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Business Associations Outline
Professor:
Kevin Michels
AGENCY An agency relationship is created when a principal engages another person (the agent) to act on their behalf. An agency relationship requires a fiduciary relationship: a manifestation of assent by the principle to the agent that the agent shall act on behalf of the principle, and consent from the agent. A fiduciary relationship is where one party owes a duty to another. A manifestation of assent must give the agent some authority to act on the principal’s behalf. Authority is the power of the agent to affect the legal relationships of the principal by acts done in accordance with the principal’s manifestation. A genuine manifestation creates authority. Actual authority occurs when the principle causes the agent to believe they have authority to act. Actual authority can be created expressly, through the principal’s words to the agent, or impliedly, through the principal’s actions that reasonably lead the agent to believe the agent has authority. Apparent authority occurs when the principal causes a third party to believe the agent has authority. It requires the principal to make a manifestation to a third party, which reasonably leads a third party to believe another party has authority. Inherent agency power occurs when an agent is given power to bind the principle to dealings with third parties which arise out of the agency; in other words, the agency arises by virtue of a particular relationship. A master-­‐servant relationship is an agency relationship created between employers and employees, where the employer exercises control over the employees day to day functions. In the event of a tort, liability on a principal can arise out of a master-­‐
servant relationship. The tort must be committed by the agent with in the scope of their employment. This is called vicarious liability. In vicarious liability, an employee may commit a tort out of a frolic or detour. A detour is a minor departure from the service of employment, where as a frolic is a major departure. Employers are liable for torts committed during detours, but not frolics. Employers may also not be liable for intentional torts, depending on the nexus of control. Additionally, vicarious liability never removes the personal liability of the employee, since an individual is always accountable for their own actions. NON-­‐CORPORATE BUSINESS Page 1 of 12 2014 SPRING
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A sole proprietorship is a business in which there is a single owner. Formation of a sole proprietorship requires no special formation, merely the starting of business. Sole proprietors are personally liable for all debts and obligations of the business, but retain all profits of the business. Income form the business is taxed as personal income of the business owner. A partnership is an association of two or more persons to carry on as co-­‐owners of a business for profit. Formation of a partnership requires no formal steps. Generally the partnership is governed first by the partnership agreement, if any, state statutes, RUPA, and UPA. A partnership is a legal entity, which can own property apart from the owners. It is not a legal person though. A partnership can be financed in several ways. The partnership agreement can make financing from the partners compulsory, but should make clear how and when this will happen. Outside financers can also finance the partnership, and in some states can ask the individual owners to guarantee the finance. Additional owners can be added to increase financing, but this should take place in accordance with the partnership agreement. However, additional partners cannot be held liable for obligations incurred before the partner’s commission. Lastly, earnings from the business can be used to finance the business, but generally earnings are distributed to the owners, unless there is some sort of lucrative practice. Unless the partnership agreement states other wise, partners are entitled to an equal share of the profits, and chargeable with a share of the losses proportional to their partnership share. Generally this is determined by the value of the partner’s investments minus any distributions made to the partner plus an equal share of the net profits or losses. However, labor hours do not count as investment into a business. A partnership includes a duty of loyalty to the partners. When an opportunity arises out of or related to the partnership, then an effort should be made, in good faith, to make all partners aware of the opportunity, at least such that the other partner could take advantage of such an opportunity if they wanted. Partners have a fiduciary duty to each other; they have an obligation to good faith and fairness and honesty in dealings. This duty may be eliminated in the partnership agreement, but only to the extent that the elimination is reasonable and objective. Partners may be either jointly or severally liable for obligations of the business. A partnership may be terminated in a number of ways. A partner may be terminated by dissolving their interests, which will be governed either by the partnership agreement or state law. Generally this involves a dissolution, which is the first step to ending a partnership. The partnership continues during the dissolution and into the winding up stage. Winding up is the last process of concluding all partnership obligations, including completing in-­‐progress work, selling assets, and paying debts; this is also called liquidation. Termination is the completion of the winding up. Page 2 of 12 2014 SPRING
