Malpractice Actions•Civil actions brought against professionals (lawyers, doctors, architects, accountants, financial advisors, consultants, real estate brokers, etc.) are referred to as “malpractice actions.” ----------------------------------------------------------------------------------------------------- •Book focuses on accountant civil liability, but the same theories apply to most professions, including lawyers. •Regulatory actions by a state board of accountancy or the Internal Revenue Service are separate matters.
Three primary types of civil liability for accountants under common law:1. Negligence 2. Breach of contract 3. Fraud (4. Fiduciary Liability) •Fiduciary liability applies in some instances •Professionals are not guarantors of the accuracy of their work or that advice they give to clients will work out well
Limiting Risks of Liability in Audits and Legal Opinions (aka Ways to Limit Risks of Liability)•Issue a “Qualified” Opinion Letter with express limitations of the scope of the services or an express disclaimer of liability •Limit the scope of services, such as by expressly providing only an unaudited financial statement ------Complete Version-------------- •Issue a “Qualified” Opinion Letter with express limitations of the scope of the services or an express disclaimer of liability (usually requires a statement of support rather than blanket disclaimer, such as where client did not make all financial information available or prepared the necessary information incorrectly (such as not accounting for inventory correctly)) •Limit the scope of services, such as by expressly providing only an unaudited financial statement
"Professional's Duty to Clients: Negligence"•Elements of Negligence: Duty, breach of duty, causation, and damages. •Liable to client for negligence if he/she fails to exercise the care expected of a competent, reasonable professional and that failure causes loss/injury to client •At a minimum, for accountants, this requires performing responsibilities according to generally accepted accounting principles (GAAP) and generally accepted auditing standards (GAAS)
Defending Allegations of Negligence in Professional Malpractice•Professional standards were adhered to •Professional’s failure is not the cause of the loss •A few states allow the assertion of the defenses of contributory negligence or comparative negligence (many states limit these types of defenses because a professional is expected to have superior skills to the client) -------Extra---------------- -Contributory Negligence (book): A defense to negligence whereby the defendant can escape all liability by proving that (1) the plaintiff failed to act in a way that would have protected him or her from an unreasonable risk of harm and (2) that the plaintiff’s negligent behavior contributed in some way to the plaintiff’s accident.
"Professional's Duty to Clients: Breach of Contract"•Whenever professional hired to perform specific task, he/she enters into contract (often called an engagement letter) with client •Apply common law of contracts: Express terms set out in contractImplied terms including agreement to complete work in a competent and professional manner, according to professional standards (for accountants, GAAP and GAAS) *Me: Contracts contain explicit and implicit promises/terms
Defending Allegations of Breach of Contract•Apply common law breach of contract rules: Full defense where professional’s duty was discharged due to client’s breach or where client obstructed performanceMinimize damage calculation: Consequential damages were not foreseeable.The professional’s performance was “substantial,” and therefore, even though professional liable for damages, professional entitled to full compensation for services as an offset to any damages.
"Professional's Duty to Clients: Fraud"•Elements of fraudulent misrepresentation: The professional misrepresented a material fact,The professional acted with intent to deceive (“constructive fraud” generally eliminates the need to prove this element if professional acted recklessly),The client justifiably relied on the misrepresentation, andThe client suffered an injury by relying on the fraudulent misrepresentation •Compensatory and punitive damages can be awarded for fraud
Defending Allegations of Fraud•Misrepresentation was not material •Client relied upon another (such as another professional) •Client’s reliance upon the professional was unjustified •Client’s damages were not the result of misrepresentation
Fiduciary Duties*Traditional fiduciary duties include: •Loyalty: Act in the best interest of the principal; avoid conflicts of interest (includes duty not to compete) •Performance / Care: Use same skill and care of reasonable person in the same situation •Obedience: Follow the lawful instruction and direction of the principal •Notification / Disclosure: Communicate any information that may be important to principal •Accounting: Keep an accurate account of the money and property received on behalf of the principal (this is often included with duty of loyalty) and avoid misappropriation of client assets
Immediate Trends in Breach of Trust and/or Fiduciary Duty•Lawyers are always fiduciaries, so they have always risked this type of liability •Accountant most likely to be fiduciary when providing tax or asset management services •Registered investment advisors owe fiduciary duties, but traditional stockbrokers are not required to fulfill those duties •All professionals owe a duty of trust to clients Information and assets entrusted by client to professional may be used only to benefit the clientDuty of trust also requires a professional to maintain confidentiality of a client’s information
Consider These Risks for Accountants in Tax and Asset Management Services•Missed deadlines for tax elections and disclosures •Advising on use of business entities •Advising on next generation transitions of businesses •Handling private financial information •Making representations concerning value or financial condition of a company
"Accountant's Liability to Third Parties – Different Approaches by State (Privity or Near Privity (Ultramares Rule) vs Foreseeble Users Rule)""•Privity or near-privity (Ultramares rule): Requires that third party be in privity of contract with accountant, or be close enough to accountant to constitute near-privity with clear awareness of reliance (such as intended third party beneficiaries) •Foreseeble users (and class of users) rule: Requires that accountant knew or should have foreseen recipient or class of recipients as users of the accountant's work"
Most Significant Federal Laws (Statues) Affecting Accountant Liability•Securities Act of 1933 •Securities Exchange Act of 1934 •Sarbanes-Oxley Act of 2002
Securities Act of 1933"•Accountants civilly liable for misstatements and omissions of material facts made in registration statements filed with the Securities and Exchange Commission (SEC) •Does NOT require reliance by investor, but does require that the accountant failed to exercise due diligence (i.e. didn’t follow professional standards) *It's about that initial filing -----------Book---------------------------- 1. To recover damages, a plaintiff—someone who purchased a security covered by a flawed registration statement—does not need to prove reliance on the statement or to establish privity. 2. Accountants are liable when they do not perform their jobs according to the generally accepted standards and practices of their profession. Under the Securities Act, accountants have a duty to perform their tasks with due diligence."
Securities Exchange Act of 1934• Accountants liable for fraudulent financial statements (higher burden than negligence) made in annual and quarterly filings with the SEC Requires statements actually affected the price of the security and investor relied upon statements •This means that accounting professionals who have acted in good faith and without knowledge of the falsity of the statements have a viable defense to liability under the Act.
Sarbanes-Oxley Act (SOX) of 2002"•Requires auditors to attest to an “internal control report” acknowledging management’s responsibility to maintain “an adequate internal control structure and procedures for financial reports” •Attempts to assure auditor independence, primarily by limiting audit firms from supplying most types of non-audit services to their audit clients, including management and human resources services, financial information system design, bookkeeping, and other financial services ME: Prevent audit firms from doing non-audit services for a company while/when they're also Auditing that same company b/c that can cloud that audit firm's judgment. •Sets five year record retention requirements for auditors"
"Accountants' and Clients' Rights – Papers and Records (Define Workpapers. Who owns Personal Records and Workpapers?)"•Workpapers: Various documents used and developed during audit Accountant (or firm) is legal owner of working papers, but client may access at any time upon request •A client’s personal records, such as accounting records, are the property of the client and the professional must return the records at end of job Accountant has the legal right to keep copies of the records that are returned.
