agent if performed within the scope of his agency. Note that a partner may even be liable for a transaction in which a co-partner committed fraud. This does not mean, of course, that each partner is himself guilty of fraud. But, he is not excused from financial liability to the aggrieved third party merely by reason of the fact that his copartner’s conduct was fraudulent. Casenotes.

D is a partner in a law firm with A, B, and C. Unknown to A, B, and C, T, D’s client, gives $28,000 to D to invest for her. For a period, D sends interest to T, but later D embezzles the money. T sues A, B, and C to recover the money embezzled. The court held that T may not recover from A, B, or C because D was not acting on a matter within the scope of the law firm’s business. Investment of a client’s money is not part of the usual practice of law. A, B, and C did not know of D’s actions or approve of them. Professor Series.

Roach v. Mead (1986)

Mead (D) had acted as Roach’s (P) attorney on several traffic violations and tax matters. Subsequently, Mead (D) became law partner with Berenston (D). Roach (P) consulted with Mead (D) concerning investment of $20,000. Mead (D) borrowed the money from Roach (P) at a stated interest rate. Mead (D) was unable to repay the loan, and Roach (P) sued, contending the partnership owed him the money based upon a vicarious liability theory. Berenston (D) contended that such a loan was outside the scope of the partnership, and, therefore, he could not be found vicariously liable. The trial court found that Roach (P) acted reasonable in believing that he was receiving legal advice from Mead (D) with regard to the investment of the money and, therefore, found Berenston (D) vicariously liable. Berenston (D) then appealed to the Supreme Court of Oregon. Casenotes.

The court held that one partner is responsible to third parties for the acts of the other partner where that third party reasonable believes that those acts were within the partnership business. Casenotes.

Duties of Partners to Each Other

The agent owes a duty of loyalty to the principal. Within the scope of the agency, the agent must act solely for the benefit of his principal, with no adverse or competing interest. Rest.(2d) of Agency; Professor Series

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Meinhard v. Salmon (1928)

S obtains a twenty year lease of a hotel from O, the owner. S agrees to convert the hotel to use as shops and offices. S forms a joint venture with M to complete the conversion. M supplies half the money, but S retains sole power to manage and operate the building. The venture is very profitabl. Before the lease expires, S is offered a new long-term lease by O. Under this lease, the building is to be razed and another, larger building constructed. O does not know that M is the business partner of S. Neither O nor S notifies M of the new lease. M sues to impress a trust on the new lease as an asset of the joint venture. S contends that the new lease is not a renewal of the old lease, but a new venture in which M has no interest. Professor Series.

Held, M is entitled to his share of the new opportunity so long as he assumes his proportionate share of the obligations. “Joint adventurers, like copartners, owe to one another, while the enterprise continues, the duty of the finest loyalty.” S used his position as manager to obtain the new business opportunity, and thereby breached his fiduciary duty to M. S had the duty to notify M of this opportunity. Note that if O presented S with an opportunity to invest in a venture in Australia, S probably would not need to notify M of this opportunity, because it does not relate to the subject matter of their joint venture. Professor Series.

Partnership Property

UPA:If we conceive of a partnership as having an existence separate from its members; it’s easy to understand that a partner’s basic interest in the partnership is her share of the profits and surplus. This interest is the same as personal property. UPA § 26.

Under UPA, each partner will be a co-owner of the real property with his partners, as well as of all other specific partnership property. He is said to hold as a tenant in partnership (aggregate theory).

RUPARUPA abolishes the concept of tenancy in partnership adopted by UPA § 25(1). In its place it adopts the entity theory. The partnership as an entity, not the individual partners, owns the partnership property.

Creditors:The creditor of any one partner can levy on the partner’s interest in the partnership, but not on any specific partnership property. See UPA § 25(2)(c)

RUPA compels the same treatment of creditors as in UPA: a partner’s personal creditors cannot attach an individual partner’s interest in the partnership. A partner’s personal creditors have to obtain a charging order to reach the partner’s transferable interest in the partnership. See RUPA § 501

Death:The death of a partnership functions to cause dissolution of the partnership. On dissolution, the partnership is not terminated, but continues until the winding up of partnership affairs is completed. During the process of dissolution, the interest of each partner is considered personal property, even if the distributable partnership assets consist of real property.

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Hypo: A person dies leaving a will that provides that son A inherits all his property and daughter B inherits all his real estate. His only asset on his death is a one-half interest in a partnership whose sole asset is a valuable piece of real estate. Who is entitled to his interest in that real estate?

Partnership Dissolution

The dissolution of a partnership is the change in the relation of the partners caused by any partner’s ceasing to be associated in the carrying on (as distinguished from the winding up) of the business. UPA § 29.

The partnership does not terminate on dissolution, but continues until the winding up of partnership affairs is complete. UPA §30.

RUPA lists 10 events which can cause a partner’s dissociation from a partnership. RUPA is substantially different from UPA. Unlike dissolution under UPA, a dissociation under RUPA does not automatically precipitate a winding up and termination of the partnership. This change is consistent with the entity theory of partnership followed by RUPA. RUPA anticipates that most dissociations will result in a buy-out of the dissociated partner’s interest.

Dissociation under RUPA:1. receipt by partnership of notice of a partner’s express will to withdraw…2. occurrence of an event specified in the partnership agreement3. expulsion of a partner pursuant to partnership agreement..4. partner’s expulsion by unanimous vote 5. judical expulsion

Collins v. Lewis

After entering into a long-term lease of space in a building then under construction, Collins (P) and Lewis (D) established a partnership. Collins (P) agreed to advance money to equip a cafeteria which Lewis (D) agreed to manage, Collins’ (P) investment to be repaid out of the profits of the business. Delays and rising costs required a larger initial investment than the parties had anticipated, and Collins (P) eventually threatened to discontinue his funding of the venture unless it began to generate a profit. Eventually, Collins (P) sued Lewis (D), seeking dissolution of the partnership, the appointment of a receiver, and foreclosure of a mortgage upon Lewis’ (D) interest in the partnership’s assets. Lewis (D) filed a cross-action in which he alleged that Collins (P) had breached his contractual obligations to provide funding for the enterprise. The trial court denied Collins’ (P) petition for appointment of a receiver, and a jury, after finding that the partnership’s lack of success was attributable to Collins’ (P) conduct, returned a verdict denying the other relief sought by Collins (P). Casenotes.

The court held that a partner who has not fully performed the obligations imposed on him by the partnership agreement may not obtain an order dissolving the partnership. Casenotes.

Cauble v. Handler (1973)

Cauble and Handler (D) were equal partners in a retail furniture and appliance business. Cauble eventually died, and the administratrix (P) of his estate sued Handler (D) for an accounting of the partnership assets. After receiving the report of a courtapppointed auditor, the trial judge awarded Cauble’s administratrix (P) $20.95 and some interest. He then taxed

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the entire $1800 in auditor’s fees to the administratrix (P). She appealed, claiming that the court should have used market value rather than cost in appraising the existing partnership assets and that the court should have awarded her half of the more than $40,000 that Handler (D) had earned in profits by continuing to operate the partnership’s business after Cauble’s death. Casenotes.

The court held that if a partnership continues to do business after it has been formally dissolved, the noncontinuing partner or his representative may elect to receive his share of the profits earned by the firm after the date of its dissolution. Casenotes.

Adams v. Jarvis (1964)

Adams (P), Jarivs (D), and a third doctor (D) entered into a partnership for the practice of medicine. Adams (P) later withdrew and claimed a right to share in the partnership’s existing accounts receivable. Casenotes.

The court held that a partnership agreement which provides for the continuation of the firm’s business despite the withdrawal of one partner and which specifies the formula according to which partnership assets are to be distributed to the retiring partner is valid and enforceable. Casenotes.

Events that trigger dissolution: death, retirement, expulsion, disability, withdrawal…

Valuation Techniques:1. fixed sum;2. book value (very poor for real estate assets);3. capitalization of earnings;4. project future earnings5. negotiation after the fact (bad option);6.

Every partner owes the fiduciary duties of utmost good faith and loyalty to the partnership and to his partners. Professor Series.

Meehan v. Shaughnessy (1989)

A and B were partners in a law firm. They arranged to open their own practice and to take with them some of their associates. A was asked on three occasions by other partners whether he was leaving, and on each occasion A denied that he planned to leave. Finally, after giving formal notice to the firm of their plan to leave, A and B began soliciting the firm’s clients. They delayed telling their former partners the names of all the clients they had solicited. Also, their solicitation failed to make clear to the clients that the clients had a choice of staying with the old firm or going to A and B’s new firm. Professor Series.

Held, A and B breached their fiduciary duty to their former firm. They had an obligation to be candid with the firm about their plans. Moreover, they should have provided a full list of the clients whom they had solicited. Finally, their letter to the clients was one-sided and failed to give clients a fair choice between the old firm and the firm formed by A and B. The burden was on A and B to prove that the clients would have moved to the AB firm without their solicitations. Professor Series.

Gelder Medical Group v. Webber (1977)

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Webber (D) joined an existing medical partnership, agreeing to the partnership agreement which provided for expulsion without cause and, upon expulsion or resignation, a covenant not to compete. The other partners expelled him for alienating the patients, and he was paid off according to the terms of the partnership agreement. He thereafter engaged in practice, and the partnership, Gelder Medical Group (P), sued to enjoin his practice through enforcement of the covenant not to compete. Webber (D) cross-claimed for declaratory relief and breach of contract, contending he could not be expelled without cause and that the covenant to compete was not enforceable. Casenotes

The court held a partner who has been forced out of a partnership pursuant to the terms of the partnership agreement may be held to his covenant not to compete. Partnership agreements may validly allow expulsion without cause. Casenotes

Inadvertent Partnerships

Martin v. Peyton (1927)

X and Y loaned a stock brokerage firm $2.5 million in securities. By agreement, they were to receive 40% of the firm’s profits as interest, but not less than $100,000 nor more than $500,000. The agreement gave X and Y the right, among others, to veto any business of the firm believed injurious, to inspect the firm’s books, to buy up to 50% of the firm, and to force each partner of the firm to resign. In addition, the firm’s partners assigned their interests to X ad Y, and the agreement set the partners’ compensation. The firm’s creditors sued X and Y, seeking to hold them liable as partners.