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A partnership may also be terminated by expulsion. This is not covered under uniform statutes, but may be permitted by the partnership agreement. The partnership agreement should usually state both that termination is acceptable and the specific conditions under which expulsion may occur. If the partnership agreement does not state the conditions under which expulsion may occur, the partnership is called an “at will” partnership. Expulsion in an “at will” partnership should be subject to good faith requirements. However, courts may use discretion, since partners are not obligated to stay partners (constitutional matter). Another possibility for termination is a freeze out. A freeze out is when the majority interest forces a minority of the owners to sell or otherwise give up their interests. This generally is not acceptable, as courts will not find the good faith requirement met. A limited liability partnership is a business formed by two or more owners having one or more general partner and one or more limited liability partner. CORPORATIONS Forming a Corp. Forming a corporation requires filing the articles of incorporation (AOI) with the proper state authority. The AOI is only required to contain the name of the corporation, a statement of purpose, the number of shares to be issued, in a minority of states the par value, the name and address of the registering agent, and the name and address of the incorporator. A general statement of corporate purpose is usually sufficient, such as “any thing the corporation is legally entitled to do.” However, as a general rule, the corporation has the power to make charitable givings, even for the purpose of advancing public policy. The corporation may do so even if it is contrary to the wishes of the owners. Failure to form by mistake When all statutory requirement for incorporation have been satisfied, a “de jure” corporation has been formed, meaning the corporation is now liable for its actions (not people). When a person conducts business as a corporation without attempting to comply with the incorporation procedure in good faith, the person is liable for any obligations they incur. However, when a person makes an unsuccessful effort to comply with requirement, but the effort is in good faith, and the person operates as a corporation without realizing their efforts were in vain, the person has formed a “de facto” corporation. A de facto corporation is usually an exception to personal liability. Furthermore, the doctrine of corporation by estoppel prevents personal liability for de factor corporations who engage in contract. Pre-­‐formation issues Before a corporation is formed, agreements may be made by a promoter on behalf of the pre-­‐formed corporation. A promoter is personally liable for acting on behalf of a Page 3 of 12 2014 SPRING
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corporation before incorporation, and is jointly and severally liable after formation, unless there is a subsequent novation, or an express or implied adoption of the contracts by the corporation. A promoter is in a fiduciary relationship with the pre-­‐
inc. corporation, and can be held liable as such. A promoter can seek compensation for pre-­‐inc. activities, but can not compel repayment. Generally, a corporation carries no liability for transactions entered into by a promoter. Likewise, an incorporator does not engage in liability on behalf of the corporation. Governance The articles of incorporation need not, but may, spell out the governance of the corporation. The AOI can be corrected or amended if necessary. The bylaws contain any lawful provisions for the management and regulation of the corporation that is consistent with the AOI. If there is a contradiction between the AOI and the bylaws, the AOI is controlling. Generally the BOD adopts the initial bylaws, but this is not necessarily the case. Generally, once the AOI is filed, an organizational meeting is held at which the appointment of officers, adoption of bylaws, and approval of contracts takes place. The board of directors generally appoints high-­‐level corporate officers to facilitate the management of the corp. All corporations must have 1) shareholders 2)officers and 3) a board of directors. The Board of Directors The board of directors manages and directs the management of the corporation’s business and affairs. The board authorizes corporate officers to exercise powers possessed by the corporation. Directors must be natural persons, not other legal entities. The AOI or the bylaws should indicate the number of directors required, and the specifics of their terms. After the initial election, shareholders will elect directors at regular intervals, according to the AOI or bylaws, typically directors serve annually. Directors may resign by giving written notice. Directors of a corporation may receive compensation for serving as directors. However, for the majority of the directors this is not their full time job. Directors can be regular employees or even officers of the corp., although the majority are not. Directors are not physically required to be at meetings. The board of directors should hold regular meetings, usually at monthly, quarterly, or even annual intervals. Directors may organize into committees. Typically, a public held corporation has an audit committee, a nominating committee, and a compensation committee. The SEC requires companies listed on the national securities exchange to have an independent audit committee responsible for arranging audits. Officers and Other Employees Typically a corporations officers are composed of a president, secretary and treasurer. An individual may hold more than one office, but some states limit this activity. Selection of primary officers is usually by the BOD. An officer has actual authirty based on what is defined in the AOI and bylaws. An officer has implied Page 4 of 12 2014 SPRING