Client Rights – Nonlawyer Professional/Client Privilege"•Communications between clients and nonlawyer professionals generally are not protected from judicial and administrative agency scrutiny when the professional’s client is a party to legal or administrative action (i.e. there is “typically” no common law accountant/client privilege or similar rule for other nonlawyer professionals) •When granted, the “client” has right to privilege (not the professional) *Privilege: The client's right/ability to give the profesional the ability to refuse to testify against that client and the client has the ability to stop the professional from testifying. ------Complete Version------- •Communications between clients and nonlawyer professionals generally are not protected from judicial and administrative agency scrutiny when the professional’s client is a party to legal or administrative action (i.e. there is “typically” no common law accountant/client privilege or similar rule for other nonlawyer professionals) •Some states have changed the general rule by adopting a statute creating an accountant/client privilege •When granted, the “client” has right to privilege (not the professional)"
Malpractice Insurance (aka Errors & omissions insurance)•typically available to protect professionals against most types of malpractice liability. •Malpractice insurance is “liability insurance”
Agency (aka Agency Relationship)Two-party relationship in which one party (the “agent”) has the power to act on behalf of and under the control of the other party (the “principal”). ------Extra----------------------------------------------------------------------- -Agency Law and Agency Relationships are fiduciary relationships -Agency (Book): The fiduciary relationship that arises when one person consents to have another act on his behalf and subject to his control and the other consents to do so.
Agency law generally divided into two areas:1. Legal relations between agent and principal (the relationship is considered a “fiduciary” relationship where the agent must act for the principal’s benefit) 2. Principal’s and agent’s relations with third parties (where the central issues are the agent’s ability to bind the principal to contracts and the principal’s liability for the agent’s torts)
3 Common Types Agency Relationships in Business•“Employer-Employee” Relationships: Employer hires employee to perform certain tasks; employer has right to control conduct of employees •“Employer-Independent Contractor” Relationships: Employer hires persons (other than employee) to conduct some sort of task; employer has no control over details of conduct of independent contractor (sometimes an “agent,” but not always) •Business Organization Relationships: Partners in a partnership, officers/directors in a corporation, members in a member-managed LLC, and managers in a manager-managed LLC.
Agent’s “Fiduciary” Duties To Principal•Loyalty: Act in the best interest of the principal; avoid conflicts of interest (includes duty not to compete); communicate any information that may be important to principal (often called the duty of “Notification” or “Disclosure”) •Performance / Care: Use same skill and care of reasonable person in the same situation •Obedience: Follow the lawful instruction and direction of the principal •Accounting: Keep an accurate account of the money and property received on behalf of the principal (this is often included with duty of loyalty) and avoid misappropriation of client assets by not commingling assets
3 Common Breaches of the Duty of Loyalty1. Usurping Opportunity of the Principal (often called “Usurping Corporate Opportunity”) 2. Self-dealing 3. Competing with the principal *The principal has a right to recover any profits made by the agent as a result of any of these activities
Usurping Opportunity of the Principal (often called “Usurping Corporate Opportunity”)personally stealing an opportunity for the agent’s own benefit rather than passing the opportunity on to the principal/company
Self-dealingUtilizing contractual relationships to benefit the agent or some other person or organization that the agent has a relationship with to the detriment of the principal
Competing with the principal•Engaging in business activities that compete with the principal without full disclosure and approval of the principal
Most Important Duties of Principal To Agent•Compensation •Reimbursement and Indemnification (meaning to compensate for harm or loss caused by the agency relationship) •Cooperation *These are usually enforced using traditional contract law principles
Creation of Agency Relationship•Generally, only two things must exist to create an agency relationship: A principal with “capacity” (principal has contractual capacity)Consent of both the principal and the agent •Although not required for agency to exist, these are often contractual relationships
Only certain instances require a “written” contractual relationship:•Agency with the authority to enter into contracts that must be in writing under the statute of frauds (ex. land sale contracts) •Powers of attorney •Statute of frauds (cannot be performed in less than year) -EXTRA- *Power of Attorney (bk): A specific type of express authority that grants an agent specific powers. *Statute of Fraud: state-level legislation that require certain contracts to be in writing
Agent’s Power to Contractually Bind the Principal to Third Parties: “Actual” Authority•Actual authority to bind the principal to contracts entered into with third parties comes from two sources: Expressed Authority/Agency: Agency/authority formed by making written/oral agreement that expressly grants power to the agentImplied Authority/Agency: Authority given to the agent by implication that a person has authority necessary to carry out express authority (cannot contradict express agency authority)Implication comes from the interactions between the principal and agent
Agent’s Power to Contractually Bind the Principal to Third Parties: Other Sources of Authority•“Apparent” Authority/Agency (Agency by Estoppel): Agency/authority formed when principal leads third party to believe that another individual serves as his/her agent (although principal had actually made no agreement with purported agent) Comes from the connection between actions of the principal and reasonable belief of third parties •Authority/Agency By “Ratification”: Agency that exists when individual misrepresents himself/herself as agent for another party, and principal accepts/ratifies unauthorized act -----BOOK----- Apparent Agency: An agency relationship created by operation of law when one party, by her actions, causes a third party to believe someone is her agent even though that person actually has no authority to act as her agent. Also called agency by estoppel.
Contractual Liability of Principal and Agent For Authorized Agent Acts (and define Authorized Acts)“Authorized” Acts: Agent acts within scope of agent’s authority •Classification of Principal: Must be classified as either disclosed, partially disclosed, or undisclosed •Disclosed Principal—Agent not liable, principal liable•Partially Disclosed Principal—Agent possibly liable, principal liable•Undisclosed Principal—Agent liable, principal liable
Contractual Liability of Principal and Agent for Unauthorized Agent Acts (and Define Unauthorized Acts)“Unauthorized” Acts: Acts that go beyond scope of agent’s authority •Third Party Reasonably Believes Agent Has Authority Agent liable; Principal not liable •Third Party Aware that Agent is Mistaken About His/Her Authority Agent not liable; Principal not liable
"When is the Principal Liable for an Agent's Tortious Conduct? (Tort Liability to Third Parties / Agency Relationship Impact)"•Agent’s Tortious Conduct—Principal liable if: 1. Vicarious liability / Respondeat Superior applies (this is liability without fault); or 2. ”Direct liability” applies, such as where the Principal is responsible for negligent hiring or fails to provide proper instruments, tools, or adequate instructions (note, this is not the same as vicarious liability, although the book does not sufficiently distinguish it – here, the principal has independently committed a tort) *NOTE: Agent is always liable for his or her own torts.