Held, X and Y were not firm partners, so were not liable to the firm’s creditors. Sharing profits is only one consideration in determining whether there is a parntership. It is not decisive when the sharing is adopted merely as a device to pay a debt, wages of interest on a loan. X’s and Y’s other rights were security measures designed to protect their loan to the firm. It does not matter that the loan was of securities rather than cash. X and Y had no affirmative control of the business even with the rights described. X and Y were not partners of the business.

Smith v. Kelly (1971)

Kelley (D) and Galloway (D) were partners in an accounting firm for which Smith (P) went to work as a salaried employee. Smith (P) contributed no assets to the firm, had no authority to hire or fire personnel or to make purchases, had no managerial authority, executed no promissory notes on behalf of the firm, and was not obligated to bear any losses of the firm. Kelley (D), Galloway (D), and another employee all concurred in the fact that there had never been any agreement that Smith (P) would be a partner or would share in the firm’s profits. However, Smith (P) was held out to members of the public as a partner and was designated as a partner on the firm’s tax returns and a statement filed with a state agency. Smith (P) was also listed as a partner in connection with a contract entered into by the firm and in connection with a contract entered into by the firms and in connection with a lawsuit the firm filed. Thus, after resigning from the firm after a 3 year tenure, Smith (P) claimed to have been a partner and argued that he was entitled to 20% of the firm’s profits. When Kelley (D) and Galloway (D) disputed his right to share in the profits, Smith (P) sued for an accounting. Casenotes

The court held unless the rights of third parties are involved, a partnership cannot exist in the absence of an intention to create it…. In an action by an outsider, the parties’ conduct might estop them from denying that Smith (P) was a partner in the firm…Casenotes

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This ruling is not applied consistently. … For example, an agreement to share profits was, at common law, often considered sufficient to prove a partnership. Under UPA, such an agreement is deemed a prima facie evidence of the existence of a partnership agreement…. Casenotes.

Young v. Jones (1992)

P invested money in a corporation in reliance on an audited statement of the corporation by “Price, Waterhouse/Bahamas.” P couldn’t recover from “Price, Waterhouse/U.S, because even if the U.S. PW group allowed itself to be represented as being in partnership with the Bahamas group, P did not “give credit” to the apparent partnership. Emanuels.

Two people who don’t actually intend to be in partnership with each other can even be found to have created a partnership “by estoppel,” if they represent to the outside world that they are in partnership together. Thus UPA says that “a person.. [who] represents himself, or consents to another representing him to any one, as a partner an existing partnership … is liable to any such person to whom such representation has been made, who has, on the faith of such representation, given credit to the actual or apparent partnership.” Emanuels.

Observe that this UPA section is not very broad: it’s only where the third party extends credit to the partnership that the section kicks in – reliance of other sorts will not suffice. Emanuels.

III. Other Unincorporated Business Forms

In General

Today, most ventures may select their desired business form from a complex menu:1. The proprietorship (for single-owner business) or the general partnership for (multi-

owner business);2. The general partnership which elects to be a limited liability partnership (LLP);3. The limited partnership with one or more individuals as general partners;4. The limited partnership with a corporation or other limited liability entity as general

partner;5. The limited partnership which elects to be a limited liability partnership;6. A “member managed” limited liability company;7. A “manager managed” limited liability company;8. A corporation which for tax purposes may be (a) a “C corporation” or (b) an “S

corporation” ; and 9. A professional corporation (if the owners are engaged in a profession which is

prohibited from incorporating under the general business corporation statute). Hamilton.

Limited Liability Partnership

In absence of statute (or failure to comply with the mandatory provisions of an applicable statue), all partners are general partners no matter what their private understanding is or how they are designated in the partnership agreement. Hamilton.

Continental Waste System, Inc. v. Zoso Partners (1989)

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Continental Waste Systems (P) sought to hold Ivo Zoso (D) personally liable, as a general partner in I. Jones Partners, for the payment of the partnership’s promissory notes. Casenotes.

The court held under the Uniform Limited Partnership Act (ULPA), filing defects will prohibit the establishment of a limited partnership, which cannot be created by informal agreement, leading the court to treat all partners as general partners. Strict compliance with ULPA is mandatory; a limited partner cannot be created by informal agreement. Casenotes.

Limited Liability Company (LLC)

A LLC is an entity created by one or more members who, after proper filing with secretary of state, enjoy general limited personal liability for any LLC debt or liability whether arising in tort, contract, or otherwise. Of course, members are personally liable for their own torts or personal guarantees. The members who are owners may engage in any management function without jeopardizing their limited liability status.

In order to form an LLC, one or more persons must file the articles of organization and an initial report with secretary of state.

The articles of organization need only state the name of the LLC and the purpose.

The initial report must include the address of the LLC’s registered office, the names and addresses of its registered agents, and names and addresses of those who will manage the LLC business.

It must also contain an affidavit of acknowledgment and acceptance signed by each of the registered agents of the LLC.

The members may also have an operating agreement which is like partnership articles or by-laws of a corporation.

Limited Partnership

A “limited partnership” can only be created where:1. there is a written agreement among the partners;2. a formal document is filed with state officials.

Two types of partners:1. one or more “general partners”, who are each liable for all the debts of the

partnership; and 2. one or more “limited partners,” who are not liable for the debts of the partnership

beyond the amount they have contributed.

Failure to comply with the statutory formalities will result in a limited partner being treated as an ordinary partner. The limited partner loses his limited liability protection if he participates in the management and control of the ordinary affairs of the business. He also loses limited liability if he holds himself out as general partner or allows others to make such representation and does nothing to rectify it.

This entity is a also a “flow through” one for tax purposes.

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Registered Limited Liability Partnership (RLLP)

If the application is properly executed and filed, the partners of a RLLP are not individually liable for the liabilities or obligations of the partnership entity arising from errors, omissions, negligence, incompetence, malfeasance, or willful or inadvertent misconduct committed in the course of the partnership business by another partner, agent, or representative of the partnership. Partners remain personally liable for their virile share of all other types of debts of the partnership such as contracts, contractual warranties, etc. Of course, each partner is always personally liable for his own torts.

This is also a flow through entity.

Corporations

Where to incorporate

For a closely held corporation, incorporation should usually take place in the state where the corporation’s principal place of business is located.

But for a publicly held corporation, incorporation in Delaware is usually very attractive because:1. well-defined, predictable, body of law.2. Slight pro-mgmt bias.

How to incorporate

To form a corporation, the incorporators file the “articles of incorporation” or charter with the Secretary of State.

After the corporation has been formed, it adopts bylaws. The corporation’s bylaws are rules governing the corporation’s internal affairs (e.g., date, time and place for annual meeting; number of directors; listing of officers; what constitutes quorum for director’s meetings, etc.).

Ultra Vires

Traditionally, acts beyond the corporation’s articles of incorporation were held to be “ultra vires,” and were unenforceable against the corporation or by it.

Modern corporate statutes have generally eliminated the ultra vires doctrine. See RMBCA § 3.04(a).

Most modern corporations are formed with articles that allow the corporation to take any lawful action.

Even if the articles of incorporation are silent on the subject, corporations are generally held to have an implied power to make reasonable charitable contributions. See Theodora Holding Corp. v. Henderson.

Ultra vires issues have arisen in the past with respect to a number of transactions that, like charitable contributions, provide no immediate direct benefit to the corporation. Such transactions include contracts of guaranty and suretyship, purchases of the corporation’s own shares, the

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building of homes for corporate employees… Most of these transactions are now specifically authorized by powers clauses of modern statutes… Rousseau quoting Hamilton

Promoter

A “promoter” is one who takes initiative in founding and organizing a corporation. A promoter may occasionally be liable for debts he contracts on behalf of the to-be formed corporation.

Promoter Liability?

Promoter aware, other party not:

If the promoter enters into a contract in the corporation’s name, and the promoter knows that the corporation has not yet been formed (but the other party does not know this), the promoter will be liable under the contract. See RMBCA § 2.04. But if the corporation is later formed and “adopts” the contract, then the promoter may escape liability.

Contract says corporation not formed:

If the contract entered into by the promoter on behalf of the corporation recites that the corporation has not yet been formed, the liability of the promoter depends on what the court finds to be the parties’ intent.

Urging by other side to use corporate name

If the other party urges the promoter to contract in the name of the corporation-to-be-formed, the court is more likely to find that the other party intended to look only to the credit of the corporation once it was formed and assented. A “well recognized exception… is that if the contract is made on behalf of the corporation and other party agrees to look to the corporation and not to the promoters for payment, the promoters incur no personal liability.” Quakerhill, Inc. v. Parr.

Corporation Liability?

No adoption, no liability

Even though the contract may have been made in the corporation’s name, the corporation does not become automatically liable merely by coming into existence. If the corporation does not take any action to manifest its assent to the contract, it is simply not bound.

Adoption by Corporation

If the corporation after its formation does manifest its assent to be bound by the contract previously signed in its name, the corporation will be liable. This adoption or ratification may be express or implied. An adoption may be implied if the corporation receives benefits under the contract without objection. See McArthur v. Times Printing Co.

De Jure Corporation

A de jure corporation is one which has been created and recognized in compliance with the general incorporation law of the particular state.

De Facto Corporation

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At common law, if the person made a “colorable” attempt to incorporate (e.g., he submitted articles to the Secretary of State, which were rejected), a “de facto corporation” would be found to have been formed. This would be enough to shelter the would-be incorporator from the personal liability that would otherwise result.

Examples of defects for de facto corporation include: 1) secretary of state rejects articles of incorporation because of a missing or incorrect item; 2) promoter unaware that the lawyer had failed to do the filing.

The de facto doctrine was especially likely to be applied to shield the “shareholders” from liability where the other party was quite willing to forego personal liability and to look solely to the corporation’s assets.

Example: On Dec 3, D submits a certificate of incorporation for Sunshine Greenery, Inc. to the secretary of state, together with the filing fee. On Dec. 16, D executes a lease on behalf of Sunshine Greenery with P. On Dec. 18, the secretary of state finally accepts the filing of the corporation. The corporation defaults on the lease.

Held, D will not be personally liable, even though the corporation was not officially in existence at the time the lease was signed. Because there was a bona fide attempt made to organize the corporation prior to the lease signing, and because P signed a lease that was issued in the corporation’s name, the corporation will be treated as having had a “de facto” existence on the date the lease was signed. Cantor v. Sunshine Greenery, Inc.

But today, most states have abolished the de facto doctrine, and expressly impose personal liability on anyone who purports to do business as a corporation while knowing that incorporation has not occurred.

