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Business Associations
Professor Bradford
Fall 2013
Exam Answer Outline
The following answer outlines are not intended to be model answers,
nor are they intended to include every issue students discussed. They
merely attempt to identify the major issues in each question and some
of the problems or questions arising under each issue. They should
provide a pretty good idea of the kinds of things I was looking for. In
some cases, the result is unclear; the position taken by the answer
outline is not necessarily the only justifiable conclusion.
I graded each question separately. Those grades appear on your
printed exam. To determine your overall average, each question was
then weighted in accordance with the time allocated to that question.
The following distribution will give you some idea how you did in
comparison to the rest of the class:
Part I, Question 1:
Part I, Question 2:
Part I, Question 3:
Part I, Question 4:
Part II, Question 1:
Part II, Question 2:
Part II, Question 3:
Part II, Question 4:
Part II, Question 5:
Range 0-8; Average = 5.29
Range 3-8; Average = 5.18
Range 3-9; Average = 5.98
Range 3-8; Average = 6.20
Range 3-9; Average = 7.44
Range 2-8; Average = 5.64
Range 5-8; Average = 7.07
Range 5-9; Average = 7.40
Range 0-8; Average = 6.20
Total (of unadjusted exam scores, not final grades):
Range 3.43-7.62; Average = 6.11
All of these grades are on the usual law school scale, with 9 being an
A+ and 0 being an F.
If you have any questions about the exam or your performance on the
exam, feel free to contact me to talk about it.
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Part I, Question 1
Liability under State Law
Corporate officers and directors are sometimes held liable for breach
of fiduciary duty under state law for trading the securities of their
corporations using nonpublic information. See, e.g., Goodwin v.
Agassiz. Darla is not an officer or director of Acme, so she would not
be liable under state law.
Liability under Rule 10b-5
Trading on the basis of nonpublic information is sometimes a
violation of Rule 10b-5. However, Darla is liable for insider trading
under Rule 10b-5 only if she or someone from whom she acquired the
information breached a fiduciary duty. Chiarella.
Classical Insider Trading
Darla does not owe a fiduciary duty to Acme; in fact, she has no
relationship to Acme whatsoever. Therefore, she is not liable as a
classical insider. See Texas Gulf Sulphur.
Tippee Liability
Even if she does not breach a fiduciary duty herself, Darla is liable if
a tipper breached a fiduciary duty (for personal gain) and Darla knew
or should have known of the breach. See Dirks.
Vinnie as Tipper
Vinnie owes a fiduciary duty to Acme as its vice -president. Vinnie
was contractually bound not to disclose the information. He violated
this contract, but he did not disclose the information to Carl for
personal gain, a requirement of Dirks. Because of that, Darla cannot
be liable as an indirect tippee of Vinnie.
Carl as Tipper
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Carl might have breached a duty to Acme or Sweepaway when he
disclosed to Darla. Carl might be a temporary insider of Acme. See
Dirks fn. 14. Sweepaway is working as an independent contractor for
Acme and has access to secret corporate information. The question is
whether Sweepaway (and therefore Carl) have an obligation to keep
the nonpublic information confidential. If Sweepaway ’s contract with
Acme provides for confidentiality, then fn. 14 would seem to apply.
Even if the contract contains no such provision, the cleaning
relationship may imply such a duty. Alternatively, Carl might owe a
duty directly to Sweepaway. If Carl’s contract with Sweepaway
requires he keep any information learned confidential, then Carl ’s
disclosure could violate that contractual duty. See Rule 10b5-2(b)(1).
However, even if Carl owes a duty, Darla is liable only if Carl
breached that duty for personal gain. Dirks. Carl received nothing
from Darla for the tip. A gift to a family member can be personal gain
under Dirks, but it doesn’t look like Carl intended to give Darla a gift.
He was merely explaining why he couldn’t come to lunch. If that’s his
real motive, there’s no breach of fiduciary duty by Carl within the
meaning of Dirks.
If Carl did breach his duty, Darla is still only liable if she knew or
should have known Carl breached his duty in providing the
information. Darla knows Carl’s job and he told her the source of the
information, so she should have known where this nonpublic
information came from. But should she have known he was providing
the information to her for personal gain (a gift), given the context of
the conversation (why he couldn’t have lunch)? If not, she’s not liable
under Dirks.