Respondeat Superior•Principal/employer liable for torts of agent: - Who is an employee; and - Who commits the tort while acting within the “scope of his or her employment”
Requirements for an Act to be considered in the “Course and Scope” of Employment"•It was of the kind that the employee was employed to perform, •It occurred substantially within the authorized time period of employee’s work responsibilities, •It occurred substantially within the location authorized by the employer, and •It was motivated, at least in part, by the purpose of serving the employer * Substantial departure relieves this liability – often called a “frolic” If an agent makes a substantial departure from the course of the employer's business, the employer is not liable."
Principal’s Liability and the Independent ContractorGeneral Rule: A party who hires an independent contractor is generally not liable for independent contractor’s tortious actions under doctrine of “respondeat superior”
Independent Contractor v. Employee Status Affects the Following•Tort liability •Workers Compensation •Workplace Safety •Unemployment Status •Employer Tax Contributions •Employment Discrimination •Rights to Unionize
Termination of Agency Relationship•Because these are commonly contractual relationships, the relationship can be terminated under traditional contract theories, such as where the they can be terminated by mutual agreement; or •The relationship can be terminated by operation of law, such as when one of the parties dies or becomes incapacitated.
Major Forms of Business Organizations•Sole Proprietorship •General Partnership •Limited Partnership •Limited Liability Partnership •Limited Liability Company •Corporation *Fictitious names are often used so that it is not always obvious which form of business organization is being used.
Sources of the Law for Business Organizations•Business organizations are governed almost exclusively by state statutes, a number of which are based upon “uniform” laws. ------Complete Version------ •Business organizations are governed almost exclusively by state statutes, a number of which are based upon “uniform” laws. •To the extent federal law applies, it is typically in the area of federal taxation. •The purpose of most state laws is to provide basic requirements and to set up certain “default” rules for the operation of business organizations.
The Life Cycle of a (General) Partnership•Formation--Partnership formed either by written agreement, articles of partnership, or by estoppel •Performance—Business conducted as partners work for benefit of partnership, in accordance with partnership agreement (if any) •Dissolution—Partnership dissolves either by act of court, act of partners (dissociation), or operation of law (doesn’t necessarily lead to winding up, as remaining partners can agree to continue the business) •Winding Up—Partners complete unfinished partnership business, collect and pay debts, collect partnership assets, take inventory, and distribute assets
The Life Cycle of a Partnership: Formation•Formation--Partnership formed either by written agreement, articles of partnership, or by estoppel ------Complete Version----------------- •Formation--Partnership formed either by written agreement, articles of partnership, or by estoppel •Performance—Business conducted as partners work for benefit of partnership, in accordance with partnership agreement (if any) •Dissolution—Partnership dissolves either by act of court, act of partners (dissociation), or operation of law (doesn’t necessarily lead to winding up, as remaining partners can agree to continue the business) •Winding Up—Partners complete unfinished partnership business, collect and pay debts, collect partnership assets, take inventory, and distribute assets
The Life Cycle of a Partnership - Performance•Performance—Business conducted as partners work for benefit of partnership, in accordance with partnership agreement (if any) -------Complete Version----------------- •Formation--Partnership formed either by written agreement, articles of partnership, or by estoppel •Performance—Business conducted as partners work for benefit of partnership, in accordance with partnership agreement (if any) •Dissolution—Partnership dissolves either by act of court, act of partners (dissociation), or operation of law (doesn’t necessarily lead to winding up, as remaining partners can agree to continue the business) •Winding Up—Partners complete unfinished partnership business, collect and pay debts, collect partnership assets, take inventory, and distribute assets
The Life Cycle of a Partnership - Dissolution•Dissolution—Partnership dissolves either by act of court, act of partners (dissociation), or operation of law (doesn’t necessarily lead to winding up, as remaining partners can agree to continue the business) -----------Complete Version------------------------ •Formation--Partnership formed either by written agreement, articles of partnership, or by estoppel •Performance—Business conducted as partners work for benefit of partnership, in accordance with partnership agreement (if any) •Dissolution—Partnership dissolves either by act of court, act of partners (dissociation), or operation of law (doesn’t necessarily lead to winding up, as remaining partners can agree to continue the business) •Winding Up—Partners complete unfinished partnership business, collect and pay debts, collect partnership assets, take inventory, and distribute assets
The Life Cycle of a Partnership: Winding Up•Winding Up—Partners complete unfinished partnership business, collect and pay debts, collect partnership assets, take inventory, and distribute assets --------Complete Version---------------- •Formation--Partnership formed either by written agreement, articles of partnership, or by estoppel •Performance—Business conducted as partners work for benefit of partnership, in accordance with partnership agreement (if any) •Dissolution—Partnership dissolves either by act of court, act of partners (dissociation), or operation of law (doesn’t necessarily lead to winding up, as remaining partners can agree to continue the business) •Winding Up—Partners complete unfinished partnership business, collect and pay debts, collect partnership assets, take inventory, and distribute assets
Partnership (Uniform Partnership Act Definition):“Association of two or more persons to carry on, as co-owners, a business for profit” (NOTE: No written partnership agreement, articles of partnership, or approval by the state is necessary in general partnerships. I.e. a general partnership can be created by actions of the parties (usually by agreeing to share profits and management) or by “estoppel” where, out of a sense of fairness to affected third parties, a partnership will be found to exist.)
Key Characteristics of Partnerships•Voluntary and consensual relationship between two or more individuals, partnerships, corporations, or other forms of business organizations •Rights can be governed by a written partnership agreement, but the law will set default rules/rights and responsibilities for instances where there is no written agreement •Partners own a partnership interest and share profits and management of business •Taxed as a “flow through” entity i.e. when the partnership makes money, the partners make money (for tax purposes) even if those funds are not paid out to the partners
Partnership Duties Fiduciary duties that partners owe to each other•Loyalty: Act in best interest of partnership, avoid self-interest; avoid conflicts of interest (includes duty not to compete); communicate any information that may be important to principal (often called the duty of “Notification” or “Disclosure”) •Performance / Care: Use same skill and care of reasonable person in the same situation •Obedience: Follow the lawful instruction and direction of the principal •Accounting: Keep an accurate account of the money and property received on behalf of the principal (this is often included with duty of loyalty) and avoid misappropriation of client assets by not commingling assets
General Partnership/Partner Rights (Default Rules)•Right to share in management (default is equal voting rights) •Right to share in profits (default is to share equally) If allocation of losses is not addressed in an agreement, the default is to share losses in same manner as profits.No automatic right to compensation for services but when paid, it is considered a “guaranteed payment” under the tax laws rather than profits •Rights to partnership property (considered owned in common as a group, even if titled in name of individual partner) •Right to inspect books •Right to an accounting (which, in this instance, means a right in certain circumstances to file a lawsuit allowing review of all partnership assets and/or financial transactions)
Liabilities to Third Parties"•Each general partner in a partnership has agency authority to bind the partnership contractually •Each general partner in a partnership has unlimited personal liability (“joint and several” liability) for debts and liabilities of partnership, so creditor (third party) can choose to sue partners separately or all partners jointly in one action for partnership debts/liabilities Liability continues after dissociation unless the debt / obligation is satisfied, released, or replaced (such as in a novation)Extra: I can't just dissociate from the partnership to eliminate my risk of a liability that occur while I was a partner. So liability continues after I leave the partnership for anything that happened while I was in a partnership.Limited to partner’s capital contribution if partner was not a partner at time debt/liability was created (note that the financial performance of the company could be impacted, though, so the actual loss to the partner is still significant) -----------Extra Info------------------ When you're in a general partnership, all of your obligations are unlimited for any liability of the partnership. All partners are 100% liable for every liability for the business.Joint and Several Liability: A type of liability in which a third party can choose to sue the partners separately or to sue all partners jointly in one action."