Corporation by estoppel

The common law also applies the “corporation by estoppel” doctrine, whereby a creditor who deals with the business as a corporation, and who agrees to look to the “corporation’s” assets rather than the “shareholders’” assets will be estopped from denying the corporation’s existence.

Example: D agrees to invest in a new business that is to be incorporated. He is advised by the business’ lawyer that incorporation has taken place, and he pays for and receives a stock certification in the “corporation.” Acting as its president, he orders typewriters from P (IBM) in the corporate name. Unknown to D, incorporation does not take place until after these orders. P relies on the business’ credit in shipping the typewriters, not on D’s personal credit.

Held, D is not personally liable because P is estopped from denying the corporation’s existence. P dealt with the business as if it were a corporation and relied on its credit. The corporation-by-estoppel doctrine will apply even though the defect in incorporation is so severe that the de facto corporation doctrine will not apply. Cranson v. IBM.

Piercing the Corporate Veil

A properly formed corporation will normally shield the stockholders from being personally liable for the corporation’s debts, so their losses will be limited to their investment. However, in a few extreme cases, courts sometime “pierce the corporate veil,” and hold some or all of the shareholders personally liable for the corporation’s debts.

Individual Shareholders

Factors:

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1. Courts are more likely to pierce the veil in a tort case (where the creditor is “involuntary”) than in a contract case (where the creditor is “voluntary”).

2. Fraud or wrongdoing (e.g., the sole shareholder siphons out all profits).3. Inadequate capitalization (i.e., where the shareholder invests no money whatsoever;

not enough initial capitalization). However, if capitalization is adequate, and the corp then has unexpected liabilities, the failure to put in additional capital will generally not be inadequate capitalization.

4. Failed to follow corporate formalities.

In nearly all cases at least two of the above four factor must be present for the court to pierce the veil; the most common is probably inadequate capitalization plus a failure to follow corporate formalities.

Parent/Subsidiary

A parent is not automatically responsible for the obligations of its subsidiary. The veil will not be pierced so long as:

1. proper corporate formalities are observed;2. the public is not confused about whether they are dealing with the parent or the

subsidiary;3. the subsidiary is operated in a fair manner with some hope of making a profit; and 4. there is no other manifest unfairness.

Thus the parent/subsidiary will not be pierced merely because there is a close relationship. For example, the fact that the directors are mostly or even entirely the same between the two corporations, the officers are the same, they have common accountants and lawyers, and they file a consolidated tax return, are not by themselves enough to cause a piercing of the corporate veil.

Example: D, a cooperative corporation composed mostly of veterans, is in the business of providing low-cost housing for its members. It forms Subsidiary to act as construction contractor. Construction proves more expensive than planned, and Subsidiary declares bankruptcy. Subsidiary’s creditors (represented by P, Subsidiary’s trustee in bankruptcy) sue D to hold it liable for Subsidiary’s debts.

Held, for D. Although D as sole stockholder of Subsidiary controlled its affairs, the veil should not be pierced because:

1. the “outward indicia” of these two separate corporations were at all times maintained;

2. creditors were not mislead about whom they were doing business with;3. there was not fraud;4. D did not deplete the assets of the Subsidiary or do anything else to hurt the

creditors.But a dissent contended tat D ran Subsidiary’s affairs in such a way that Subsidiary could

not possibly make a profit, since it was required to do all work at cost. The dissent would have pierced the veil on the theory that Subsidiary was merely an “agent” to enable D to build houses at cost. Bartle v. Home Owners Cooperative

Again factors:1. failure to follow separate corporate formalities for the two corps (e.g., both have the

same board, and do not hold separate director’s meetings);2. the subsidiary and parent are operating pieces of the same business, and the

subsidiary is undercapitalized;3. the public is misled about which entity is operating which business;4. assets are intermingled as between parent and subsidiary; or5. the subsidiary is operated in an unfair manner (e.g., forced to sell at cost to parent).

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Debt and Equity Capital

Capital may be obtained:1. borrowing funds from private sources, from banks, or on credit cards;2. capital contributions from the owners of the firm;3. capital contributions from outside investors who thereafter become co-owners of the

firm; or4. retained earnings.

The Securities Act of 1933 imposes substantial disclosure requirements on the public sale of securities… All states have “blue sky laws” that regulate the distribution of securities within the specific state.

A “class” of shares simply means all authorized shares of a corporation that have identical rights. Hamilton.

A “dividend” is a distribution from current or retained earnings. The decision to make distributions to shareholders is within the business judgment of directors. Typically, shareholders have no legal basis for complaint if distributions or dividends on common shares are omitted over extended periods of time.

The articles of incorporation must set forth “the number of shares the corporation is authorized to issue.” MBCA § 2.02(a)(2).

If more than one class of shares is authorized, the articles of incorporation must prescribe “the classes of shares and the number of shares of each class that the corporation is authorized to issue”; in addition the articles of incorporation “must prescribe a distinguishing designation for each class and, prior to the issuance of shares of a class the preference, limitations, and relative rights of that class..” MBCA § 6.01(a)

Common Shares

MBCA does not expressly define “common shares,” but it does identify two fundamental characteristics:

1. they are entitled to vote for the election of directors and on other matters, and

2. they are entitled to the net assets of the corporation (after allowance for debts), when distributions are made in the form of dividends or liquidating distributions. MBCA §§ 6.01(b), 6.03(c).

At least one share of each class with each of these basic attributes must always be outstanding – that is, issued to some person or persons.

The Supreme Court identified the characteristics usually associated with common stock as:

(i) the right to receive dividends contingent upon an apportionment of profits;

(ii) negotiability ;(iii) the ability to be pledged or hypothecated,

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(iv) the conferring of voting rights in proportion to the number of shared owned, and

(v) the capacity to increase in value.

Holders of common shares have other rights as well:a. right to inspect books and records (see MBCA § 16.02),b. a right to sue on behalf of the corporation to right a wrong committed

against it (see MBCA §§ 7.40-7.47),c. a right to financial information (see MBCA § 16.20)…

Preferred Shares

Preferred means… preference or priority in payment… Priority may be either the payment of dividends or in the making of distributions in liquidation of a corporation, or both.

Preferred shares are often described by reference to amount of their dividend preference, or by the percentage such preference bears to the stock’s par or stated value. E.g. “$5.00 preferred” or “5% preferred”

The dividend preference of preferred shares may be cumulative, noncumulative, or partially cumulative. A cumulative dividend means that if a preferred dividend is not paid in any year, it accumulates and must be paid (along with the following years’ unpaid cumulative dividends) before any dividend may be paid on the common shares. A partially cumulative dividend typically is cumulative to the extent there are earnings in the year, and noncumulative with respect to any excess dividend preference.

Preferred shares are usually nonvoting shares.

Preferred shares usually have a liquidation preference as well as a dividend preference.

Preferred shares may be redeemable at the option of the corporation… A right to “redeem” shares simply means that the corporation has the power to buy back the redeemable shares at any time at the fixed price, and the shareholder has not choice but to accept that price.

Preferred shares may be convertible at the option of the holder into common shares at a fixed ratio specified in the articles of incorporation.

“Participating preferred” shares are entitled to the specified dividend and, after the common shares receive a specified amount, they share with the common in additional distributions on some predetermined basis.

Most states statutes prohibit shares with an “upstream conversion” right, that is, the right to convert common shares into preferred shares…

Issuance of Shares

Historically, the traditional method of raising for a new venture was by public subscriptions pursuant to which persons agreed to purchase a specified number of shares contingent upon a specified amount of capital being raised.

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Modern practice is to use simple contractual agreements to purchase securities rather than a formal subscription agreement.

Par Value

In about 20 states, the articles of incorporation must state the “par value” of the shares of each class (or state that the shares are issued “with not par value” or “without par value”).

If the stock has “par value,” stated capital is equal to the number of shares outstanding times the par value of each share.

If the stock is “no-par” stock (now permitted in most states), stated capital is an arbitrary amount that the board assigns to the stated capital amount.

If shares have a par value, the corporation may not sell the shares for less than this par value. This rule protects both the corporation’s creditors, and also other shareholders.

Example:(i) High par: corp issues 10 shares of $100 par stock for $1,000 cash.

(stated capital 1,000, capital surplus 0).

(ii) Nominal Par: corp issues 10 shares of $1 par value for $1,000 cash.(stated capital 10, capital surplus 990)

(iii) No Par: corp issues 10 share of no par stock for $1,000 cash.(varies from by state; board may choose; Texas requires 25%: e.g., stated capital 250, capital surplus 750)

Dividends

A “dividend” is a cash payment made by a corporation to its common shareholders pro rata. It is usualy paid out of the current earnings of the corporation, and thus represents a partial distribution of profits. Emanuels.

“Stated Capital” is the stockholder’s permanent investment in the corporation. Emanuels.

“Earned surplus” is equal to the profits earned by the corporation during its existence, less any dividends it ever paid out. (“Retained earnings”). Emanuels.

“Capital Surplus” is everything in the corporation’s “capital” account other than “stated capital.”

All states place certain legal limits on the board’s right to pay dividends, and directors who disregard these limits may be liable. In most states, a dividend may be paid only if both of the following general kinds of requirements are satisfied:

1. payment of the dividend will not impair the corporation’s stated capital; and 2. payment will not render the corporation insolvent. Emanuels.

La: Capital surplus = additional paid in capital + retained earnings.

La. R.S. 12:1 Terms Defined

E. “Capital Surplus” means the aggregate of (1) consideration on issuance of issued shares in excess of the aggregate allocated value

thereof; and (additional paid in capital);

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(2) amounts transferred to capital surplus as permitted…; and (retained earnings)(3) surplus arising from revaluation to reflect unrealized appreciation in value…

(revaluation)

T. “Stated Capital” means the aggregate amount of:(1) the aggregate allocated value of the issued shares; and (2) any other amounts transferred from surplus to stated capital; less(3) transfers from, or other reductions in, stated capital required or permitted by this Chapter.

V. “Surplus” means the excess of assets over liabilities plus stated capital.

Capital Tests

Earned surplus statutes

In most states, there are “earned surplus” restrictions: dividends may be paid only out of the profits which the corporation has accumulated since its inception. Emanuels.

Impairment of capital statutes

A minority of states merely prohibit dividends that would “impair the capital” of the corporation. These states are less strict than the “earned surplus” states: they allow the payment of the dividends form either earned surplus or unearned surplus.

