Professor Gulinello
Spring 2013
Chapter 2: Concepts and Terms
What is a “business organization?”
o The structure of the business.
What are the common forms of a business organization?
o Corporations
An incorporated business that must be registered with the
state, by filing articles of incorporation with the secretary of
your state.
Only one that is an incorporated organization.
o Limited Liability Companies
Generally it is managed directly by its members; there are
articles of organization, which is extremely similar to a
corporation, and you must file them with the state;
o Partnerships
Do no have to file anything with the state; many partnerships
are formed by mistake; two or more person carrying on as
partners of a business for shares of the profit earned.
o Sole Proprietorships
Not filed with the state, and you are all on your own. If you file
with the state, then you lose your status within this group.
What do these terms mean?
o Closely-held company: a very small number of shareholders.
o Public company: almost all of Public companies are traded on the
stock exchange.
Must register with the SEC and follow all of their rules.
You do this because it is easier to buy and sell the shares of the
stock; there is a much higher liquidity rate if you trade on one
of the major stock exchanges (NYSE and NASDAQ).
o Private company: a larger company with more shareholders, but it is
not publically traded.
Cargill is the US’s largest private company.
Explain the following:
o The role of CL on business organizations
Many of our fiduciary duties are CL rules
o The role of Delaware law on business organizations
Very common to see other states apply Delaware law to
business related issues within the own respective state.
Almost 60% of publicly traded corporations are incorporated
in Delaware because they have very favorable laws for
There is a much higher degree of certainty and efficiency for
business that are incorporated in Delaware.
o The role of federal law on business organizations
It deals almost exclusively with publically traded companies
There has been a trend over the years for Federal Government
to get involved in corporate governance.
o Internal Affairs Doctrine
The internal governance of a business organization is governed
by the law of the business organization’s state of organization
or incorporation.
What do these terms mean?
o Debt Financing: borrowing money to finance a project from a bank,
or you can sell bonds in your company, which is very similar to selling
stocks in your company (also called debt securities).
o Equity Financing: you sell ownership in the company, thus, the
investors get a share of the money the company makes.
o Residual Claim: the residual is the same thing as equity; it is the
amount of money leftover after all the fixed debt has been paid off.
What are the four characteristics of business organizations?
o Limited liability (or not)
o Legal personality (or not)
Perpetual, meaning even if the owners die, the corporation
lives on; it also has the ability to sue an be sued.
o Centralized management (or not)
Default rule is that a LLC does not have centralized
The members have direct control over the company’s affairs.
o Freely transferable ownership interests (or not)
Generally, but not usually with LLCs.
What do these terms mean?
o Agency cost: the principal must take steps to insure that the agent is
not abusing the authority given to them.
Monitoring cost, bonding costs, and residual losses
o Dispersed ownership: having a lot shareholder with none having a
significant stake in the company.
o Default rule: this is a set of basic rules that, if you do not draft
another rule in their place, then your corporation will be held to have
assumed the default rule.
o Mandatory rules
Basic Accounting
Three statements:
o Balance Sheet (We will use this one the most in this class)
One specific moment in time
What assets? What liabilities?
Note Payable = a fancy word for a bank loan
Residual Claim = Owner’s Equity = Total Assets – Total
Assets are not usually listed as their true market value.
Par Value: the company when it sold those shares it got
at least a dollar. Aka Legal Capital
Legal capital + Additional paid-in capital = total amount
of money received from investors
o Income Statement
Essentially profit
Revenue (Sales) – Expenses = Profit
o Cash Flow Statement
Income is not always in cash.
Usually in the form of financing or investing
Things that are cash but not income:
Loans from a bank
Selling shares or borrowing money
Investing- buying land is not considered an expense; it is
considered an investment.
Chapter 3: Entity Formation
Choosing a business form:
a. Governance/ management
b. Liability
c. Income Taxes (Not going to spend a lot of time on this)
a. Drives this process
Governance and Management
Centralized management
Board of Directors – elected by the shareholders
Executive officiers and employees – appointed by the board
Shareholders only vote to elect or remove directors and on a few
fundamental transactions:
o Amendment of the articles of incorporation
o Mergers
o Sale of virtually all of its assets
o Dissolution
o Amendment of the bylaws (but board might be able to amend without
shareholder approval.