Partnership Dissolution and Termination•Dissolution can be caused by: •Partner dissociation (ex. partner withdraws or dies)•Court action •Dissolution just means the partnership relationship between the partners ceases (principal effect is termination of authority – especially for the partner triggering the dissolution) •Once partnership dissolved, the remaining partners either decide to continue the business or to liquidate and distribute assets (“winding up”), meaning the partnership terminates
Order of Distribution of Partnership Assets (Upon “Winding Up”) [1st to Last]•Payment to partnership creditors•Payment of refunds/loans to partners for loans made by partners to partnership•Payment of partners for invested capital•Payment of profits distributed to partners per terms of partnership agreement
Varying Partnership Structures: Limited Partnership•Definition: Agreement between at least one general partner and at least one limited partner •Must be formed by filing Certificate of Limited Partnership with the state •Allows investor (limited partner) to share in profits of partnership •Limited partner’s liability limited to amount he/she invests in business, but there must be a general partner with full liability (note, the general partner may be a limited liability entity such as a corporation)
Limited Partnership: What needs to be filed to be formed?Must be formed by filing Certificate of Limited Partnership with the state
Common Requirements for Limited Liability of Limited Partner•Limited partner has complied in good faith with state’s certificate of limited partnership filing requirement •Limited partner typically does not have the right to participate in management or control of business and therefore also will not have fiduciary duties to the partnership •Limited partner’s surname is not part of partnership name
Comparison of General Partners and Limited Partners in an Limited Partnership"•General Partner: •Has all rights associated with controlling business•Has unlimited personal liability for all partnership debts•Acts as agent of partnershipExtra: So General Partners can bind the partnership (to contractual relationships).Extra: Thus General Partners have Fiduciary DutiesEXTRA: This is true for General partners in General Partnerships and those in a Limited Partnership •Limited Partner: •May have limitations on the right to participate in management and control of business•Liability limited to amount of capital partner has contributed to businessEXTRA: Limited Partners are NOT at risk for unlimited liability for partnership's debts/obligations•Is not an agent of the partnership and has no fiduciary obligations"
Reasons For Dissolution of Limited Partnership•Expiration of term established in certificate of limited partnership •Completion of objective established in certificate of limited partnership •Unanimous written consent of all partners (limited and general) •Withdrawal of general partner (unless certificate establishes that other general partners will continue operation of business) •Court action *Termination for tax purposes occurs under slightly different circumstances.
Varying Partnership Structures: Limited Liability Partnership"•Definition: Partnership in which all partners assume liability for his or her own actions and for any partner’s professional malpractice but then, only to the extent of the partnership’s assets and/or capital contributions •Personal assets of partner exposed only to liabilities for his or her own personal malpractice or liabilities (including liabilities associated with those he or she supervises) •In most other respects, these operate the same as general partnerships, however, more formalities are required in creation -------EXTRA (from Intro to Business Law Notes)-------------- *All partners assume (unlimited/personal) liability for their own action and the actions of those they supervise. *Partners only have personal liability for the debts and obligations caused by other partners (partners that they don't supervise) to the extent of the LLP's assets and/or capital contributions (investment) to the LLP *LLP is better than limited partnership b/c in an LLP you can actually participate in management"
Key Characteristics of the LLC•The limited liability company (LLC) combines the advantages of corporations (with regard to protection from personal liability) with the advantage of partnerships •LLCs are a separate legal entity from their owners •Owners of an LLC are called “members” •An individual, partnership, corporation, or another LLC may be a member of an LLC•In most states, an LLC can exist with only one member --------Complete Version------------------- •The limited liability company (LLC) combines the advantages of corporations (with regard to protection from personal liability) with the advantage of partnerships •LLCs are a separate legal entity from their owners •Owners of an LLC are called “members” •An individual, partnership, corporation, or another LLC may be a member of an LLC•In most states, an LLC can exist with only one member
Creation of the LLC•At least one person (called the “organizer”) must file the Articles of Organization with a secretary of state or other state filing agency •Articles generally must include LLC name, duration, and the name and address of its registered agent ---------------Complete Version--------------------------- •At least one person (called the “organizer”) must file the Articles of Organization with a secretary of state or other state filing agency •Articles generally must include LLC name, duration, and the name and address of its registered agent •Initially distinguishable from partnerships due to the formality of creation and the recognition that these are, for most purposes, separate legal entities from their owners (creating the need for registered agents)
Maintaining the LLC•Aside from the formality of filing articles of organization, there are very few formalities required to maintain the LLC (i.e. typically no need to file renewals, no requirement to hold meetings, etc.) •An LLC should have an operating agreement covering how members will share profits, manage the LLC, and withdraw from the LLC, but most states allow this to simply be a verbal agreement.
Operating AgreementUsed by an LLC. Covering how members will share profits, manage the LLC, and withdraw from the LLC, but most states allow this to simply be a verbal agreement. -----------Original------------ •An LLC should have an operating agreement covering how members will share profits, manage the LLC, and withdraw from the LLC, but most states allow this to simply be a verbal agreement.
Taxation of the LLC•An LLC may elect to be taxed like a partnership, corporation, or sole proprietorship (meaning it’s a disregarded entity for federal income tax purposes) •Election of tax treatment is now a very informal process – often referred to as the “check the box” rules•Election as partnership is historically the most common (b/c it has Flow Thr/ Taxation, not Double Taxation)•When choosing partnership taxation, the LLC pays no federal income tax and all LLC income and losses are reported by the owner-members on their individual income tax returns (i.e. the LLC will receive “flow through” tax treatment)
Flow Through Taxation (online definition)"A flow-through entity is a legal business entity that passes any income it makes straight to its owners, shareholders, or investors. As a result, only these individuals—and not the entity itself—are taxed on the revenues. With flow-through entities, the income is taxed only at the owner's individual tax rate for ordinary income: The business itself pays no corporate tax."