Thus an “impairment of capital” statute allows a corporation with no earned surplus to pay its entire “paid-in surplus” out again as dividends.

Many “impairment of capital” states also allow the board to create, and then pay out “revaluation surplus”. This is the surplus produced by “writing up” the corporation’s assets to their current market value.

Finally, a “impairment of capital” statue usually allows the “reduction surplus” to be paid out. “Reduction surplus” is caused by reducing the corporation’s stated capital (which in the case of stock having a par value requires a shareholder-approved amendment to the articles of incorporation).

Nimble Dividends

Some states allow payment of “nimble dividends.” These are dividends paid out of the current earnings of the corporation, even though the corporation otherwise would not be entitled to pay the dividends (because it has no earned surplus in an earned-surplus state, or because payment would impair its stated capital in an impairment of capital state).

LA: all surplus test…and nimble dividends?… balance sheet test applies before and after dividend.… re-evaluation surplus? Yes. See definition of capital surplus R..S. !2:1 E

La. R.S. 12:63 Dividends

A. … board of directors may declare and the corporation may pay dividends in cash, property or its own shares out of surplus, except:(1) when the corp is insolvent;(2) …contrary to articles of incorporation;

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… When a dividend is paid out of capital surplus, notice shall be given to… shareholders…… When a dividend is paid out in shares without par value, notice shall be given….

B. If corp has no surplus available for dividends, it may pay out of its net profits for then the current year or the preceding fiscal year or both; except that no dividend shall be paid:(1) when assets exceed liabilities;(2) or would reduce assets below liabilities…

Watered Stock

If shares are issued for less than their par value, creditors will often be allowed to recover against the stockholder who received the cheap stock (usually called “watered stock”).

A minority of courts apply the “trust fund” theory, under which the stated capital of the corporation is a trust fund for the benefit of creditors. Under this theory, a creditor can recover even if he became a creditor before the wrongful issuance, or even if he issued the credit after the wrong but with full knowledge of it.

But most courts apply the “misrepresentation” theory, under which only a creditor who has relied on the corporation’s false assertion that the shares were issued for at least par value, may recover. Under this theory, one who becomes a creditor before the wrongful issuance, and one who becomes a creditor after the wrongful issuance but with knowledge of it, may not recover since he has not “relied.”

A shareholder is liable to corporate creditors to the extent his stock has not been paid. Hanewald v. Bryan’s Inc.

In most states watered stock liability arises only in connection with the original issuance of shares. If a corporation reacquires some of its shares after they have been lawfully issued, it may resell those shares at any price it desires without giving rise to watered stock liability. The theory is that shares remain “issued” even though they are held in the corporation’s treasury and their resale at less than par does not water the corporation’s stock account. These shares (called “treasury shares”) have an intermediate status under most statutes: they are not viewed as “outstanding” for purposes of dividends, quorum, and voting purposes, but are view as “issued” so that their “reissuance” does not violate the restrictions imposed by the par value statutes.

Consideration

In most states, shares may be paid for not only in cash, but also by the contribution of property, or by the performance of past services. States vary as to whether shares may be purchased and returned for promises to perform or donate property. Delaware does not allow payment in the form of a promise to perform future services. But the RMBCA is more liberal: any kind of consideration is valid, so long as the board acts in good faith and with reasonable care. Thus promissory notes and promises to perform future services are both valid consideration under the RMBCA.

L.A. does not allow a secured promissory note for consideration.

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Debt Financing

Evidences of indebtedness usually referred to as “securities” are bonds and debentures. Both involve unconditional promises to pay a stated sum in the future, and to pay interest periodically until then.

Technically, a debenture is an unsecured corporate obligation while a bond is secured by a lien or mortgage on corporate property. However, the word “bond” is often used indiscriminately to cover both bonds and debentures.

A sharp distinction must be drawn between debt owed to third persons (outside debt), and debt owed to shareholders (inside debt).

Advantages of Debt:1. Leverage;2. no dilution of equity;3. security (inside debt).

Debt owed to third persons creates leverage. Leverage is favorable to the borrower when the borrower is able to earn more on the borrowed capital than the cost of the borrowing.

In a C corporation, there are usually tax advantages for shareholders who are individuals to lend to the corporation a portion of their investment in the corporation rather than making a contribution to capital. Interest payments on debt are deductible by the borrower whereas dividend payments on equity securities are not.

Slappey Drive Indus. Park v. United States

Because of he tax advantages of loans by individuals shareholders to C corporations, there is an extensive jurisprudence as to whether debt should be reclassified as equity for tax purposes. Slappey is a classic case.

Test for debt:1. look at the names;2. presence or absence of maturity debt;3. failure to pay interest when due *** (major factor for slappey).

A debt/equity ratio is the mathematical ratio between a corporation’s liabilities and the shareholders’ equity… This ratio may be calculated on an aggregate or overall liabilities basis (taking into account debts and obligations owed to persons other than shareholders) or on an “inside” basis (taking into account only debts owed to shareholders). At one time it was thought that under the case law an inside debt/equity ratio of 4:1 or higher would be decisive in reclassifying the debt as equity. This ratio test was generally rejected by courts in favor of the more flexible approach set forth in Slappey Drive.

A corporation with a high debt/equity ratio is sometimes referred to as a “thin corporation.”

Obre v. Alban Tractor Co.

Obre and Nelson formed a new corporation. Acting upon the advice of a well known CPA firm, Obre capitalized only $20,000 (as preferred stock) of his $65,548.10 total invest in the corporation, and categorizing the remaining balance or $35,548.10 as debt (unsecured promissory note). The venture failed and ended up in state insolvency proceedings. Obre successfully claimed the right to participate as an unsecured creditor to the extent of his $35,548.10 unsecured note. The unpaid trade creditors argued that a “subordinating equity” principle required that this note be treated as equity – a capital contribution – rather than as

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valid debt. The Court rejected this argument stating that there was no showing of undercapitalization, fraud, misrepresentation, or estoppel. The court also relied on the fact that Obre’s “loan” to the corporation was either known to the creditors or could easily have been discovered by examining public state tax filings, by requesting financial statements, or by obtaining a credit report.

Planning Capital Structure

1. Will is stand up in the event of a legal attack? 2. Will it provide the desired result?3. Will it provide the desired tax treatment?4. Will it give rise to unexpected liabilities (i.e., watered stock and piercing the corporate veil)?5. Are the client’s financial contributions protected in an unexpected event (i.e., termination)?

Notes (pg 328):

1. A and B seek to form AB Furniture Store. A is to contribute $100,000 and B render services in exchange for “salary” and a 50% interest. Assume that B is to have “earned out” his 50% at the end of two years.

(a) At outset, A and B are each issued 1,000 shares of stock, par value of $100. Does B have a watered stock liability?

Assets Liabilities and Owners Equity

Cash 100,000 A 1,000 shares at par 100 100,000B 1,000 shares at par 100 ??????

Answer: Ques 1(Legal):Problem w/ quality of B’s consideration (promise to pay future services). In most states, shares may be paid in cash, property, or the performance of past services. Delaware does not allow future services; RMBCA allows any kind of consideration so long as the board acts in good faith and with reasonable care; LA does not allow a secured promissory note.

Ques 2(Desired Result):

Ques 3(Tax);

Ques 4(Liability):

Ques 5(Termination):

(b) At the outset, A is issued 100 shares of $1 par stock for $100,000, B is issued 100 shares only after he has performed services for two years. Does this avoid the MBCA § 19 (watered stock) problem? Yes. What happens if A decides to close out the business after 18 months? A gets all the assets. Where does B stand? (B,

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however, may have a breach of contract action against A if A wrongfully excludes B from the venture in violation of the agreement).

(c) At the outset, A is issued 100 shares of $1 par stock; B executes a promissory note for $100,000 payable in two years out of future services, and B is issued 100 shares in exchange for that note.

Assets Liabilities and Owners Equity

Cash 100,000 Salary expenses for B for 2 years 100,000Prepaid services of B 100,000

A 100 shares at par $1 100 Addt’l Paid in Cap 99,900 100,000B 100 shares at par ??? 100,000

Public Offerings

The Securities Act of 1933

Generally, the offerings of the securities are extensively regulated by the Securities Act of 1933 (the “33 Act”) also known as “Truth and Lending” Act. The ’33 Act is virtually limited to the regulation of new issues. By contrast, the ’34 Act regulates nearly all securities law aspects of publicly held companies apart from new issues.

Section 5 of ’33 Act

Section 5 makes it unlawful (subject to some exemptions) to sell any security by the use of mails or other facilities of interstate commerce, unless a registration statement is in effect for that security. This registration statement must contain a large amount of information about the security being offered and the company offering it. Additionally, section 5 prohibits the sale of any security unless a statutory prospectus is delivered. Financial statements?

The 33 Act requires extensive disclosure. The SEC has no power to decide that a particular stock issue should be prohibited on the grounds that it is too risky, overpriced, or otherwise inappropriate on the merits so long as there is full disclosure.

The 33 Act applies not only to stocks, but all securities, including bonds and other forms of debt.

Definition of a Security

Section 2(1) gives the definition of a security to include any “note,” “stock,” “evidence of indebtedness,” “investment contract,” …

In general, the courts have interpreted “investment contract” broadly. Courts are likely to hold a deal an investment contract if A pays B money as an investment in a venture whose economic success will depend heavily on the efforts of B or third persons.

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Smith v. Gross “Earthworms”

An investment contract of type security exists when:1. involves all investment of money;2. in a common enterprise (meaning one in which the fortunes of the investor are

interwoven with and dependent upon the efforts and success of those seeking the investment or of third parties;

3. with profits to come solely from the efforts of others. SEC v. W.J. Howey Co.

Time sequence of offering

The offering process has three distinct periods:1. The pre-filing is the period when the offering is being planned but the registration

statement has not yet been filed with the Commission. During the pre-filing period not only sales but also offers to sell are completely forbidden;

2. The period between the filing date and effective date of the registration statement is called the “waiting period.” During the waiting period, some types of offers to sell and offers to buy, but no sales and contracts to sell are allowed. The main type of offer allowed is the “preliminary prospectus.” Additionally, a “tombstone ad,” that is, a newspaper ad which is meant to just inform. No free writings;

3. The post effective period is the period after the registration statement has become effective. Note, a final prospectus must be sent to any purchaser before or at the same time he receives the securities.