Darla’s Breach of Duty(?) to Carl
Darla could be liable if her use of the nonpublic information
breached a duty she owes to Carl. See O’Hagan. Under Rule 10b52(b)(3), a duty of trust or confidence exists when a person obtains
nonpublic information from her parent. Darla breaches that duty by
using the confidential information. Darla can rebut that duty by
showing that she neither knew nor should have known that her father
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expected her to keep the information confidential (assuming she
didn’t agree to keep it confidential). However, the burden of proof is
on Darla, and there doesn’t seem to be anything in the conversation
with her father that would indicate he did not expect confidentiality.
Thus, Darla might be liable for breaching a duty she owes as her
father’s daughter.
Materiality
A final question is whether the information was material. Rule 10b-5
imposes liability only for trading on the basis of material nonpublic
information. Darla knew only that Acme was “busy with a secret
project involving new products.” Is this sufficiently concrete that a
reasonable investor would consider it important? Darla certainly
considered it important enough to trade one, but that isn’t necessarily
determinative.
Other Federal Provisions
Darla is not an officer, director, or 10% shareholder of Acme, so
section 16(b) is inapplicable. Rule 14e-3 is also inapplicable; it only
applies in the context of tender offers.
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Part I, Question 2
A. Undercapitalization is a failure to contribute to the business
sufficient assets to meet the reasonably anticipated needs of the
corporation’s business—in other words, sufficient assets to cover the
debts and liabilities the corporation is reasonably expected to incur.
One cannot anticipate a business’s needs exactly; the amount of
capital required is only a prediction. And capital needs can vary from
business to business, so what is sufficient can vary from business to
business.
It is not as clear when the adequacy of the corporation’s capital is
measured. All courts consider undercapitalization at the formation of
the business, but some cases, such as Dewitt Truck Brokers, say
businesses have a continuing obligation to remain adequately
capitalized.
B. Your answer to this question could vary. Here ’s one possible answer:
I think undercapitalization should be important in deciding whether
to pierce the veil in the case of involuntary creditors, such as tort
victims, but not in the case of voluntary creditors, such as those who
contract with the company.
Anyone in a contractual relationship with the company has an
opportunity to check the company’s capital and either refuse to deal
with the company or demand a personal guaranty if they are worried
about the company’s ability to pay. If they choose not to do so, they
have received exactly the bargain they anticipated.
Involuntary creditors, on the other hand, have no choice and
therefore no opportunity to bargain. An undercapitalized corporation
can externalize its accident costs, lessening its incentive to take
proper precautions to avoid accidents. Using undercapitalization as a
factor to pierce the veil makes more sense in these circumstances.
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Part I, Question 3
“Regular” Fiduciary Duties
Wilma’s actions probably do not violate the ordinary fiduciary duties
that corporate officers and directors owe to their corporations.
Duty of Loyalty
Wilma’s actions are unlikely to violate her duty of loyalty. The duty
of loyalty involves a conflict of interest between the officer or
director and the corporation—where the officer or director has a
personal interest. Wilma has no personal interest in the decision to
stop paying dividends other than her proportionate interest as a
shareholder, and that doesn’t trigger self-dealing analysis. Weinberger.
She has a personal interest in the salary she receives from Omega, but
the decision to cut her salary is costing her, not benefiting her. Wilma
has no personal interest in the decision to cut Paula ’s salary.
Duty of Care
Wilma’s actions are also unlikely to violate her duty of care. Business
decisions of officers and directors are usually protected by the
business judgment rule and directors are generally held liable for
breaches of the duty of care in two extreme circumstances.
First, officers and directors have a duty to inform themselves about
the substance of the decision prior to making it. See Smith v. Van
Gorkom. Wilma is actively involved in the day-to-day business and
undoubtedly fully conversant with its operations. Because of that, she
is fully informed about the problems and possible solutions. Harry’s
involvement with the company is less clear, and it’s unclear what he
did to inform himself before deciding, so it ’s difficult to evaluate such
a claim against Harry.