Liability of Members"•An LLC member has no individual liability on LLC contracts, debts, or other liabilities unless LLC contracts signed in a personal capacity (e.g., as a guarantor or surety or there’s a failure to recognize signature as an agent of the LLC) •A member’s liability is therefore usually limited to the member’s capital contributions •Very little risk of losing this protection (i.e. very little risk of “piercing of the company veil”) *A member is personally liable for torts s/he committed while acting for the LLC -------Extra------------------ One of the possible reasons in corporate law why there's ""piercing of the corporate veil"" is when a corporation doesn't follow all of the formalities that are required. Well In LLC, there aren't as many formalities required. So the risk of piercing the veil to create personal liability for the members is relatively small."
What type of protection does LLC have? (Liability Protection – “Inside and Out”)"•LLC’s have one type of liability protection that is even better than corporation liability protections – “inside” protection •If someone obtains a judgment against a member, the most that the judgment creditor can obtain is a “charging order” (limited to the right to receive distributions/profits, but not the right to engage in management or exercise other membership rights), as compared to the judgment creditor’s ability to execute on a shareholder’s corporate stock (which results in the acquisition of voting rights) *Extra: Charging Order (Me) = Prevents judgment creditor from taking my voting/membership interest away (therefore judgment creditor can't vote in the LLC and can't get engage in management) Corporations do NOT have Charging Orders and therefore judgment creditors can take a stock from a shareholder and therefore get voting rights that shareholders have ---------------Complete Version---------------------------- •LLC’s have one type of liability protection that is even better than corporation liability protections – “inside” protection •If someone obtains a judgment against a member, the most that the judgment creditor can obtain is a “charging order” (limited to the right to receive distributions, but not right to engage in management or exercise other membership rights), as compared to the judgment creditor’s ability to execute on a shareholder’s corporate stock (which results in the acquisition of voting rights) *(Note, creditors of partners in a partnership can also obtain “charging orders,” but because partnerships are not limited liability entities, the value of the protection is not as significant as with the LLC.)"
Management of the LLC•An LLC must choose to be member-managed or manager-managed •Generally, the Articles of Organization state which management format is used by the LLC If manager-managed, some states require the initial managers to be named in the Articles
Member-Managed LLC•The default rule is that each member in a member-managed LLC shares equal rights in the management of the business and each member is an agent of the LLC Extra: All members have fiduciary obligations. ------------Complete Version---------------- •The default rule is that each member in a member-managed LLC shares equal rights in the management of the business (regardless of other factors, such as differences in capital contributions) and each member is an agent of the LLC with implied authority to carry on its ordinary business •The LLC operating agreement may modify ULLCA default rules by granting more power to some members
Manager-Managed LLC"•Managers in a manager-managed LLC are elected and removed by a vote of the LLC’s members •Managers do not have to be members •In this type of LLC, only the manager(s) is/are an agent of the LLC with implied authority to carry on its ordinary business EXTRA: Manager Managed LLC means that the managers have fiduciary duties to the members, but members don't have fiduciary duties to each other. ----------------Complete Version------------------------ •Managers in a manager-managed LLC are elected and removed by a vote of the LLC’s members •Managers do not have to be members •In this type of LLC, only the manager(s) is/are an agent of the LLC with implied authority to carry on its ordinary business •There may be securities law implications to this type of management structure. * Despite this option, an LLC cannot become a publicly held/traded company."
Duties of Manager or Members•Each member in a member-managed LLC and each manager in a manager-managed LLC has fiduciary duties to the others managers/members •Non-managing members of a manager-managed LLC generally owe no fiduciary duties *This is why the decision between manager-managed or member-managed is so critical.
Distributions to Members•Subject to the provisions of an operating agreement: •A member in an LLC has the right to receive distributions of (usually profits)•Members share profits and other distributions equally, regardless of differences in their capital contributions
Transferability of Member Interest•A member’s ownership interest in an LLC is the member’s personal property, but ability to sell or transfer LLC rights is often limited by statute or an operating agreement •A member may transfer the distributional interest in the LLC to another person •Transferee not a member, but receives right to member distributions•Right of transfer may be altered in the operating agreement •Typically, membership rights only granted with consent of other members and compliance with any additional requirements stated in Operating Agreement
Dissolution of LLC"•The default rules are that an LLC will be dissolved upon the following events: •Member agreement or expiration of term•Death, retirement, withdrawal, etc. of a member (unless articles or operating agreement contradict this)•Court action •Perpetual existence allowed in some states •Upon dissolution, the LLC proceeds with “winding up"" Extra: After dissolution of LLC, we do winding up. ------------------COMPLETE VERSION------------------- •The default rules are that an LLC will be dissolved upon the following events: •Member agreement or expiration of term•Death, retirement, withdrawal, etc. of a member (unless articles or operating agreement contradict this)•Court action •Perpetual existence allowed in some states •Upon dissolution, the LLC proceeds with “winding up,” and the LLC will be bound by reasonable acts of members during winding up"
Winding Up After Dissolution (LLC) - After all the LLC assets sold, proceeds distributed in this order:•First to LLC creditors, •Then to members to repay loans from members to the LLC,•Then, members’ contributions are returned, and•Last, the remainder is distributed as profits •Under most default rules, any remaining proceeds are distributed in equal shares to the members (unless the Operating Agreement changes the rules on distribution) This is shown/done in step 4
Basic Characteristics of Corporations•Legal entity separate from owners •Limited liability of shareholders (except where “veil is pierced” and shareholders are consider the “alter ego” of the corporation) •Typically unrestricted transferability of corporate shares •Typically has perpetual existence •Centralized management (like a manager-managed LLC) •Corporate taxation: C Corporation status (which has double taxation) is the default, but special flow-through treatment may be achieved through qualification as an S Corporation -OWNER=SHAREHOLDER
Double Taxation (my definition)The corporation pays taxes on their annual earnings and then when the corporation pay out dividends to shareholders, the shareholders have to pay taxes on the dividend that they received.
Public Versus Private Corporation•Public Corporation: Corporation created by government to administer law, with specific government duties to fulfill •Example: U.S. Postal Service •Private Corporation: Corporation created for private purposes (this category includes most corporations)
For-Profit Versus Non-Profit Corporations"•For-Profit Corporation: Objective is to operate for profit; shareholders seeking to make profit purchase stock these corporations issue EXTRA DEFN: it's a corporation that is operating to try to generate profits for the benefit of its shareholders. •Non-Profit Corporation: May earn profits, but they do not distribute these profits to shareholders (non-profit corporations do not issue stock, nor do they have shareholders); instead, corporation reinvests profits in business or other related activity Extra Defn: This simply means that we're not trying to generate profits for the benefit of shareholders. Instead, any profits that are generated are simply going to be reinvested for the basic purpose of the corporation. *Note that non-profit corporations are not necessarily “tax exempt” under the Internal Revenue Code."