Filing Exemptions

1. Non-Public (Private) offerings;2. “Small” offerings (special SEC Rules apply);3. Sales by persons other than issuer ;4. Mergers;5. Exempt Securities (i.e., State bonds);6. Sales to Control persons – Rule 144;7. Accredited Investors;

Non-Public (Private) Offerings

Section 4(2) of the ’33 Act gives an exemption for “transactions by issuer not involving any public offering.”

If a corporation sells a large block of stock, bonds, or other securities to one or few large and sophisticated institutions (institutional investors, e.g., insurance companies or pension funds), the transaction will be a private offering for which no registration statement is needed.

If a corporation offers stock (or stock options) to key employees, say its three most senior and important executives, this will almost certainly not constitute a public offering.

SEC v. Ralston Purina Co.

Ralston allows any “key employee” to buy unregistered stock in the company. The company defines “key employee” very broadly to include any individual “who is eligible for promotion” or who “especially influences others.” Loading foreman, clerical

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assistant, and production trainee are some of the people permitted to buy under the plan. The company claims the offering is private because it is limited to “key employees.”

Held, this was not a private offering. An offering only to a small number of people, or to a tightly defined class, is not sufficient to make it “private.” “Private” depends upon “whether the particular class of persons affected need the protection of the Act.” The offerees were not shown to have access to the kind of information that registration would have disclosed and needed the protection.

Small Offerings

Rules 506, 505, and 504 are part of the broader SEC Regulation D, which sets forth a number of rules governing both “private” and “small” issues.

Rule 506 allows an issuer to sell an unlimited amount of securities to up to 35 non-accredited investors if the issuer sells to at least one accredited investor. Rule 506, although applicable, will not suffice in every case for small business because each investor must be either “accredited” or sophisticated. Rules 504 and 505 give a safe harbor for certain small size offerings, without reference to sophistication.

Rule 504 allows an issuer to sell up to a total of $1 million of securities in any 12 month period. There is no limit on the number of investors. No disclosure required, however, still must comply with general anti-fraud provisions. Generally, the offering may not be publicly advertised or accomplished by widespread solicitation.

Rule 505 allows an issuer to sell up to $5 million of securities in any 12 month period but the number of investors is limited to 35 non-accredited and any number of accredited investors.

Sale by persons other than the issuer.

Section 4(1) of the ’33 Act exempts registration requirements “transactions by any person other than an issuer, underwriter or dealer.”

An issuer includes “any person directly or indirectly controlling or controlled by the issuer, or any person under direct or indirect common control with the issuer.”

An underwriter means “any person who has purchased from an issuer with a view to, or offers or sells for an issuer in connection with, the distribution of any security…”

Intrastate offerings

Section 3(a)(11) of the ’33 Act exempts from the registration requirements “any security which is part of an issue offered and sold only to persons resident within a single State… where the issuer of such security is a … corporation, incorporated by and doing business within, such State…”

All offerees (not just purchasers) must be residents of the state in question. If even one non-resident is offered the shares, this destroys the entire exemption, even if that offeree doesn’t buy.

The issuing corporation must not only be “doing business” in the state, it must be doing substantial business there. Furthermore, the corporation must be incorporated in the state in question.

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Rule 147 gives a safe harbor as to several of the important features of the interstate exemption.

Preemptive Rights and Dilution

A preemptive right is a right sometimes given to a corporation’s existing shareholders that permits them to maintain their percentage of ownership in the corporation, by enabling them to buy a portion of any newly-issued shares.

Formally, most states recognized preemptive rights as a common law matter. The shareholder exercising the preemptive right was obligated to pay the same price as was being paid by the other buyers.

Stokes v. Continental Trust Co.

Stokes (P), a shareholder of Continental Trust (D), demanded that they sell him an equivalent number of newly issued shares of stock to the proportion he now holds. The court held that the corporation “could not lawfully dispose of the new shares without giving an existing shareholder a chance to get his proportion at the same price that outsiders got theirs.”

Today, every state governs preemptive rights by statute. All modern statutes allow the corporation to dispense entirely with preemptive rights if it so chooses.

Some statutes give the corporation an “opt out” election – the corporation has preemptive rights unless it expressly specifies in the articles of incorporation.

But the modern trend is toward an “opt in” election – the corporation does not have preemptive rights unless it expressly elects in the articles of incorporation.

The RMBCA and LA follow the “opt in”;

Katzowitz v. Sidler

Two of three directors of a closed corporation voted an additional issuance of stock which they opted to purchase and which the third director refused. When the coporate assets were sold, the proceeds were distributed in proportion to the stock owned, and the third director sought to have this distribution set aside.

The court held despite the availability of preemptive rights, board must show that the issuing price fell “within some range which can be justified on the basis of valid business reasons.” – the corollary of preemptive rights is “the right not to purchase additional shares without being confronted with dilution of one’s existing equity if no valid business justification exists for the dilution.

Freezeouts

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A freezeout is a transaction in which those in control of a corporation eliminate the equity ownership of the non-controlling stockholders. In other words, the insiders somehow force the outsiders to sell their shares, or the insiders find some other way of eliminating the outsiders as common shareholders. The net result of a freezeout is that the controlling shareholders go from mere control to exclusive ownership of the corporation.

Distributions

Gottfried v. Gottfried

Minority stockholders (P) brought suit against the board of directors (D) of a closely held family corporation to compel it to declare dividends on the common stock. No dividends were paid on the common stock for 14 years until immediately before commencement of this action, the purpose of which was now to compel payment in such amount as would be fair and adequate. The minority stockholders (P) contended that the directors (D), who owned the controlling stock, had bitter animosity toward the minority (P) and sought to coerce them into selling their stock to the directors (D) at a grossly inadequate price.

The court held if an adequate corporate surplus is available for the purpose, directors may not withhold a declaration of dividends in bad faith. The essential test of bad faith is to determine whether the policy of the directors is dictated by their personal interests rather than the corporate welfare.

Factors of bad faith:1. intense hostility of the controlling faction against the minority;2. exclusion of the minority from employment by the corporation;3. high salaries, or bonuses, or corporate loans;4. the fact that the majority may be subject to high personal income taxes if substantial

dividends are paid;5. the existence of a desire by the controlling directors to acquire the minority stock

interest as cheaply as possible.

The court held for D because it appeared the directors (D) had legitimate business reasons (i.e., pay down mort, sites for new plants) for not declaring dividends.

Dodge v. Ford Motor Co.

Ford Motor Company, under the leadership of Henry Ford, reaps incredible financial success in 1916. Henry Ford announces that the company will no longer pay any dividends, and will reinvest all profits in the business. The Dodge Brothers (P), who are minority stockholders, sue to have the court order Ford to resume payment of dividends. The Dodge Brothers (P) proved that Henry Ford has frequently stated that (1) the company is already making enough money, and (2) he wants to reduce the price of cars to benefit the working man instead of increasing corporate profits.

The court held the company must pay a dividend. A corporation is organized for the benefit of stockholders, not for charitable purposes.

Wilderman v. Wilderman

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Joseph Wilderman (D), as president of a family owned business, paid himself large sums without the approval of his wife, Eleanor (P), who was the company’s only other director, officer, and shareholder. The court held in the absence of a specific authorization by the company’s board of directors, a corporate executive may receive only that amount of compensation which is reasonably commensurate with his functions and duties.

Donahue v. Rodd Electrotype Co.

As a controlling stockholder of Rodd Electrotype (D), a close corporation, Harry Rodd (D) caused the corporation to reacquire 45 of his shares for $800 each ($36,000). He then divested the rest of his holding by making gifts and sales to his children. Donahue (P), a minority stockholder who had refused to ratify this action, offered to sell her shares on the same terms but was refused. A suit followed in which Donahue (P) sought to rescind the purchase of Harry Rodd’s (D) stock and make him repay to Rodd Electrotype (D) the $36,000 purchase price with interest.

The court held that the corporation was required to repurchae shares from P in the same portion, and at the same price, as it had purchased form the majority holder. The rationale: “Stockholders in the close corporation owe one another substantially the same fiduciary duty in the operation of the enterprise that partners owe to one another…. This is the duty of utmost good faith and loyalty…Stockholders may not act out avarice, expediency or self-interest..”

VII. Management and Control of the Closely Held Corporation

Agreements restricting the Board’s Discretion

If the shareholders agree to restrict their discretion as, there is a risk that the agreement will violate the principle that the business shall be managed by the board of directors. If a court finds that the board’s discretion has been unduly fettered, it may refuse to enforce the agreement.

Present Law: However, this danger is not very great today. Most courts will probably uphold even a shareholder agreement that substantially curtails the board’s discretion, so long as the agreement:

1. does not injure any minority shareholder;2. does not injure creditors or the public;3. does not violate any express statutory provision.

McQuade v. Stoneham (1934)

Stoneham (D), the majority shareholder, together with McQaude (P) and McGraw (D), two minority shareholders agreed that they would use their best efforts to keep one another in office as directors and officers at specified salaries. Subsequently, Stoneham (D) and McGraw (D) refused to try to keep McQuade in office as director and treasurer; after he was dropped from these posts he sued for breach.

The NY Court of Appeals found that the shareholder agreement was invalid, and thus held for the defendants. The court reasoned that stockholders may not, by agreeing among themselves, place “limitations… on the power of directors to manage the business of the

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corporation by the selection of agents at defined salaries.” In other words, the board must be left free to exercise its own business judgment. The agreement here prevented the board form doing that, by purporting to restrict the board from firing McQuade from his treasurer’s post.

Clark v. Dodge (1936)

Clark (P) owned 25% and Dodge (D) 75% of two corporations. They signed an agreement whereby D was to vote for P as director and general manager, and to pay him one-fourth of the business’ income, so long as he remained “faithful, efficient and competent.” D argued that this agreement violated the McQuade rule, since it purported to restrict the discretion of the board of directors.

The Court of Appeals upheld this business agreement, despite McQuade. The court seemed to rely on two respects in which this agreement was different from the one struck down in McQuade:

1. all shareholders had signed the agreement, and there was no sign that anyone would be injured by the contract; and

2. the impairment of the board’s power was “negligible,” apparently since P could always be discharged for cause, and his one-fourth income could be calculated after the board determined in its discretion how much should be set aside for the company’s operating needs.

Long Park, Inc. v. Trenton-New Brunswick Theaters Co. (1948)

All three stockholders agreed that one of them would manage the company for 19 years. This agreement, the court held, clearly violated the statutory rule that “the business of a corporation shall be managed by its board of directors.” The court reached this conclusion even though there was no possible injury to creditors, and all shareholders had signed the agreement. The court distinguished Clark as involving only a “innocuous variance from the statutory norm.”