Second, officers and directors can be held liable if a decision is so
extreme that it constitutes a no-win transaction for the corporation,
sometimes referred to as corporate waste. See, e.g., Joy v. North.
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Cutting salaries and dividends are clearly not no -win transactions.
Reasonable people might disagree about whether the business can
survive without those actions, but Wilma has a legitimate argument
that these actions are in Omega’s best interests. This is not a situation
where there’s no plausible argument of corporate benefit.
Fiduciary Duty of Controlling Shareholders in Closely Held
Corporations
Many jurisdictions impose a stronger fiduciary duty on the
controlling shareholders in closely held corporations. See, e.g.,
Donahue v. Rodd Electrotype. This two-shareholder company is clearly a
closely-held corporation so, in those jurisdictions, Wilma would owe
a duty to Paula akin to that of a partner in a general partnership. The
exact contours of that duty are unclear, so it’s uncertain whether
Wilma would be liable.
As a result of Wilma’s actions, Paula is receiving neither divide nds
nor a salary, defeating her reasonable expectation of a return on her
investment. Paula could point to Wilma’s offer to purchase her shares
for book value, probably lower than their fair market value, as
showing a freezeout motive.
Wilma will argue that Paula’s departure was voluntary; her loss of
salary was her own fault, as in Zidell, where the court found in favor
of the defendants. But, given her financial situation, Paula had no
choice but to quit, and Wilma was aware of this. In addition, Zidell
did not involve a simultaneous dividend cut; the corporat ion in that
case had a longstanding policy of not paying dividends. Thus, Paula’s
situation is arguably closer to Hollis v. Hill, where the controlling
shareholder fired the other shareholder and refused to pay dividends.
That case found in favor of the plaintiff.
Wilma will argue that the pay and dividend cuts were motivated by a
legitimate business purpose, and therefore are not in breach of her
duty to Paula. See Hollis v. Hill; Wilkes v. Springside Nursing Home . The
business is losing money and needs to reduce its expenditures to
survive. Moreover, unlike the defendant in Hollis v. Hill, Wilma cut
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both shareholders’ salaries proportionately; she was not treating
Paula disproportionately.
However, Paula will argue that there is a less drastic means for
achieving the corporate purpose: a quick recovery is likely and less
drastic cuts would have sufficed. Many courts refuse to apply
ordinary business judgment deference in these types of cases, so the
court will have to evaluate these competing claims and decide, in
essence, whether the business downturn justifies the measures taken
and whether there are ways to deal with the problem that have a less
drastic effect on Paula’s expectations. The outcome of that balancing
is uncertain.
Involuntary Dissolution
Many corporate statutes allow a court, at a shareholder’s request, to
dissolve the corporation if those in control have acted in a manner
that is “illegal, oppressive, or fraudulent.” See MBCA §
14.30(a)(2)(ii). The meaning of “oppressive” in this context is
somewhat similar to what constitutes a breach of the Donahue
fiduciary duty. See, e.g., Giannotti v. Hamway (departure from
“standards of fair dealing” or violation of “principles of fair play”).
Paula’s argument that Wilma’s actions were oppressive would track
her arguments that Wilma’s actions violated her fiduciary duty as a
controlling shareholder.
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Part I, Question 4
Dan is right to be concerned about the duty of loyalty. He clearly has
a personal interest in the land sale, so this would clearly fall within
the self-dealing branch of the duty of loyalty. There are three possible
ways to avoid liability for breach of his duty of loyalty.
1. Approval by Disinterested Directors
The first possibility is if the transaction is approved by a majority of
the disinterested directors on the Alpha board after Dan fully
discloses both the nature of his conflict of interest (his ownership of
the property) and all of the material facts concerning the transaction.
The directors who approve the transaction may not themselves have a
conflict of interest or be controlled by Dan, or otherwise related to
Dan in a way that is likely to affect the independence of their
decision-making.
2. Approval by Disinterested Shareholders
The second possibility is similar to the first, but involves approval by
a majority of the disinterested shareholders of Alpha, again after full
disclosure by Dan.
3. Fairness
The final way to avoid liability is if the transaction is fair to the
corporation. Fairness involves two elements, fair dealing and fair
price.