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authority to perform those tasks necessary to the scope of their duties. An officer has apparent authority to do anything the corporation holds him out to be able to do. An officer may be removed at any time for cause. Corporate Duties Directors and Officers both have a duty of loyalty and care to the corporation. The Duty of Care The duty of care requires directors to act with the care of an ordinarily prudent person in a like position and similar circumstances. A director is entitled to rely on the performance or, as well as informed reports of others, so long as the director reasonably believes them to be reliant and competent. A claim against the duty of care must overcome the business judgment rule. The business judgment rule states that generally a court will not interfere with the business judgments of directors or officers without a showing of fraud, illegality, or conflict of interests. In order to overwhelm the business judgment rule, a complainant must show the director did not act in good faith, the director was not informed to the extent reasonably required, the director was not objective or independent in their decision making, the director failed to exercise oversight, the director failed to give timely investigation, or the director received financial benefits to which they were not entitled. The duty of care can be asserted against a careless officer or director who failed to issue proper oversight. However, may statutory provisions have been enacted to allow a corporation to insulate directors from claims against carelessness by stating in their AOI that directors are immune from this kind of liability. However, a party can attempt to claim a director did not exercise good faith, but, these claims are largely unsuccessful. The Duty of Loyalty The duty of loyalty requires directors and officers to act in a way that the reasonably believe in in the best interest of the corporation. There are three general kinds of transactions which trigger a duty of loyalty: conflict of interest, usurpation or a corporate opportunity, and direct competition. Conflicts of interests, or self-­‐dealings are transactions between a director and their corporation that would normally require approval of the board of directors, and that is of such financial significance to the director that it would reasonably be expected to influence director’s votes on the transaction. Conflicts of interests apply not only to directors and officers, but to their relatives. In order to avoid liability for a conflict of interest, a director or officer should take one of three actions, depending on their jurisdiction: 1. disclosure of all material facts to, and approval by a majority of the BOD who don’t have a conflict. Page 5 of 12 2014 SPRING
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2. Disclosure of all material facts to, and approval by a majority of the votes entitle to be cast by shareholders without a conflicting interest, 3. Consider the fairness of the transaction at the time of the transaction If a violation occurs the conflict may be enjoined or rescinded. Usurpation of a corporate opportunity violates the duty of loyalty if the opportunity is not first offered to the corporation and refused. A corporate opportunity under the interest or expectation test, there is a corp. op. if there was an existing interest or an expectancy arising from an existing right in the opportunity. Under the broader line of business test, there is an opportunity if the opportunity is within the corporation’s current or prospective line of business. The court will also look at the relationship between the person offering the opportunity and the director/officer, how knowledge of the offer was acquired, and the relationship between the officer/director. A director/officer who engages in a business venture that competes with the corporation breaches their duty of loyalty. However, notice that this duty can be revoked if the AOI or the bylaws provide for it. Indemnification Corporations may purchase indemnification and liability insurance for directors and officers. A corporation is required to indemnify a director for any reasonable expenses, including court costs and attorneys feed, incurred in the successful defense of proceedings related to the party’s role in the corporation. A corporation is prohibited from indemnifying party’s liability because of improper personal benefit. A corp. may otherwise indemnify parties who acted in good faith or in the case of a criminal proceeding where they believed their actions to be lawful. Shareholders and Stocks Corporations are required to hold at least annual shareholder’s meetings. Special meetings may be called for a particular purpose. Shareholders must be given notice of these meetings. Failure to hold these meetings doesn’t invalidate the corporation, but a shareholder can seek legal action to compel a meeting. Typically, shareholders have the right to vote, although certain classes of share holders may not. The corporation itself is not entitled to vote on its own shares. However, other corporate owners typically are entitled to their votes. Shareholders may also be required to approve certain financial decisions or corporate changes, depending on the unique corporate structure. Usually, each share constitutes one vote, however, this is the default not the rule. Voting decisions are settled by a quorum of voters, usually a majority of votes available to be cast. A shareholder may vote in person, or by proxy. Shareholders may enter into binding voting agreements, called voter pools, in which voters maintain ownership over their shares. A shareholder may also use voting trusts, while the shareholder retains the benefit of the share, the ownership is transferred to a trustee who votes with the shares. Page 6 of 12 2014 SPRING