Galler v. Galler (1965)

The two principal owners of the corporation, Benjamin and Isadore, each owned 47.5% of the stock. They signed a shareholders’ agreement in which they agreed to pay certain dividends each year and to pay, in the event either should die, a specified pension to his widow. Benjamin died, and Isadore refused to carry out the agreement.

The Illinois court upheld the agreement, even though it limited the discretion of the board of directors. The court required an agreement to satisfy three tests before it would be enforced:

1. there must be no minority interest who is injured by it;2. there must be no injury to public or to creditors;3. the agreement must not violate a clear statutory prohibition.

Perhaps more importantly, the court stressed the importance of broad and enforceable stockholder agreements in the close corporation context.

Zion v. Kurtz (1980)

All stockholders agreed that they would not cause the corporation to engage in any business transactions over Zion’s objection. The corporation was incorporated in Delaware, and under Delaware law this arrangement would have been valid had the corporation elected to be

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treated as a statutory close corporation and placed in its articles of incorporation a special provision electing to have the corporation run by the shareholders rather than the directors. The corporation had done neither.

But the NY court viewed these omissions as technical ones that could be remedied by a court order; it therefore enforced the arrangement.

Shareholder Resolutions

Generally, shareholders cannot require the directors or officers to take any particular action during the corporation’s day-to-day operations. However, the shareholders can seek to influence the board by exercising their right to adopt shareholder resolutions that recommend particular actions to the board.

Matter of Auer v. Dressel (1954)

The board of directors of the Hoe Corp. removes X from his post as president. The Ps, who hold a majority of class A stock in the company, seek to put to a shareholder vote a resolution endorsing X and requesting X’s reinstatement as president (among other actions). Held for the Ps. It is true that the stockholders do not have the direct power to require the board to reinstate X as president. But they are entitled to vote to pass a resolution recommending that action to the board, if only as a way to signal their desires to the board (and, in effect, to warn the directors who will soon be standing for election that this is what the shareholders desire).

Shareholder Voting and Shareholders’ Agreements

A shareholder voting agreement or pooling agreement is an agreement in which two or more shareholders agree to vote together as a unit on certain or all matters.

The person in whose name shares are registered is called the “record holder” and may or may not be the person who is the actual owner of the shares, usually referred to as the “beneficial owner.” Generally speaking, the corporation may treat the record owner as the owner of the shares for purposes such as voting, the payment of dividends or distributions, and determining to whom shares have been transferred. Hamilton.

The record owner is the one shown on the corporation’s own books as being the owner of that stock. The beneficial owner, by contrast, is the person who has the real, effective economic ownership of the share.

E.g. Suppose that Minor is a beneficiary under a trust set up by his grandparents, and the trustee for the trust is Mega Bank. If the trust holds shares of stock in X Corp., X Corp.’s transfer records will probably show that Mega Bank is the record owner of the stock. Minor is the beneficial owner of these shares (it is he who takes the actual economic gains or losses). Emanuels.

Today, about 70% of all shares in publicly-held corporations have a record owner who is not the beneficial owner. Other examples include:

1. Street names at brokerage firms;2. Nominees – large institutional investors (mutual funds, pension funds) generally hold their

shares in the names of “nominees” usually a partnership of employees formed just for that purpose.

Salgo v. Matthews

``A corporate election inspector (D) appointed by Salgo (P) refused to accept several proxies which, if accepted, would have enabled Matthews (P) to win his proxy fight against Salgo (D).

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The court held that shares of stock may be voted only by an authorized representative of the party designated in the corporate record as legal owner of the shares.

Cumulative v. Straight voting

Straight voting:

e.g. S/HA has 18 shares; S/HB has 82 shares; 5 directors to be elected. A casts 18 votes per director for 5 directors. B casts 82 votes per director for 5 directors.

Note here straight voting can severely limit or exclude completely, any minority representation.

Cumulative Voting:

e.g. A may cumulate votes (18x5) or 90 votes to vote for any one director or distribute in any proportion among the five directors.

Number of shares needed to elect one director:

(S/D+1)+1 where S is the total number of shares voting, and D equals the number of directors to be elected. The analogous formula to elect n directors is: (NS/D+1)+1

Humphrys v. Winous Co.

The board of directors of Winous Co. (D) consisted of three members. The company (D) created separate classifications for each of the three directors so that no two would be required to stand for reelection at the same time. Humphrys (P) filed suit against the company (D), contending that its classification scheme nullified the effectiveness of cumulative voting. A state statute expressly conferred the right to vote cumulatively and prohibited the restriction or qualification of that right. Classification of directors was also authorized by statute. The trial court rejected Humphry’s (P) argument, but the appellate court reversed.

The court held a statute prohibiting restrictions upon the exercise of cumulative voting rights should not be construed as guaranteeing minority representation on a company’s board of directors.

Under MBCA, cumulative voting, like preemptive rights, is an “opt in” election to be chosen by an appropriate provision in the articles of incorporation.

Ringling Bros.-Barnum & Bailey Combined Shows v. Ringling (1947)

Mrs. Ringling, Mrs. Haley, and Mr. North are the three shareholders of Corporation (which operates Ringling). Mrs. Ringling and Mrs. Haley sign a voting agreement, in which each agrees to consult and confer with the other and to vote their shares together on any issue put to a stockholder vote. They also agree that if they can’t agree on how the shares should be voted, their lawyer, Mr. Loos, shall act as arbitrator. At a subsequent shareholders meeting to elect directors, Mrs. Haley and Mrs. Ringloing disagree, and the arbitrator is called in. Mrs. Ringling agrees to

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vote her shares in accordance with the arbitrator’s decision, but Mrs. Haley refuse to do so. The chairman rules that the arbitrator may cast Mrs. Haley’s vote (i.e., that Mrs. Haley should be deemed to vote as the agreement provides). For reasons that are unclear, Mrs. Ringling (not Mrs. Haley) sues to overturn the election. The court of equity holds that the agreement is valid, and orders a new election at which the agreement is to be followed (with the arbitrator casting the votes if Mrs. Ringling and Mrs. Haley cannot agree). Emanuels.

Held (on appeal), the agreement is valid. (This is not a disguised voting trust and therefore need not be held illegal for failure to meet the statutory formalities for such trusts.) However, the lower court was wrong in holding that the agreement created an implied irrevocable proxy (which would allow the arbitrator to cast the votes of a non-complying shareholder.) Instead, Mrs. Ringling’s remedy for Mrs. Haley’s failure to follow the agreement should be that Mrs. Haley’s votes will not be counted. In other words, the court denies specific performance of the agreement (since specific performance would mean allowing the arbitrator to cast Mrs. Haley’s vote as he deems fit). Emanuels.

Today, many if not most courts would give Mrs. Ringling the specific performance she desired. A number of states have enacted statutes that make the voting agreements specifically enforceable. RMBCA provides that “a voting agreement created under this section is specifically enforceable.” Emanuels.

Voting Trusts

A second device by which shareholders can agree to limit their voting discretion is by use of a “voting trust.”

To create a voting trust, the shareholders who are part of the arrangement convey legal title to their shares to one or more voting trustees, under the terms of a voting trust agreement. The shareholders become “beneficial owners” or “equitable owners” of the shares. Usually they receive a “voting trust certificate” representing their equitable interest. They are entitled to receive dividends and their share of proceeds of any sale of corporate assets. But they no longer have voting power – votes are cast by the trustees in accordance with the instructions in the voting agreements.

Originally, courts were reluctant to enforce voting trust agreements. But today, nearly all states have statutes authorizing voting trust arrangements. Most states impose these requirements:

1. Statutes generally set a maximum term (usually ten years).2. Statutues require public disclosure;3. In writing.

The voting trustees are subject to the fiduciary obligations of trustees.

Brown v. McLanahan

The corporation needed funds, and its stockholders agreed to create a voting trust in which third persons are made trustees in return for advancing funds to the corporation; unless the trust expressly authorizes otherwise, the trustees cannot act to the detriment of the beneficial owners they represent (e.g., the trustees cannot vote to issue new stock to themselves, or vote to favor creditors over stockholders). Emanuels.

The trustees (D) of voting common and preferred stock of a corporation approved an amendment which diluted the power of the preferred stock and enhanced their privately owned debentures. The court held under a corporate voting trust agreement, “a trustee may not exercise powers granted in a way that is detrimental to the cestuis que trustent (i.e., actual owner of the voting

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shares); nor may one who is trustee for different classes favor one class at the expense of another.” Casenotes.

In an extreme case, a class of stock may even be created that gives its holder voting power without any real economic ownership. This can be useful as a tie-breaking device.

Lehrman v. Cohen (1966)

The Lehrman Cohen families each own half the stock of Giant Food Corp. Because they are worried that dissension between and within the families may interfere with the company’s operations, they agree to create three classes of common stock: Classes AL, AC, and AD. All AL stock belongs to the Lehrmans, all LC stock belongs to the Cohens, and the single share of AD stock is to be issued to the company’s lawyer, Danzansky. The certificate of incorporation is amended to give the AL holders and the AC holders each the right to elect two directors, and the AD holder the right to elect the fifth (presumably tie-breaking) director. The AD share has no right to dividends or assets, and can be redeemed at any time by the company for its ten dollar par value. After this arrangement has worked satisfactorily for 15 years, the AC and AD stock (voted by the Cohens and Danzansky respectively) is voted in favor or giving Danzansky a 15 year employment contract as president. The AL holders oppose this and sue to have the classification scheme rule invalid, on the theory that it is in substance a voting trust that does not conform with the statutory requirements for such trusts.

Held, the arrangement is valid. The creation of the AD stock did not separate the voting rights of the AC or AL classes from the other ownership aspects of those classes. Instead, there was simply a new class created; the fact that this new class somewhat diminished the voting power of the old classes did not amount to creation of a voting trust. Nor does anything in Delaware law prevent creation of stock which has voting power but no substantial economic stake in the corporation; the Delaware corporation statute “permits the creation of stock having voting rights only, as well as stock having property rights only.”