Fair dealing considers the fairness of the procedures followed to
approve the transaction. Dan should not be involved on Alpha’s side
of the transaction; the transaction should be under the control of
directors or officers who are independent of Dan and themselves
disinterested. The people representing Alpha should negotiate the
terms of the deal vigorously.
Fair price looks at the fairness of the consideration paid for the
property. Alpha should pay no more than the fair market value of the
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property. The best way to establish a fair price would be to have an
independent appraisal, or perhaps more th an one independent
appraisal, of the property and not to pay more than that appraised
value.
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Part II, Question 1
A. The maximum amount of dividends Delta may pay is $50,000.
Under Delaware law, a corporation may pay dividends “out of its
surplus,” or, if it has no surplus, out of its net profits for the current
and/or the prior fiscal year. Del. § 170(a). Delta incurred a loss last
fiscal year and so far this year, so the latter provision is irrelevant.
“Surplus” is the excess of net assets over stated capital. Del. § 154.
“Net assets” means the difference between total assets and total
liabilities. Id. Delta’s total assets are $218,800 and its total liabilities
are $160,600, so its net assets are $218,800 - $160,600 = $58,200. Its
total stated capital is the sum of the stated capital for the two classes
of stock, $4,300 + $3,900 = $8,200. Thus, its surplus is $58,200 –
$8,200 = $50,000.
B. The Class B shareholders would receive $4 a share (a total of
$20,000) and the Class A shareholders would receive $3 a share (a
total of $30,000).
The Class B stock has a dividend preference of $1 a share. That
preference must be paid before Delta may pay any dividends to the
Class A shareholders. That preference is non-cumulative, so it does
not matter that Delta has not paid dividends in prior years. The
preference is only $1.
There are 5,000 Class B shares outstanding, so the preference totals
$5,000, leaving $45,000. The Class B stock, according to the articles,
is “fully participating,” meaning that, after the preference is paid, the
Class B shares receive the same dividends as the other shareholders.
Thus, the remaining $45,000 would be split equally between the
10,000 Class A shares and the 5,000 Class B shares. That ’s $3 a share
($45,000/15,000 shares). The Class A shareholders would receive $3 a
share. The Class B shareholders would receive $3 plus the $1/share
preference, for a total of $4 a share.
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Part II, Question 2
Obtaining a Copy of the Shareholder List
One alternative is to communicate directly with the shareholders. To
do that, Matak needs to know who they are. Under Delaware law, a
shareholder may obtain a copy of the shareholder list for a “proper
purpose.” Del. § 220(b).
The problem is that Matak may not have a proper purpose. A proper
purpose is one “reasonably related to such person’s interest as a
stockholder.” Del. § 220(b). It’s not clear that Matak’s purpose relates
to his interest as a stockholder. If his concern is that arms sales will
eventually have a negative effect on Beta, even though sales are
currently profitable, he probably has a proper purpose. If his concern
is stopping the supply of arms to the guerillas in Sudan, that ’s a
political purpose, and he probably will not be able to use Del. § 220.
Rule 14a-7
Matak may use Rule 14a-7 to communicate directly with
shareholders. Since Beta’s common stock is traded on the New York
Stock Exchange, it is a section 12 registrant. See Exchange Act §
12(a). It is therefore subject to the SEC’s proxy rules. See Exchange
Act § 14(a).
If Matak chooses to use Rule 14a-7, Beta has two options. See Rule
14a-7(b)(2). It may either provide Matak with a copy of Beta ’s
shareholder list or mail any communication provided by Matak to the
shareholders. See Rule 14a-7(a). Beta is likely to choose to mail the
material itself rather than furnish the list to Matak.
There are no limits on what Matak may say to the shareholders using
Rule 14a-7, other than the Rule 14a-9 prohibition on fraud in
connection with a proxy solicitation, but the obvious downside is that
Matak will have to pay the full cost of sending this to all the
shareholders, even if Beta mails it itself. See Rule 14a -7(e).
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Public Communications
An alternative to direct communication with the shareholders is some
sort of public communication, such as an advertisement in the
newspaper. Matak can do that without a shareholder list.
The Substance of Matak’s Communications and Proxy Regulation
Matak needs to be very careful what he says in his communications to
the shareholders. If his communication is a proxy solicitation, he
needs to file a proxy statement with the SEC and provide that filing
to all of the shareholders. See Rule 14a-3(a). The cost of doing so
would be very high.