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The primary issue to vote on is the BOD. Voting for directors typically occurs through straight voting, but may occur through cumulative voting only if the articles of incorporation designate the possibility. Straight voting gives a shareholder the number of votes equal to the number of shares they own; which may be cast on each director’s seat separately. Cumulative voting gives a shareholder votes equal to the number of shares a shareholder owns times the number of director’s seats available; which may be cast on any seat separately. Shareholders are not able to make agreements that will usurp the decision making powers of the board of directors. However, some statutory exceptions have been made for closely held corporations to exercise power over the board. A closely held corporation is a small, non-­‐public corporation. Shareholders do maintain a right to review and inspect corporate records. The request to review corporate records must be in good faith and for a proper purpose, and generally is restricted to during business hours at business locations. The SEC may require corporations to provide annual records to shareholders. Rules relating to the disclosure of certain proxy statement (based on SEC proxy rules) are under rule 14(a), by which a shareholder can compel a corporation to provide statements, or incur legal action. The corporation may issue stock provided the AOI allows for it, and the BOD has authorized it. Prior to incorporation, a person may subscribe to purchase stock on its issuance. Corporations may issue rights, warrants, or options to buy stock. Corporations who issue stock may be required to register with the SEC, and most likely will if they are publicly traded. Authorized shares are the number of shares authorized for issuance by the articles of incorp. An issuance is the initial sale of a stock. Outstanding stock is stock which is issued, but has not been reacquired, converted or cancelled. Stock which has been reacquired is called treasury stock. Stock may be preferred or common. Preferred stock is stock which is to be treated more favorably than common stock, potentially by issuance of dividends, liquidation rights, or redemption rights. Common stock is all other stock. Par value, if used at all, is the minimum price for which a corp. can issue it’s shares. This only applies to the issuance, no necessarily the resale. A capital surplus is funds received in excess of par value. Stated capital is the aggregate value of all issued shares at par. Most states have eliminated par requirements, and if the have not, a corporation can effectively eliminate them by setting at par as low as possible. When the BID decides to issue new shares, the rights of shareholders to purchase those shares in order to maintain their proportional ownership over the corporation is called a “preemptive right”. Under modern law, preemptive rights are available if the AOI establishes them. A shareholder may waive their preemptive right, and a waiver is writing is irrevocable. The preemptive right does not apply to stocks issued as compensation to directors, officers, agencies, or employees, shares issued Page 7 of 12 2014 SPRING
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within six months of incorporation, and shares exchanged for property other than money. Distributions (usually in the form of dividends) are transfers of property from the corporation to its owners. The BOD has the power to authorized distributions, but only if there is profit after debts are paid on the income statement. Shareholders cannot compel the BOD to authorize a distribution, but may request to court to compel the BOD if the BOD has acted in bad faith or abuse of discretion. (this is obviously incredibly rare). When one shareholder-­‐ or group of shareholders-­‐hold a high enough percentage of ownership the shareholder effectively controls the decision making power of the corporation. Any single shareholder with 51% of the share is automatically a majority shareholder. However, notice that different voting schemes can create majorities in lesser amounts. For example, a corporation requiring a 2/3 super majority for votes in favor of motions can effectively give control to a minority share holder possessing 34% of the shares. Shareholders with a controlling interest in a corporation that sells to an outsider may have a fiduciary obligation to other shareholders. This duty arises when the majority share holder sells their interest to an outsider, seeks to eliminate other shareholders from the corporation, or receives a distribution denied to other shareholders. Majority shareholders have a responsibility to disclose any information it knew, or reasonably should have known would impact the way the shareholder would vote, or if non-­‐disclosure would cause loss of minority shares. When majority shareholders purchase the interests of the minority they have a duty of good faith and fair dealing. A tender offer is an offer to shareholders of publicly traded corporations to purchase stock for a fixed price, usually higher than market price. Frequently this is used in hostile takeovers. A tender offer must remain open for at least 20 days. If at any time the tender offer price is raised, the tender my pay the higher price to those who have already accepted the lower tender price. Sale of Stock (Rule 10b-­‐5 and 16b) Rule 10b-­‐5 prevents the fraudulent sale of stocks. A violation of 10b-­‐5 requires that the plaintiff purchased or sold securities, involving interstate commerce, the defendant engaged in fraudulent or deceptive conduct related to material information with recklessness or intent, the plaintiff relied on the defendants conduct, and the plaintiff suffered harm. Opinions do not generally constitute fraud or deception if they were made in good faith. The bespeak caution doctrine says statements of opinions accompanied by a cautionary statement are not fraud or deception. The disclose or abstain rule is that a person with insider information does not incur liability unless they also trade stocks or other securities on the basis of such knowledge. A person is presumed to have traded on the basis of the information they posses at the time of the trade, unless the trade was made in accordance with a Page 8 of 12 2014 SPRING