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See LA RS 12:81D, 82F

Share Transfer Restrictions

The stockholders of a close corporation will usually agree to limit the transferability of shares in the corporation. For instance, they may agree that no holder may sell the shares to an outside party until the corporation has first been given the right to buy them at a pre-established price (“first option”), or the right to buy them by matching what the outside person is willing to pay (“right of first refusal”). Or, they may agree that the corporation has a firm obligation to buy the shares, and the stockholder has the obligation to sell them, at pre-established price upon the happening of certain events (e.g., stockholder’s death, retirement or termination of employment with the corporation). Emanuels.

Courts are far more willing than they used to be to uphold share transfer restrictions. Traditionally, share transfer restrictions have been viewed as “restraints on alienation.” However, today, courts still generally require that the restraint be “reasonable” before they uphold its. Emanuels.

There are five principal techniques by which the transfer of shares in a closely-held corporation may be restricted:

1. Right of first refusal;2. First option at fixed price;3. Consent (i.e., subject to approval of directors or stockholders);4. Buy-back rights (e.g., the corporation might be given the right to repurchase shares of a

holder/employee upon that person’s retirement or termination of employment.);5. Buy-sell agreement (e.g., most often, the corporation and shareholders will make a buy-sell

agreement under which the corporatin must re-purchase the shares upon the death of a shareholder/employee);

If a shareholder signs an agreement imposing a transfer restriction, he has clearly received notice of that restriction and consented to it, so the restriction will be applied to him as long as it is reasonable. But in a number of other situations, the holder will be able to argue either that he had no notice of the restriction at the time he purchased his shares, or that he did not consent to the restrictions. Special rules have evolved to determine whether the holder is bound in this situation. In general, the rule is that a holder who purchased without either actual or constructive notice of the restriction will not be bound by it. Emanuels.

First, consider a person who purchases shares without actual knowledge of pre-existing restrictions at the time he makes the purchase. Such a purchaser will not be bound by the restrictions unless the restriction was conspicuously noted on the share certificate. The reason is the UCC section 8-204(a) provides that “a restriction on transfer of a security imposed by the issuer, even if otherwise lawful, is ineffective against any person without actual knowledge of it unless… the security is certificated and the restriction is noted conspicuously thereon…”

UCC defines “conspicuous” as follows: “A term or clause is conspicuous when it is so written that a reasonable person against whom it is to operate ought to have noticed it. A printed heading in capitals… is conspicuous. Language in the body of a form is “conspicuous” if it is in larger or other contrasting typeor color…” Therefore, the certificate should have notice of the restrictions written in capital letters, larger type size, or color, in order to be certain to be conspicuous….

Ling & Co. v. Sav. & Loan Ass’n (1972)

A single line of a small type on the front of the stock certificate refers to a 14-line small-type paragraph on the reverse. This paragraph in turn refers in very general terms to transfer restrictions in the articles of incorporation. Held, the transfer restrictions were not “conspicuous” as required by § 8-204(a), because “something must appear on the face of the certificate to attract the attention of a reasonable person when he looks at it.” Emanuels.

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Buy-Sell Agreements

What are the magic ingredients in buy-sell agreements which solve these problems? There are two: First, bargaining positions are usually equal since none of the shareholders knows whether he will be on the buying end or the selling end of the agreement. Secondly, once there is an agreement everybody knows where he stands and can plan accordingly. Hamilton quoting Walbaum.

Valuation methods:1. book value…at date of death or end of preceding accounting period;2. fixed price (works only if periodically updated);3. appraisal;

Buy-sell agreements that are triggered by the death of a shareholder may raise serious estate tax problems for the decedent’s estate. The stock is likely to be the principle asset in the estate and have considerable (but certain) value. Rousseau quoting Hamilton.

Deadlocks

Gearing v. Kelly (1962)

Corporation has three directors, including P. It also has one vacant seat on the board. The bylaws set a quorum for directors’ meetings of a majority of the full board (i.e., three of four). P, knowing that the other two board members will elect a new directors sympathetic to them, stays away from the board meeting for the express purpose of preventing a quorum and thus blocking board action. The other two directors nonetheless purport to hold an election, and elect D to the vacant seat. P sues to have the election set aside. Emanuels.

Held, the election stands. P is seeking equitable relief, and a court of equity will not allow a plaintiff to attack the lack of a quorum when she herself brought it about. (A dissent argued that “this is a mere contest for control, and the court should not assist either side,” especially where P was willing to attend board meetings generally but not willing to participate in a meeting whose sole purpose was to strip her of control.) Emanuels.

In Re Radom & Neidorf, Inc. (1954)

David Radom (P) and his sister Anna Neidorf (D) were the sole shareholders in a music publishing corporation. Due to a mutual dislike and distrust of each other, they were deadlocked as to the election of directors and the declaration of dividends. David Radom (P) sought dissolution to resolve the dispute. Casenotes.

The court held where corporate dissolution is authorized by statute in the case of deadlock or other specified circumstances, the existence of the specified circumstances does not mandate the dissolution. The court will exercise its discretion, taking into account benefits to the shareholders as well as injury to the public. Casenotes.

Davis v. Sheerin (1988)

Davis (D) contended the trial court erred in imposing a forced buy-out of Sheerin’s (P) shares in the corporation for Davis’ (D) oppressive conduct toward the minority shareholder. Held, in appropriate cases, a court may order a buy-out as a remedy for oppressive conduct on the part of the majority shareholders. Casenotes.

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A number of states allow the court to appoint a provisional director. Most commonly, a provisional director can be appointed to break a deadlock on the board. Once the tie is broken, the provisional director is normally removed. The provisional director has no powers beyond those of an ordinary director. Many state statutes explicitly require that the provisional director be impartial. Where the statute does not explicitly say that the provisional director must be impartial, courts have tended to say that he need not be. Emanuels.

Abreu v. Unica Indus. Sales, Inc. (1991)

The trial judge finds that the board is deadlocked between P (a 50% holder) and the Ds (who collectively own 50%). The judge therefore appoints a provisional director, who is P’s son-in-law and who is also the business’s General Manager. The Ds complain that the provisional director must be impartial. Emanuels.

Held for P. The statute is silent as to whether the provisional director must be impartial, and there is no evidence that the legislature intended a requirement of impartiality. “When appointing a provisional director, the trial court considers only the best interests of the corporation, and not those of any warring factions. If the trial court … finds that there is no traditionally independent third party with the skills and abilities necessary to fulfill the position within an urgent time frame, it may use its discretion to appoint a provisional director in the best interest of the corporation, whether or not that person has been aligned or appears to have been aligned with a particular group of shareholders.” Here, the son-in-law, as General Manager of the business, was qualified. Emanuels.

Action by Directors

Normally, the board of directors may take action only at a meeting, not by individual action of the directors. Directors, unlike shareholders, may not vote by proxy. Emanuels.

Baldwin v. Canfield (1879)

The Minneapolis Agriculture Mechanical Association (MAMA) owns, as it sole valuable asset, some real estate. All the shares of MAMA are owned by King. King borrows money for the State National Bank, and pledges his stock in MAMA with Baldwin, the bank’s cashier. King contracts to have MAMA sell the real estate owned by it to Canfield in return for $65,000 in railroad bonds. No board meeting of MAMA is ever held to discuss the sale of property. However, King causes each member, at different ties and places, to sing a deed to the property as directors. King gives the deed to Canfield, receives the bonds from him, and disappears without paying back the loan to Baldwin or the bank. Baldwin and the bank sue Canfield to obtain a ruling that the deed was not validly conveyed to MAMA to Canfield. Emanuels.

Held, for Baldwin and the bank. The members of a corporation’s board of directors “have no authority to act, save when assembled at a board meeting. The separate action, individually, of the persons composing such governing body is not the action of the [board].” Since the deed was never authorized by board action, it was invalid, so Canfield has paid the bond over to King for nothing in return! Emanuels.

Note: Clearly, the lawyers for Baldwin and his bank on the one hand, and Canfield on the other, were guilty of sloppiness if not negligence. Since King was the holder of all the shares, and could have controlled the corporation’s action, Baldwin and his bank should have gotten a security interest (mortgage) directly in the real estate, rather than merely accepting a pledge of the corporation’s shares. The lawyering for Canfield was even worse: at a bare minimum that lawyer should have gotten a copy of the resolution of the board of directors of MAMA authorizing the sale, together with a certificate from the corporate secretary reciting that the action was taken by a

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majority of directors at a meeting for which a proper notice and quorum existed. (This certificate and accompanying resolution would have been binding on the corporation even had the meeting not taken place, since the corporate secretary can bind the corporation by his certification that a resolution was duly passed).

Mickshaw v. Coca-Cola Bottling Co. (1950)

Prior to World War II, Mickshaw (P) was employed by Coca-Cola (D). A company (D) director promised that all employees drafted by the military would be paid the difference between their military salary and the wages Coca-Cola (D0 had been paying them. Casenotes.

The court held an act of a single director will be binding upon a corporation if it is subsequently ratified or acquiesced in by a majority of the corporation’s directors. Casenotes.

Cooke v. Lynn Sand & Stone Co.(1994)

Cooke (P), a director, officer, and shareholder of Lynn Sand (D), sued Lynn Sand (D) for specific enforcement of an employment contract naming himself as an employee and for misrepresentation. Casenotes.

The court held the execution of an undisclosed employment contract by an officer or director of a corporation, in which he names himself as an employee, violates the officer or director’s fiduciary duties to the corporation and is invalid. Casenotes.

Authority of Officers

Black v. Harrison Home Co.

Black (P) purchased property which the Harrison Home Co. (D) had, through its president, agreed to sell. A company (D) resolution required joint action by the president and secretary whenever property was to be sold. Casenotes.

The court held that the president of a corporation has no authority to execute contracts on behalf of the company in the absence of a bylaw or a resolution of the board of directors permitting him to do so. Casenotes.

Presumably, the chief executive officer of a small corporation, no matter what his or her formal title, will be required to take a number of actions on his or her own authority. For example, who is to hire secretaries, order needed equipment and supplies and the like? Where does one go to find the basis of authority? One possible source is the bylaws of the corporation, which usually describe the roles and responsibilities of the principle officers… Rousseau quoting Hamilton.

Under the traditional view, the corporation is managed by the board of directors, not by the officers. Therefore, even when an officer purports to act on behalf of the corporation and to bind the corporation, his action may not be legally sufficient to bind the corporation. Since the officer is an agent of his principal (the corporation), the officer’s authority to bind his principal is usually analyzed by use of traditional agency principles. Emanuels.