Matak’s communication is bound to fall within the general definition
of a proxy “solicitation.” Even if he doesn’t ask the shareholders to
give him their proxies to vote at a meeting, his complaints about
Beta’s actions and the arms sales are likely to affect the willingness of
the shareholders to give their proxies to management. They are thus
an “other communication to security holders . . . reasonably
calculated to result in the procurement, withholding, or revocation of
a proxy.” Rule 14a-1(l)(1)(iii).
However, there are three exceptions that could free him from
complying with most of the proxy rules:
1. If his communication is public (public speeches, press releases,
advertisements, etc.) and he does not in any way request anyone ’s
proxies. Rule 14a-1(l)(2)(iv)(A).
2. If he limits his communication to no more than 10 shareholders.
Rule 14a-2(b)(2).
3. Any other communication, as long as he is not in any way involved
in an actual proxy solicitation. Rule 14a-2(b)(1).
[If he chooses either of the last two alternatives, the proxy fraud rule
would still apply. See Rule 14a-2(b).]
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Rule 14a-8
A final alternative is to force Beta to include a proposal for
shareholder vote in Beta’s proxy solicitation for the next Beta
shareholders’ meeting. A disadvantage of this method is that Matak’s
proposal and any supporting statement may not exceed 500 words.
Rule 14a-8(d). But a major advantage is that Beta would bear the
expense of this option, since it’s included in Beta’s proxy statement.
Matak owns $5000 worth of Beta stock, which makes him eligible to
use Rule 14a-8 if he has held that stock for at least a year. See Rule
14a-8(b)(1). Thus, the primary question is whether Beta has any
ground for excluding Matak’s proposal. See Rule 14a-8(i).
The (i)(1) exclusion
Matak’s proposal may not force the directors to get rid of Arms-R-Us.
Such a proposal would violate exclusion (i)(1). Under state law,
management authority is in the hands of the board of directors and
that power may be taken away only in the articles of incorporation.
See Del. § 141(a). Only the board may initiate amendments to the
articles, see Del. § 242(b), so a binding resolution to force divestment
would unlawfully divest the Beta board of its power to manage the
company. However, as suggested in the Note to Rule 14a-8(i)(1),
Matak may propose a nonbinding resolution wherein the shareholders
suggest such action. This would not force the board to do what Matak
wants, but it would get the issue in front of the shareholders and
allow them to express their view.
The (i)(5) exclusion
The question indicates that Arms-R-Us accounts for only a “tiny
proportion” of Beta’s revenues, profits and assets. If the arms
business accounts for less than 5% of Beta’s total assets, less than 5%
of its net earnings, and less than 5% of its gross sales, subsection
(i)(5) could allow Beta to exclude the proposal.
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However, the proposal must also be “not otherwise significantly
related to the company’s business. The SEC staff has taken the
position that proposals that would otherwise be excluded by these
sections are not excluded if they raise significant social or policy
issues. The sale of arms to guerillas probably raises significant policy
issues; if so, the subsection (i)(5) exclusion is unavailable.
The (i)(7) exclusion
Selling arms is arguably within the company’s ordinary business
operations. Rule 14a-8(i)(7). However, the SEC staff has interpreted
subsection (i)(5) similarly to subsection (i)(7). A policy that raises
significant policy issues is not within “ordinary business operations.”
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Part II, Question 3
Betty is Amy’s agent
Betty is an agent of Amy. When Amy hired her, she consent to have
Betty act on her behalf, and Betty consented to do so by taking the
job. Restatement Second of Agency (RSA) § 1(1).
Amy, the principal, can be liable for Betty’s entering into the
transaction on her behalf if Betty had actual, apparent, or inherent
authority. See RSA § 140.
Actual Authority
Actual authority is action “in accordance with the principal’s
manifestation of consent” to the agent. RSA § 7. The principal’s
words or conduct, reasonably interpreted, must cause the agent to
believe the principal desires her to act as she did.