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pre-­‐existing written plan. Four kinds of traders are required to disclose insider information: 1. Insiders: directors, officers, or other employees 2. Constructive insiders: persons who have a relationship with the corporation that give them access to non-­‐public information (attorneys, accountants, etc.) 3. Tippees: persons given information by an insider whit the expectation that the information would be sued to trade the stock or securities The tipper must receive a personal benefit from the disclosure, or intend to make a gift or the tippee. To be liable the tippee must have known, or should have known, the information was provided in violation. 4. Misappropriators: a person who uses confidential information in the trading of stock or securities in violation of a duty of confidentiality owed to the corporation. Rule 16(b) states that stock traded form corporations that have securities traded on a national securities exchange, or corporations that have assets of more than $10 million and more than 500 shareholders, are subject to the rule that: shares from corporate directors, officers, and shareholders who hold more than 10% of any stock can be forced to return short swing profits on sale of their shares within a six month period of acquiring them. These parties are required to report sales to the SEC. Derivative Suits A shareholder can bring suit either in a direct action or in a derivative action. A direct action will most likely be for a breach of fiduciary duties, or in order to enforce shareholder’s rights. A derivative action is a shareholder suing on behalf of the corporation for a harm suffered by the corporation. Generally only a person who is a shareholder at the time of the action or omission can bring suit. Before bringing suit, the plaintiff must show they made a written demand that the BOD take action, called a BOD. The plaintiff must allow 90 days to pass before bringing suit. If the board does not adequately address the demand on board, the plaintiff must allege that there was no justification for the actions taken due to lack of care, failure of a duty of loyalty, or lack of good faith. However, there is an exception to the demand on board requirement if executing a demand on board would be futile. There is also an exception to the 90 day waiting if the suit requires timely action. From a practical standpoint, most derivative suits bypass the demand on board altogether, because of the difficulty in overcoming the business judgment rule upon issuing the demand on board. Liability The general rule of liability is that a corporation is an entity and a legal person. As a legal person it can sue and be sued for its actions, contracts, torts, and statutory violations. Parties to a corporation are only liable to the extent of their own investment, unless some extenuating circumstances apply. For example, lenders to a corporation with limited assets may require a shareholder(s) to agree to personal Page 9 of 12 2014 SPRING
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liability. Agents of the corporation may be held liable for personally committed torts, although, this does not waive vicarious liability. Another exception is the corporate veil doctrine. When a party to a corporation treats a corporation as merely an alter ego, the court may find there is no entitlement to limited liability. An alter ego occurs when the corporation is merely an instrumentality for personal dealings. There is not bright line rule for piercing the corporate veil. The court will consider under capitalization of the corporation at the time of its formation, if there was a disregard of corporate formalities, co-­‐
mingling of assets, self-­‐dealing, use of corporate form to avoid statutory or legal obligations, one shareholders impermissible control over the corporation, and if there were wrongful or fraudulent dealings. A subsidiary is a corporation who’s majority stock holder is another corporation. Parent corporation have the same expectation for limited liability as any other stockholder, unless there is a contractual obligation or a corporate veil argument that indicates otherwise. The enterprise liability doctrine states that corporations that, although separate, are commonly owned and engaged in one enterprise, should be treated as a single legal entity for legal purposes of liability. The court will examine if the corporations co-­‐mingle funds, share facilities, employees, or are otherwise indistinguishably entangled. Corporate Financing Corporate financing can occur a number of ways, however the choice of which way to finance depends on a nexus of risk and return. Corporate financing generally sits on a spectrum of low risk-­‐low return to high risk-­‐high return in this order: loans, bonds, debentures, issuance of preferred stock, and issuance of common stock. Companies can borrow