Domestic, Foreign, and Alien Corporations•Domestic Corporation: Doing business within state of incorporation •Foreign Corporation: Doing business in states other than state of incorporation •Foreign corporations must obtain a certificate of authority from each state in which they do business •Alien Corporation: Doing business in country other than country of incorporation ---------------------Complete Version----------------------- •Domestic Corporation: Doing business within state of incorporation •Foreign Corporation: Doing business in states other than state of incorporation (regulation by states is limited by Commerce Clause and 14th Amendment of U.S. Constitution) •Foreign corporations must obtain a certificate of authority from each state in which they do business •Alien Corporation: Doing business in country other than country of incorporation
Publicly Held Versus Closely Held Corporation•Publicly Held Corporation: •Stock available to public with outstanding shares on a major U.S. stock exchange•Generally same meaning as “Publicly Traded Corporation” with a few slight differences •Closely Held Corporation (sometimes called “Close” or “Family” Corporation): •Generally does not offer stock to public, with all stock being held by private investors•Note: Term “close corporation” may also describe a specific designation in state formation laws such as a state’s “close corporation” rules
“Subchapter S” Corporation"•Has flow-through taxation (It Combines advantages of limited liability and single taxation; profits and losses flow through to the shareholders’ personal tax returns) •In order to become a S corporation, it requires all shareholders to elect this special treatment in a filing with the IRS (Form 2553) •Restrictions on qualification, such as (need to meet these requirements to be an S corp): •No more than 100 shareholders•No nonresident alien shareholders•No corporations or partnerships as shareholders•Must have only one class of stock *EXTRA: Subchapter S corporation status is a way to request the taxing authority (being the IRS) to treat your corporation as a flow through tax entity. And it's to change that C Corporation default status, to give it S corporation status, which is essentially Flow-Through taxation. ---------------Complete Version--------------------- •Combines advantages of limited liability and single taxation (meaning that most taxable consequences, such as profits and losses, flow through to the shareholders’ personal tax returns) •Requires all shareholders to elect this special treatment in a filing with the IRS (Form 2553) •Restrictions on qualification, such as: •No more than 100 shareholders•No nonresident alien shareholders•No corporations or partnerships as shareholders•Must have only one class of stock"
Professional Corporation (PC)"•Those corporate entities for which many corporation statutes make special provision, regulating the use of the corporate form by licensed professionals such as attorneys, architects, engineers, public accountants and physicians. •In instances where LLCs are permitted for the same purpose, the use of PCs has decreased substantially in recent years. ---------------EXTRA------------ PC is a classification of corporation PC means that you've got a special type of corporation that usually is permitted only to operate in the name of the shareholder or shareholders. And it is usually only for instances where the shareholder or shareholders are licensed to perform a particular type of professional service and they want to do that through a corporate structure."
Pre-Formation Activities of a Corporation•“Promoters” organize corporate formation and act in a fiduciary capacity •Promoters often enter into contracts that are necessary to start the business of the corporation.•The corporation will become bound by the contract once it agrees to be bound or accepts the benefits of the contract.•Promoters and corporations generally liable on these contracts unless parties agree that promoter will be released upon formation or there is a novation.•A novation occurs when all parties agree that the newly formed corporation will operate as substitute for the promoter as the original party to the original contract.Novation (EXTRA): where once the corporation is formed, we basically substitute the corporation as a party for the promoterEXTRA: only can occur after a corporation is formed.
Legal Process of Incorporation (Process for forming a corporation)•Drafting and filing “articles of incorporation” – some variation of state by state requirements but must generally include: •Name of corporation•Name and address of registered agent•Name and address of incorporator(s)•Number of shares to be issued•Purpose clause (acting outside corporate purpose is called “ultra vires “) •First “organizational meeting” held •Election of Directors•Adoption of Bylaws -EXTRA: As soon as the Articles of Incorporation have been filed/issued, we hold an organizational meeting
Situations When Courts Likely To Pierce Corporate Veil (aka “Alter Ego” Theory)•Corporation did not follow statutory mandates or formalities regarding corporate business •Corporation lacked adequate capital when initially formed •Shareholder(s)’ personal interests and corporate interests are commingled (corporation has no separate identity) •Shareholder(s) attempts to commit fraud through corporation *Proper use of subsidiaries (one company controlled by another company, which is usually called the holding company) is acceptable and will not trigger piercing.
Overview of Roles/Duties of Directors, Officers, and Shareholders (aka Stockholders)•Directors •Vote on important corporate decisions•Appoint and supervise officers•Declare and pay corporate dividends•Manage corporation•Fulfill fiduciary duties •Officers (employees of organization) •Run “day-to-day” business of firm•Fulfill fiduciary duties •Shareholders •Elect board of directors•Approve major board decisions
Overview of Rights of Directors, Officers, and Shareholders•Directors •Right to Compensation•Right to Participation•Right to Inspection•Right to Indemnification •Officers-- •Rights determined in employment contract •Shareholders-- •Voting Rights•Right to Dividends•Inspection Rights•Right to File Derivative Suit•Preemptive rights•Right to Transfer Shares•Right to File Direct Suit
Legal Role of Board of Directors•Elected by shareholders •Authority over all corporate matters acting through a “quorum” (minimum number of directors necessary to validate corporate decisions), with responsibility running directed to the shareholders •Sarbanes-Oxley Act attempts to improve corporate oversight of officers, board independence, and accuracy of information disclosed to shareholders of publicly traded corporations (in an effort to prevent fraud)
Liability of Directors and Officers•Can be personally liable for corporation debts and obligations if corporate veil is pierced •Can be held personally liable for their own torts and crimes •Can be held personally liable for torts and crimes of other employees whom they failed to adequately supervise (even if no knowledge or participation) Can be held personally liable for torts/crimes committed by employees that you supervise •Can be held liable for wrongful transactions involving company stock •Can be liable to corporation and/or its shareholders for breach of fiduciary duties
Business Judgment RuleProvides that directors and officers are not liable for decisions that harmed corporation if they were acting in good faith at time of decision Protection for Directors and Officers
Liability of Shareholders•Shareholders typically only liable to extent of their investment for debts of corporation •Personal liability typically only extends to the shareholder if: •Corporate veil is pierced •Shareholder purchased “watered stock” (purchase price significantly below fair market value)•Shareholder received illegal dividends (such as a dividend causing insolvency)
Role / Voting Rights of Shareholders•Shareholder meetings typically only once a year for purpose of electing directors, but there are often rights for shareholders to call special meetings on other matters or to present other resolutions •Shareholders often grant a “proxy,” which authorizes a third party to vote in place of shareholder at shareholders’ meeting •Generally, once a majority of shares (typically defined as a “quorum”) is present, action can be taken upon the vote of a majority of those present.