Management in the Closely-Held corporation
Centralized in default rule
Shareholders want control
Control is with board and executives
Ways to keep your client in control:
o Draft Ks to make sure they are elected to the board
Shareholder voting agreements, different classes of shares
o Draft Ks to make sure they are appointed as officers
Limited liability: shareholder is not responsible for debt of company
o Double taxation as a default rule (IRC C-Corp)
o Example:
XYZ Inc.’s income for year = $100,000
XYZ Inc.’s federal income tax rate = 35%
XYZ Inc. pays federal income taxes = $70,000
Net Income = $130,000
XYZ Issues a dividend to shareholders: $130,000
Federal income tax rate – dividends = 15%
SH pays a federal income taxes = $19,500
Total paid in federal income taxes = $89,500
o Income Tax
Avoid double taxation
“Pass-through” taxation
o XYZ Inc.’s income for the year = $200,000
o Federal income tax rate = n/a
o XYZ pays federal income taxes = 0
o Amount remaining = $200,000
o SH federal income tax rate = 28%
o SH pays federal income tax = $56,000
o Total paid in federal income taxes = $56,000
This is paid even if they received a
To Get Pass Through Taxation -----> S-corp: 5 elements
(Issue spotting on test)
1) Domestic corporations (or LLC)
2) 100 or a fewer shareholders (special counting rules for family members)
3) Shareholders must be natural persons (tax exempt organizations are also
allowed, as well as certain trusts and estates)
4) All shareholders must be US citizens
5) There is only on class of stock with respect to economic rights (different
voting rights are allowed)
Governance and Management
Law in most jurisdictions is that the members directly manage
But you can choose between:
o Member managed LLC
Not centralized
Owners manage the business
o Manager managed LLC
Exact opposite of the previous, much like a corporation
Income Taxes
o Pass-through taxation as a default
o Taxed the same as a partnership
o Same basic concept as S-corp, some difference.
o May elect to be taxed as a C-corp (double taxation)
o May elected to taxed as a S-corp if it meets the qualifications
Business Entity Taxation:
Pass through losses: owners in companies have to assume their share of the
LLC or companies losses
Internal Revenue Code (IRC) taxes in one the following ways:
o Sub-C
Tax strategy: zero out – don’t show profits
Disguise rents, salaries, and royalties
Must be reasonable to the IRS
o Sub-K
No tax at entity level
Pass through both losses and profits
No need to zero out
o Sub-S
o Disregarded entity – no tax?
Self Employment Tax
o FICA (social security) + Medicare Tax
Not self-employed: ½ paid by the employee/er
o How to avoid?
Separate your salary and return on investment
“Payroll Tax”- tax on wages and salary
KBCA 271B.2-020 – The articles shall provide: SEVERAL THINGS see the book
This is what you need in your articles of incorporation
Name: KBCA 4-010
o Need Inc. ; Corp. ; Co. ; Ltd.
Promoter Liability:
If a corporation has yet to officially form and a promoter enters into a K
acting as they have, then the promoter is personally liable.
o In addition, the agent warrants the existence of the corporation.
You should never advise your client to enter into a K on behalf of a
corporation who is waiting for approval.
However, there are a few ways to still accomplish the goal while still limiting
the agent’s liability:
o You can try to negotiate an assignable option; (i.e and option to rent
the space, buy the goods, or receive the services) and when the
corporation is formed the corp. can exercise the option.
o Make the terms of the K very clear: expressely state that the
promoter is not liable under the K and that she will make a good
faith effort to cause the corporation to be formed and to cause them to
adopt the K.
Advice to client:
o Do not sign on behalf of corporation to be formed.
o Wait for incorporation.
o Negotiate an assignable option
De Facto Corporation: Protects the promoter
Corporation by Estoppel: Protects the newly formed corporation when a 3rd
party tries to get out of a K, usually requires some form of reliance on behalf
of the corporation.
Chapter 4: Raising Capital
Chapter 5: Governance Mechanics: Decision-Making in Business Organizations
What are dissenters / appraisal rights?
You have changed the rules, and I want my money back.
A stockholder can force the corporation to buy back their shares at market
Chapter 6: Fiduciary Duties in Corporations
Directors and Officers Liability through the following types of bad conduct:
Bad Decisions
General Premise: We are going to protect the directors and officers.
This is done with the Business Judgment Rule.
As a SH, you will not be able to sustain a cause of action unless you show they
were disinterested, acted in bad faith, or didn’t act with due care.
Business requires taking risk, which is why you protect the actions of
directors and officers.