money from banks in the form of loans. Loans can come with or without persona guarantees. Loans are generally uncommon, more common are bonds and debentures. Loans are debt, and paid before equity. Bonds are company promises to repay financing with interest. Bonds are secured by assets or collateral. Holders of bonds do not hold voting rights in a company. Bonds can be transferred. Usually the terms of bond repayment of invariable, since bonds are usually issued to a large pool of financers. Debentures are very similar to bonds, except they are unsecured, and thus carry a higher risk. Unlike stock, bonds and debentures are debt, and are paid before any distributions are made, making them less risky to the investor. An issuance of stock is an equity. Preferred stock is an issuance of a share in the company, which will be issued a specific amount per annum before common stock holders (if any dividend is issued at all). Preferred stock may carry a right to cumulative preferred stock, which means if stock is not paid in a given year, the stock holder’s right to dividends accumulates from year to year. Preferred stock may carry a participation right, allowing the stock to participate in payment of common Page 10 of 12 2014 SPRING
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stock, even after the fixed dividend amount has been paid on the preferred stock. Preferred stock are also usually granted a right to payment of a certain amount upon liquidation of the corporation. These stock may or may not have voting rights, and may or may not be convertible to common stock. Common stock is the issuance of a share in the company which participates in an equal share of dividends issued after preferred stock holders have been paid. These generally carry voting rights. Mergers, Acquisitions, and Takeovers Control of a corporation can be gained by mergers and acquisitions. A merger is a combination of two or more corporations such that only one corporation survives. When the surviving corporation is a new entity, it is called a consolidation. A statutory merger follows a specific set of statutory guidelines to merge. To merge the BOD for each corporation must approve the merger, the shareholders must approve the merger, and the required documents must be filed with the state. Usually the shareholder’s votes are taken by quorum requirements. In a statutory merger, all assets and liabilities merge into the new corporation. An asset acquisition is a reorganization by a corporation to acquire the assets of another corporation. This is a “de facto merger” if the nature of the corporation and the shareholder’s interests are significantly changed. However, unlike a statutory merger, the transferor corporation remains liable for its debts including the ones associated with the transferred assets. The transferee escapes liability unless they assume liability. A corporation may acquire stock in another corporation and thereby secure control of the corporation. A corporation may offer its own stock to shareholders in another corporation in exchange for their own stock, called a stock exchange. A corporation may also use a tender offer and purchase stock in another corporation from current stock holders, or purchase stock from the open market. In both acquisitions and mergers, dissenting shareholders are given the right of appraisal. The right is available to any shareholder whose rights are materially and adversely affected by an amendment of the corporation’s articles of incorporation. The right forces the corporation to buy back the shareholder’s stock for fair market value. Any shareholder entitled to vote on a merger has the right, and some shareholder who cannot vote may have the right. The shareholder must give written notice of their objection to the merger or acquisition before the shareholder’s vote. Then the shareholder must vote unfavorably to the motion. Then the shareholder must demand payment from the corporation. A hostile takeover occurs when the board of directors directly rejects an offer for a merger of acquisition, but the offering company continues to pursue the offer. Tender offerings can be made in a the public market, or the corporation can engage in “proxy fights”, where the corporation attempts to persuade the shareholders of Page 11 of 12 2014 SPRING
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the corporation it is pursuing to replace leadership with more favorable officers. Directors of a corporation have a duty to protect against hostile takeovers, and can exclude certain rights to certain shareholders from a stock repurchase if it is absolutely necessary. When a takeover is inevitable, the directors have a duty to obtain the best price possible for the shareholders. Closely Held Corporations Shareholders are not able to make agreements that will usurp the decision-­‐making powers of the board of directors. Some statutory exceptions have been made for closely held corporations to exercise power over the board. A closely held corporation is a small, non-­‐public corporation. Additionally, in a closely held corporation shareholders owe a duty of good faith to each other, and are in breach of that duty when terminating another shareholder to gain leverage. When a potential buyout or merger may occur in a closely held corporation, there is a duty to disclose this to other shareholders. Shareholders of a closely held corporation often execute buy-­‐sell agreements which state how shares may be bought or sold on resignation, death, or in other circumstances. The buy-­‐sell agreement should answer most questions about the handling of stock, for example, do shareholders have the right to cross purchase? How will stock be valued? Is stock heritable? Page 12 of 12