The most important concept to keep in mind is that an officer (even the president) will not automatically have authority to bind the corporation to a transaction merely by virtue of his office. The four doctrines commonly used to hold that the officer has bound the corporation: (1) express actual authority; (2) implied actual authority; (3) apparent authority; and (4) ratification.

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Express actual authority usually comes into existence by explicit grant of authority to the officer on behalf of the corporation. This explicit grant of authority comes form either the corporation’s bylaws, or in the form of a resolution adopted by the board of directors.

The doctrine of implied authority is often described as “authority which is inherent in the office.” There are two ways that implied authority can come into existence: (1) authority may be inherent in the particular post occupied by the officer, measured by common understanding of business people; (2) the board, by its own conduct or action, may have implicitly granted the actual authority to the officer in question. Emanuels.

Lee v. Jenkins Bros. (1959)

In 1955, Lee (P), an individual, brings suit against Jenkins (D) corp. Jenkins (P) alleges that in 1920, Yardley, then the president and chairman of Jenkins (D), as well as a substantial stockholder in it, promised Lee (P) that is Lee (P) would leave his existing job to come to work for Jenkins (D), Jenkins (D) would pay Lee (P) a pension of $1500 a year when he reached the age of 60. (Lee (P) was 30 at the time of the promise.) Because Lee (P) would be forfeiting a pension with his existing employer, Yardley told Lee (P) (Lee says) that Lee (P) would be entitled to the pension even if he was not still working with the company at the age of 60. Lee (P) in facts works for Jenkins (D) for 25 years, until he is discharged at the age of 55. Yardley is dead by the time of trial, and Lee (P) is the only source of testimony about the original pension understanding. Jenkins (D) defends on the grounds that Yardley did not have authority to bind the corporation to such an arrangement.

Held, the question of whether Yardley had apparent authority to make this contract (assuming that its making is proved) is a question of fact for the jury. Since there has been no showing of actual authority, Lee (P) can win only by showing that Yardley had apparent authority to make this contract. The general rule is that “the president only has [apparent] authority to bind his company by acts arising in the usual and regular course of business but not for contracts of an “extraordinary” nature. Employment contracts for life are usually regarded as “extraordinary” and therefore beyond the president’s apparent authority. On the other hand, the agreement here was not a life time employment contract, but merely a contract to pay a pension of at most $1500, assuming that Lee (P) worked for Jenkins (D) for a reasonable time. Apparent authority is essentially a question of fact, which depends on “the officer negotiating [the contract], the corporation'’ usual manner of conducting business, the size of the corporation and the number of its stockholders, the circumstances that give rise to the contract, the reasonableness of the contract, the amounts involved… to list a few… of the relevant factors.” Here, Jenkins (D) had just entered into a new line of business that it had no experience with, and it looked to Lee (P) as an experienced executive who could help it. Therefore, the court cannot say as a matter of law that Yardley as president did not have apparent authority to make the agreement; the case should thus have been heard by the jury, not decided against Lee (P) by the trial court.

In the Matter of Drive-In Dev. Corp. (1966)

Drive-In (D), a subsidiary of another corporation, want to induce Bank to make a loan to the parent corporation. Therefore, Dick, Drive-In’s (D) secretary, presents Bank with a copy of a resolution of Drive-In’s board of directors guaranteeing the loan, together with Dick’s certificate that the resolution was duly authorized by the board. Bank makes the loan, and Drive-In goes into bankruptcy. It turns out that the directors never in fact authorized the resolution. Emanuels.

Held, Drive-In is bound on the guarantee. Dick was Drive-In’s secretary. “Generally, it is the duty of the secretary to keep the corporate records and to make proper entries of the actions and resolutions of the directors.” Therefore, it was within Dick’s authority to certify that a resolution was adopted; statements made by an agent in the course of a transaction that was within the scope

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of his authority are binding on the principal. Therefore, Drive-In was bound even if its board never in fact adopted the resolution. Emanuels.

The secretary has one key element of inherent authority in virtually every jurisdiction: He has inherent authority to certify the records of the corporation, including resolutions of the board of directors. Therefore, a secretary’s certificate that a given resolution was duly adopted by the board is binding on the corporation in favor of a third party who relies on the certificate. Emanuels.

Insider Trading

Not all insider trading is illegal. In general, only insider trading that occurs as a result of someone’s willful breach or a fiduciary duty will be illegal.

Examples:1. buying on undisclosed good news;2. selling on undisclosed bad news

There are three bodies of law which apply to insider trading:1. State common law;2. The federal SEC Rule 10b-5 prohibits any “fraudulent or manipulative device” in connection

with the purchase or sale of security;3. Section 16(b) of the federal Securities Exchange Act makes insiders liable to repay to the

corporation all profits they make form “short swing trading profits” (whether based on insider information or not).

State Common Law

A shareholder can in theory bring a state common law action against an insider trader for “deceit.”

If the insider buy from the outsider in a face-to-face transaction, the rule is that the insider has no duty to disclose material facts (e.g., good news) known to him. Exceptions:

1. If the insider knowingly lies or tells a half truth, he will be liable under ordinary deceit principles.

2. Many states recognize a “special facts” exception to the general rule that silence cannot constitute deceit.

Given the difficulties that individual shareholders find at common law in recovering for insider trading, may the corporation itself recover for insider trading in its shares by one of its officers or directors?…. But in the usual insider trading situation, the corporation will not suffer direct financial harm…. In Diamond v. Oreamuno, the court held that inside information is a corporate asset, and that an insider who profits by trading upon that information has violated his fiduciary duty to the corporation and must turn over to the corporation any profits he has made (or losses he has avoided) from the trading, even though the corporation did not suffer direct financial loss.

10b-5

SEC Rule 10b-5 makes it unlawful: 1. to “employ any device, scheme, or artifice to defraud”; 2. to make any “untrue statement of a material fact or to omit to state a material fact…”; or

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3. engage in any “act, practice, or course of business which operates or would operate as a fraud or deceit upon any person.”

All three are forbidden only if they occur “in connection with the purchase or sale of any security.”

The insider does not have an affirmative obligation to disclose the material, non-public information. Rather, he must choose between disclosure and abstaining from trading.

If an insider makes an affirmative misrepresentation (as opposed to merely omitting to disclose information), he can be liable under 10b-5 even if he does not buy or sell.

Violation of 10b-5 is a crime. Also, the SEC can get an injunction against the conduct. Finally, a private party who has been injured will, if he meets certain procedural requirements, have a private right of action for damages against the insider trader.

Rule 10b-5 applies to fraud in the purchase or sale of securities in privately-held companies, not just publicly held ones.

An outsider injured by insider trading has a right of action for damages under Rule 10b-5, if he can meet:

1. P must have been a purchaser or seller of the company’s stock during the time of non-disclosure; See Blue Chip Stamp v. Manor Drug Stores.

2. P traded on material, non-public info - D must have misstate or omitted a material fact;

3. D must be shown to have had a special relationship with the issuer, based on some kind of fiduciary duty to the issuer.t

4. D must be shown to have acted with scienter, i.e., intent to deceive, manipulate, or defraud.

5. P must show that he relied on D’s misstatement or omission, and it was the proximate cause of his loss; (reliance and causation)

6. P needs federal jurisdiction… must show “by use of any means or instrumentality of interstate commerce or…”

One how already owned shares in the issuer and who decides not to sell (non sellers) because the corporation or its insiders makes an unduly optimistic representation, or fails to disclose negative material, may not sue.

The fact that the company is engaged in “merger” discussions is not necessarily “material.” This is a fact-based question that depends on how far along the negotiations are, whether a specific price is on the table, whether the investment bankers have been brought in, etc.

In the case of silent trading, D will not be liable unless he was either an insider, a “tippee,” or “misappropriator.” In other words, mere trading while in possession of material non-public information is not by itself enough to make D civilly liable under 10b-5.

Example: D is sitting in a taxi, and finds handwritten notes left by the prior occupant indicating the ABC Corp is about to launch a tender offer for XYZ Corp. D buys XYZ stock. D won’t be liable under 10b-5, because he was not an insider of XYZ, nor a “tippee” of one who was an insider of XYZ, nor a “misappropriator” who stole the information from anyone.

A person will be a “tippee,” and will be liable for insider trading, if he knows that the source of his tip has violated a fiduciary obligation to the issuer. Conversely, if the tippee does not know this (or if the insider has not breached any fiduciary obligation), the tippee is not liable.

Example: X, a former employee of ABC Corp, tells D that XYZ is engaging in massive financial fraud. X is not acting for any pecuniary benefit, but instead just wants to expose the

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fraud. D tells his clients to sell their ABC stock. Held, D did not violate 10b-5, because X was not violating any fiduciary duty, so D was not a knowing “tippee.” See Dirks v. SEC.

A misappropriator is one who takes information from anyone – especially from a person who is not the issuer – in violation of an express or implied obligation of confidentiality.

Example: Lawfirm represents Behemoth, a big company that is secretly planning a takeover of Smallco. D, a partner at Lawfirm, learns from Behemoth about these plans, and buys Smallco stock. Held, D has violated 10b-5, because he misappropraited the information from Behemoth, in violation of an implied promise of confidentiality. This is true even though neither D nor Lawfirm was an insider of Smallco, the issuer. See U.S. v. O’Hagan.

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Organization Management Finance Liability Tax Creditor Protection Sale of InterestPartnership Informal (no

minutes, resolutions, etc.)

Informal (no capital required of each partner)

* personal liability Flow thru (note could check the box though)

Strong (can sue individually; joint and several liability)

Forced legal sale.

Corp “C” Very formal (Board, officers, etc.)

Very formal (tied to capital)

Limited liability Double tax Good No forced sale (mkt)

Corp “S” Formal but less Same Yes limited but piercing the corp veil

Flow thru Good (veil) No forced buyout. (No mkt, closely held) Note, lawyers can draft buy-sell agmts.

LLC Choice of Mgmt:1. Member mgmt.2. Mgr mgmt.

(very formal)

Very formal (only put up what you want)

* No personal liability.

Flow thru Weak No forced sale; Buyer is only an assignor (unless a buy-sell agmt, then at the mercy…great hidden danger of LLC)

Hypo: Grocery store Mom & Pop form corp 50% ownership each. Campbell soup man seeks payment but Mom takes money of her own to pay. Later Mom & Pop take money out to go to dinner. After many years, they would guilty of commingling funds.

Hypo: Member of LLC dies, wife becomes assignor (wife is really giving an interest free loan).

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