Voting Rights of Shareholders (pt2)•General Rule: One share = one vote •Shareholder voting agreements often align groups of shareholders who will vote together to exert more control •Cumulative voting (when permitted by Articles and Bylaws) is used to allow shareholders to “cumulate” share voting for directors •Minority shareholders benefit from cumulative voting (as compared to straight voting) ---------------------------Complete Version---------------------------------- •General Rule: One share = one vote •Share allocation has a significant affect on the control of a shareholder (majority shareholders (51% or more) versus minority shareholders) •Shareholder voting agreements often align groups of shareholders who will vote together to exert more control •Cumulative voting (when permitted by Articles and Bylaws) is used to allow shareholders to “cumulate” share voting for directors •Minority shareholders benefit from cumulative voting (as compared to straight voting)
Do shareholders have the right to vote on all matters? (Extent of Shareholder Voting Rights)•Shareholders don’t have the right to vote on all matters •Shareholders can vote on all matters that are presented to them, but only have the “right” to vote on matters specified by organizational documents or on matters of fundamental change to the corporation (EX of Fundamental Change): •Dissolution•Amendments to the Articles of Incorporation that materially and adversely affect the shareholders’ rights•Mergers, consolidations, and compulsory share exchanges•Sale of substantially all of the assets of the corporation
DividendDistribution of corporate profits/earnings ordered by directors and paid to shareholders
Inspection RightsProtects shareholders interests by giving them right to inspect corporation’s books and records after asking in advance to inspect and having proper purpose
Derivative Suit"Filed by corporate shareholder in the name of corporation against a third party (which can include a director or officer) when corporate directors fail to take action for the corporation to sue in situation where the corporation has been harmed by third party; the result of the lawsuit benefits all shareholders EXTRA: the plaintiff in the lawsuit is actually the corporation (since the shareholders file the lawsuit in the name of the corporation), the benefit of winning that lawsuit is shared among all shareholders. Could have a derivative suit against the director (so the 3rd party could be the director) (ex: director failed to fulfill fiduciary or breach of fiduciary duty) EXTRA -""when corporate directors fail to take action for the corporation to sue in situation"" = The board of directors has not chosen to sue the other 3rd party. Thus the shareholders are going to try to initiate the action on behalf of the corporation"
Direct SuitFiled by shareholder against corporation (such as improperly withholding dividends or denying inspection rights)
Right of First RefusalBylaws can restrict ability of shareholders to re-sell stock by requiring it to be offered first to the corporation or its shareholders When corporation buys the stock back (thr/ the Right of 1st Refusal), it’s generally called a “stock redemption” EXTRA Bylaws determines whether you have the right of first refusal. Right of First Refusal: when you want to sell your stock as a shareholder, you must either offer to sell it back to the corporation or offer to sell it back to other shareholders before selling it to a 3rd party.
Preemptive Rights (often called a “Right of First Offer”)Preferential rights given to existing shareholders to purchase shares of new stock issued; preference given in proportion to percentage of stock shareholder already owns Extra Preemptive Rights: If the corporation issues new stock, you get the first opportunity to buy that new stock.
Piercing Corporate Veil (extra)meaning that shareholders and directors and officers would suddenly have personal liability for the debts and obligations of the company.
MergerA legal contract combining two or more corporations such that only one of the corporations continues to exist; in essence, one corporation “absorbs” another corporation, and all liabilities transfer to the surviving corporation *These do not generally result in a taxable event.
Consolidation"A legal contract combining two or more corporations, resulting in an entirely new corporation; in consolidation, neither of the original corporations continues to exist, but all liabilities of both transfer to the newly formed corporation (these are extremely rare) *These do not generally result in a taxable event. -----Extra------------------ Consolidation: We're putting two corporations together and creating a new 3rd Corporation. in this instance, the surviving corporation is a brand new corporation."
Procedures for Mergers and Consolidations•Boards of directors of all involved corporations must approve the plan •Shareholders typically must approve the plan (except in the instance of “short-form” mergers when a parent corporation merges with a subsidiary corporation) •Appraisal right: Dissenting shareholder’s right (upon vote to merge or consolidate) to have his/her shares appraised and to receive monetary compensation for their value Helps protect minority shareholders ---------------EXTRA----------------------------- -Dissenting Shareholder (extra defn): shareholder who oppose and vote against the merger -Appraisal right (book): A dissenting shareholder’s right to have his or her shares appraised and to receive monetary compensation from the corporation for their value. -------ORIGINAL---------
2 Types of Acquisitions1. Purchase of Assets (aka Asset Acquisition) 2. Purchase of Stock (aka Stock Acquisition)
Purhcase of Assets (also Define Corporate Assets)•Purchase of Assets: One corporation can extend its business operations by purchasing the assets of another company •Corporate Assets (Definition): All intangible and tangible items owned by the corporation•Generally, a company that purchases assets of another company/corporation does not acquire its liabilities •Selling corporation typically needs director and shareholder approval; acquiring corporation typically only needs director approval
Purchase of Stock (aka Stock Acquisition)An acquiring corporation can take control of another corporation by purchasing a substantial amount of its voting stock (this can trigger an ultimate merger/appraisal right to deal with dissenting shareholders)
Common Forms of Stock Purchases/Takeovers•Tender Offer: Aggressor (acquiring corporation) offers target shareholders a price above current market value of their stock •Exchange Offer (aka “Share Exchange”): Aggressor offers to exchange target shareholders’ current stock for stock in aggressor’s corporation •This is typically not a taxable event
“Hostile” TakeoverA takeover to which management of the target corporation objects (note that fiduciary duties still apply), but can be accomplished through the various different forms of takeovers -Book Defn: A takeover to which the management of the target corporation objects.
Common Approaches to (Hostile) Takeover Attempt: Proxy SolicitationAggressor corporation targets shareholders in a campaign to win shareholder support (typically through requests for proxy authorization) to vote for their position, such as voting for directors [who are] favorable to the aggressor’s position -Proxy solicitation (book): The process of obtaining authority to vote on behalf of shareholders.
Other Common Response to Takeover Attempt: Self-Tender OfferTarget corporation offers to buy its shareholders’ stock; if shareholders accept offer, target corporation maintains control of business
Life Stages of a Corporation•Incorporation—Company becomes incorporated when articles of incorporation signed •Corporation Conducts Business—Directors and officers oversee business, as shareholders ensure company’s stock has value •Dissolution—Corporation legally terminated, either voluntarily or involuntarily •This can effectively occur as a result of a merger, consolidation, or acquisition •Liquidation—Directors convert corporate assets into cash and/or distribute them among corporation’s creditors and shareholders Liquidations are typically taxable events.