The only grant of actual authority was to “set prices and decide how
to display items.” Everything else required Amy’s permission, and
Betty never got Amy’s permission to buy the display cases. Deciding
how to display items, reasonably interpreted, probably means only
how to lay out the merchandise, not ordering entirely new display
cases. If so, then ordering the cases exceeded Betty ’s actual authority.
Apparent Authority
Apparent authority exists if the principal, “by written or spoken
words or other conduct of the principal” causes the third party “to
believe that the principal consents to have the act done on his behalf ”
by the agent. RSA § 27. Amy’s only contact with Fred was in the brief
phone call on November 3. Fred specifically mentioned the order to
Amy and she told him to speak to Betty. Fred could reasonably
interpret this to believe that (1) Amy did not object to the order; and
(2) Amy was authorizing Betty to deal with him concerning the order.
This was after Betty had originally placed the ord er, but Fred
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nevertheless relied on Amy’s statement in continuing with the order.
Therefore, Betty probably had apparent authority.
Inherent Authority
The Second Restatement does not clearly define inherent authority. It
arises “solely from the agency relation and exists for the protection of
persons harmed by or dealing with a servant or other agent.” RSA §
8A. The question is whether ordering display cases is inherent in the
position of manager of an antique store. It probably is not. Store
managers do not order fixtures on a regular basis and it’s not
necessary for them to do their day-to-day job.
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Part II, Question 4
1. Bertha is dissociated from the LLC.
Bertha has the power to dissociate at any time. RULLCA § 601(a). A
member dissociates by expressing her will to withdraw as a member,
RULLCA § 602(1), and Bertha did that by saying, “I quit, effective
immediately.”
2. Bertha is liable for damages for wrongful dissociation.
Bertha’s dissociation is wrongful because she withdrew by express
will before the termination of the company. RULLCA § 601(b)(2)(A).
She is therefore liable to Impressa and its members for damages
caused by the dissociation. RULLCA § 601(c). In this case, since
Bertha is the prime reason for Impressa’s success, the damages caused
by her withdrawal could be substantial if Impressa loses custom ers
because Bertha is no longer participating in the business.
3. Impressa is not dissolved; it will continue in business.
Bertha’s dissociation does not result in dissolution of the LLC. See
RULLCA § 701. Absent something in the operating agreement, that
would require the consent of all the members. RULLCA § 701(a)(2).
4. Bertha’s right to participate in Impressa is terminated.
Bertha’s right to participate as a member in the management and
conduct of Impressa’s business terminates upon her dissociation.
RULLCA § 603(a)(1). Her fiduciary duties to the LLC also terminate,
at least as to post-dissociation events.
5. Bertha has the rights of a transferee.
Bertha still owns here interest in Impressa, but only has the rights of
a transferee. RULLCA § 603(a)(3). Thus, she continues to have the
same rights to receive distributions as she had prior to dissociation.
RULLCA § 502(b).
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Part II, Question 5
A partnership is an “association of two or more persons to carry on
as co-owners a business for profit.” RUPA § 202(a). Carla and Martha
are two or more persons and the bike shop is a for-profit business.
The question is whether Martha is a co-owner of that business. If so,
it’s a partnership, whether or not Carla and Martha intended to form
a partnership. RUPA § 202(a).
Profit-sharing
Martha receives a share of the profits and therefore is presumed to be
a partner unless the profits fall within one of the statutory exceptions.
RUPA § 202(c)(3). One of the exceptions is if the profits are paid “for
. . . wages or other compensation to an employee.” RUPA §
202(c)(3)(ii). Paragraph 3 of the agreement indicates that Martha is
receiving her share of the profits “[a]s compensation for her
management,” and that may be sufficient to rebut the presumption.
But this doesn’t really look like employee compensation. Martha’s
share of the profits is unlimited; she receives 25% no matter how well
the business does. And there’s no minimum amount Martha is to
receive if the business does poorly.
Control
In addition, the agreement requires that all decisions be made jointly
by Carla and Martha. This complete participation in the control of
the business seems more like co-ownership than employee status.
Gain on Sale
Martha is also entitled to receive 20% of the gain if the store
terminates, another sign of co-ownership. If only Carla owns the
business, why would Martha receive any proceeds from its sale ?
Overall, given Martha’s equal participation in management and the
sharing of profits, this is probably a partnership.