What are the director’s fiduciary duties? Put standards next to these
1) Duty of Loyalty
a. Conflicted Transactions
i. Indirect: (primary fact patterns)
1. Financial Interest
2. Immediate Family Members
3. Director of ABC is a high level employee or director of
4. Corporate Opportunity
2) Duty of Care
3) Duty to Monitor
a. Duty of oversight
4) Duty of good faith
a. Delaware says this is a subset of a duty of loyalty
Duty of Loyalty
Fully Informed:
Clearly State What Conflict is (i.e. conflicted director must say that he is
conflicted and this is his conflict).
Must give directors all information you have about the transaction.
o You DO NOT have to disclose your reserve price.
o You DO NOT have to disclose your reasons for selling/dealing.
Fairness Examined:
Last stand for the conflicted transaction by an interested director.
o Fair Price (substantive fairness) AND
o Fair Dealing (procedural fairness)
What information did the director give to the board?
Did the corporation benefit?
If the director cannot show this either, than he will be found liable and have
to disgorge any profits gained from the transaction.
Duty of Care
Flow Chart Examined:
Standard of liability is Gross Negligence or Recklessness in the decision
making PROCESS
Exculpation Clause
o RMBCA 2-020 (d)
o Not allowed to excuse for breaches of duty of loyalty or good faith
o Extra piece of protection for directors
Fair transactions
It is VERY hard to find a director liable for a breach of the duty of care.
Duty to Monitor
Must monitor the following:
Illegal acts
Corporation’s business operations
When will the directors be liable?
Only when the board acted in bad faith
Bad Faith:
o Intent to harm the corporation
o Unlikely and difficult to prove
o Failing to act and conscious disregard of a duty to act
Chapter 7: Closely-Held Business: Fiduciary Duties and Other Problems
Difference from large corp:
Unlike a large corporation, part of the expected earnings from a stockholder
in a small corp may be a salary.
Same fiduciary duties as large corp.
o Plus an additional duty of good faith.
Might want to prevent transfer of shares to maintain consistent ownership.
Might want to create a market for shares.
Duty of Good Faith
Essentially a duty not to freeze-out one another.
Do not deny them of their reasonable expectations
Deny them of their benefits and rights as SHs
Reasonable Expectations:
Only analyze this when there is a possible denial of reasonable expectations
Did the SH have a reasonable expectation of employment, benefits, dividends
o Express agreements
o Implicit understandings based on the circumstances
Practical Law Company: they have model SH agreements and other security
related documents.
Wilke Burden Shifting Test:
Minority SH must show controlling SH acted in bad faith
C-SH will then have to show some legitimate business purpose for her
M-SH will then have to show that the business purpose could have been
achieved in a less harmful manner to her minority interests
Traditional Remedy:
You must disgorge the profit to the corporation
Special Remedy in CH Corporation:
Recovery goes directly to the minority SHs
Equal treatment (“me too treatment”)
Transfer of Shares:
Contintity of ownership
Buy-Sell Agreement
o DDD BEER or “Three D’s and a beer.”
o Death
o Disability
o Divorce
o Bankruptcy
o Employment
o Exit
o Retirement
Chapter 8: Fiduciary Duty Litigation
When will the board not be able to make an impartial decision about the lawsuit?
 When they are defendants? Not a good standard
 Standard: Only when there is a strong likelihood the directors will be liable
for their actions in the underlying transactions.
 Court will require the SH to plead particularized facts proving that the BMs
were conflicted in the transactions or were dominated or controlled by a
conflicted party.
Demand-Excused Jurisdictions:
 Word for word on page 15 in the book
Universal Demand Jurisdictions:
 Word for word on page 14 and 15 in the book Ch. 8
SLC Decisions
 Delaware- court will do a strict review of the SLC decision
o See page 21 of ch. 8
SLC Steps to Insure Independence:
 Exercise all corporate authority
 Decision is final and binding
 Reasonable compensation
 Indemnification
 Pays fees for any hired advisors
Chapter 9: Mergers and Other Business Combinations
- Generally Shareholders get to vote on mergers
Chapter 10: Protecting Creditors
Piercing the Corporate Vail: (factors)
(1) Unity of Interest:
Commingled funds and assets
Some sort of capital
Failed to maintain corporate formalities
Treating Corporate Assets as My Own
(2) Something akin to fraud
DO the analysis of these four factors on the exam