Common Reasons For Involuntary (State Government- Initiated) Dissolution of Corporation (aka Common Reasons for State Govt-Initiated Dissolution of Corporation)•Corporation failed to pay taxes within prescribed due dates •Corporation failed to submit its annual report to secretary of state within prescribed due dates •Corporation did not have a registered agent or office in the state for prescribed period •Corporation’s duration (as specified in its articles of incorporation) has expired
Reasons for Court-Ordered Involuntary Dissolution of Corporation•Corporation obtained its articles of incorporation fraudulently •Corporate directors have abused their power or acted beyond their authority (this is called “ultra vires” acts) •Corporation is insolvent
Security (and Securities Laws)Security: Investment in a common enterprise with the reasonable expectation of profit gained predominantly from others’ efforts Securities Laws: are really about protecting those who invest money in a company and turn the management of that company over to someone else.
Securities and Exchange Commission (SEC)Created in 1934 to: •Interpret and enforce securities laws •Regulate the trade of securities •Regulate the activities of securities issuers, dealers, underwriters, brokers, and advisers (*these regulations typically do not apply to a casual seller)
The Securities Act of 1933:•1933 Act regulates the sale of securities while they pass from the hands of the issuer (the entity whose securities are being sold) into hands of public investors •Registration Statement: Document containing •Description of securities offered•Prospectus (used as a selling/advertising tool to attract potential investors)Prospectus (Book): A written document filed with the SEC that contains a description of a security and other financial information regarding the company offering the security; also distributed as an advertising tool to potential investors.•Description of registrant’s business and properties•Explanation of how proceeds from sale will be used•Information about management of company•Description of pending lawsuits•Certified financial statements
The Securities Act of 1933: Filing/Registration Process"Periods of the registration statement and prospectus filing process: •Pre-filing Period (cannot actually offer to sell securities during this period) Before the registration statement has been filed with the SEC. During that pre-filing period, there can't be sales of securities unless an exemption applies •Waiting Period (SEC reviews the filed documents during this period – issuers can make oral offers and may distribute red-herring prospectus or advertise with tombstone ad) Once you file that registration statement, the SEC reviews the documents that are filed to assure their compliance. During this period of time, the company that's offering the securities basically can do certain limited types of offers to sell the securities (such as oral offers) •Post-effective Period (begins when SEC declares the registration effective, and issuer can now begin offering to sell the stock to the public)"
The Securities Act of 1933: Exempt Transactions (more specifically going over Limited Offers)"Limited Offers (book): securities transactions that are exempt from the registration process because they either involve small amounts of money or are offered only to sophisticated investors 3 Types of Limited Offers: •Rule 506/Private Placement Exemption: Exempts private offerings of securities •Unlimited number of accredited investors (institutional investors (banks, mutual funds), wealthy investors, and high-level insiders of the issuer (executive officers, directors, partners)) •No more than 35 unaccredited investors (who must have expertise in securities trading)Extra: Rule 506 is when you are only offering to accredited investors or a limited number of unaccredited investors •Rule 505: Exempts small private offerings which do not exceed $5 million in a twelve-month period and which target only accredited investors or those who, there is reason to believe, have a reasonable ability to evaluate risk •Rule 504: Exempts companies that offer no more that $1 million in securities in a twelve-month period •Section 4(6): Exempts securities offered only to accredited investors for amount less than $5 million *NOTE: Rule 505, Rule 504, and Section 4(6) involves small private offerings where if if you're just seeking a small amount of money you don't have to go through the registration process. ------------------------------------------------------------------------------ Extra: Exempt Transactions are transactions in which securities are exempt from the registration procedures/process (So you're able to avoid registering the security. So the securites are unregistered)."
The Securities Act of 1933: Other Common Exempt Transactions•Intrastate Issues: Exempts local investors in local businesses •Security is offered only to permanent residents of the single state where the issuer of the security resides and does most of its business •Re-sales of Securities: Exempt transactions by any person other than an issuer, underwriter, or dealer •Average investor is allowed to re-sell without registration •Crowdfunding: Exemption for issuance of securities made through a crowdfunding process (widespread internet solicitations of small amounts from numerous investors)
The Securities Act of 1933: Liabilities•Civil liability for failing to file a required document or not giving all required documents to all investors •Civil liability for “Misstatements” in filed documents *Does not require proof of intent *Does not require proof of negligence or even any kind of reliance upon the misstatement*Anyone who signs can be liable – including the independent CPAs who audit the financial statements in a registration statement and sign off on their accuracy •Criminal liability for anyone who uses any type of fraud (requires “intent”) in connection with the issuance of a security
The Securities Act of 1933: DefensesWhen potential liabilities arise under the Act (such as for misleading investors), certain defenses may apply: •Defendant can escape liability by proving the purchaser knew of misstatement or omission when security was purchased •Certain defendants (including auditors but not issuers) may raise “due diligence defense” to escape liability
The Securities Exchange Act of 1934: Purpose•Purpose is to protect investors after the original registration and issuance of a security once the security is being traded •1934 Act: • Requires registration of securities exchanges, brokers, dealers, etc.•Requires periodic disclosure of material information by issuers•Regulates insider transactions
The Securities Exchange Act of 1934: Applies to the Following•Any company whose shares are traded on a national exchange
The Securities Exchange Act of 1934: Fraud and Market Manipulation•Section 10(b): Prohibits use of “manipulative and deceptive devices” to bypass SEC rules and creates civil liability for the conduct •Protects against fraud associated with the purchase or sale of securities•Requires “intent” to deceive and reliance by injured party•Applies even if the securities were exempt from registration •Rule 10(b–5) prohibits a person with inside information (nonpublic, confidential) from using the information when trading securities with a person without the information. ME: Rule 10(b-5) prevents insider trading
The Securities Exchange Act of 1934: Insider Trading -Define: a. Insider b. Disclose-or-Refrain Rule c. Tippees vs Tipper"•Insider: anyone with confidential corporate information for a corporate purpose Insider (prof): qualifies anyone with confidential information that's not been made public. •Disclose-or-refrain rule: insider must either disclose the information before trading or refrain from trading •Tippees receive inside information from Tipper •A tipper (person who passes along the information) is liable for his own profits, profits made by a tippee, and profits made by other tippees down the chain •Tippee is also generally liable if knew or should have known the information was nonpublic"
The Securities Act 1933 / 1934: Enforcement•Administrative Action (such as revocation of registration) •Injunctive Action (similarly, administrative Cease and Desist Orders) Injunction (extra; Prof): a court order that either forces someone to do something or forces them to stop doing something. •Criminal Prosecution *SEC has power to impose civil penalties (potential fines up to $5,000,000), criminal penalties (prison sentence up to ten years), or both. *These (those enforcements listed above) are often settled through consent orders. *Aggrieved individuals can also sue for civil liability for failure to comply with the Act.