BMAL 590 Legal Environment of Business

Closely Held Corporation

A closely held corporation may have any number of shareholders. Its important characteristic is that its shares are not traded on the stock market. Because of this characteristic, courts tend to impose a greater sense of loyalty and care on the corporation's directors and major shareholders. The impositions are not codified and exist in common law, precedent, and contemporary business practices. Examples: Dell (2013), H J Heinz (2013) and Hilton (2007).

Joint Venture

A one-time partnership between two or more persons for a specific purpose. The parties to the joint venture should have a common interest, have the right to govern, share in the venture's profits/losses, and be willing to contribute money, time, and/or skill for the success of the venture. Not a continuing relationship. Ends when the purpose has been accomplished. Authority of any one member to bind the venture with third parties is limited. The venture's legal status must be included in all communications and forms.

Duty of Candor

A partner has a duty to make a full and fair disclosure of all information that may be of value to the partnership. Many of the actions taken by directors and officers are subject to shareholder approval. The range of such actions is wide - from the issue of dividends to a possible merger or acquisition. In all such cases, it is incumbent on the directors and officers to place all material facts before shareholders. This is called the duty of candor. Any relevant information sought by shareholders should be made available honestly and without window-dressing. Failure to do so has been interpreted by courts as failure of the duty of care and duty of loyalty.

LLC continued (pt 2)

All the owners of a LLC can fully participate in the management of the business (member-managed). Or, the members may choose to appoint or hire a manager (manager-managed). This designation is typically required to be stated in the articles of organization. Similar to a partnership, a LLC can allocate profits/losses in a flexible manner. LLCs do not have a limit on the number of members. Investors in a LLC can include partnerships, corporations, and even foreign entities. Courts have repeatedly ruled that the operating agreement is the one that defines the scope of the business, the rights and responsibility of members, and the personality of LLCs.

Advantages of General Proprietorship

Allows for a range of possibilities in ownership and sharing. One partner may invest money, another may provide space, and a third may provide expertise. Yet, they may be equal partners. Subject to only one level of tax - that of the individuals who are partners. From a tax perspective, a partnership is a pass-through entity. Does not necessarily terminate on the death, resignation, and even bankruptcy of a partner. Other partners can decide to continue.

Courts tend to pierce the corporate veil under two conditions:

Alter Ego Theory - when the owners of a corporation have so mixed up the affairs of the corporation with their own, the corporation may not exist as a distinct entity. Indeed, it may be treated as an alter ego of the owners. Undercapitalization - suppose a corporation deliberately lacks adequate capital to meet its obligations. Such undercapitalization may be treated as a fraud on the public or society.

Managing the Corporation (pt 2)

An increasing trend is the concept of independent directors. These are experts from different domains who are expected to protect the interests of shareholders. Many of the leading companies have as much as 50% of their board comprised of independent directors. The board of directors in turn chooses a chief executive officer and other senior officers such as a secretary or general counsel and a financial officer. The chief executive officer and senior officers appoint executives and employees at other levels to manage the day-to-day operations of the corporation.

Corporations

An organization that is a legal entity distinct from its owners. A corporation has a name and a purpose set out in its charter called the articles of incorporation or certificate of incorporation. A corporation is owned by shareholders (or stockholders). Their ownership stake in the business is in the form of shares (or stock or equity). The liability of the shareholders is limited to their investments. Shareholders elect a board of directors to manage the corporation. The board in turn, appoints executives to carry out the day-to-day operations.

Duty of Care and Business Judgment

As a general rule, courts tend to accept directors' actions as long as the business judgment rule holds. For the business judgment rule to hold, directors should have applied their minds and made informed decisions. The business judgment rule will not hold if it turns out that: 1. The directors had a personal interest in the transaction; 2. The directors did not act in good faith; 3. The directors acted in an irrational manner; and/or 4. The directors arrived at a decision through a negligent process.

A ____ corporation is owned by a limited number of shareholders.

Close

A _____ corporation typically has no more than thirty shareholders.

Close

S-Corporations

Closely held corporations can avoid double taxation by electing to be treated as S Corporation under Subchapter S of the Internal Revenue Code. An S Corporation is treated as a pass-through entity. The corporation is not taxed on its income. Shareholders pay tax on their pro-rated share of the income.

Managing the Corporation

Corporate control is distributed among the shareholders, directors, and officers. Shareholders of any widely-held corporation do not manage the corporation. It is unrealistic to assume that a hundred thousand or a million shareholders can jointly manage any business. Shareholders elect a board of directors to govern the corporation. Directors can be officers, in which case they are called internal or executive directors. Directors who are not officers are called external directors.

Mergers and Acquisitions

Directors and officers have additional responsibilities when dealing with mergers and acquisitions. First, the offer price should represent the true intrinsic value of the target. This requires internal valuation and external validation. Second, the extent to which the negotiations are delegated to officers determines the risk; in general, higher the delegation, higher the risk. Third, directors and officers have a duty to maximize shareholder value. Fourth, due diligence needs to be exercised when relying on officers' and executives' reports. Last, any defensive tactics deployed need to be reasonable. These tactics may include so-called poison pills, which are terms that make the company's stock more expensive or the purchase of the company less attractive, in an attempt to protect against uninvited "hostile" takeovers.

Corporations are subject to _____ taxation.

Dual

Two primary components of Fiduciary Duties

Duty of care and duty of loyalty.

Advantages of Sole Proprietorship

Easy and simple to set up. One person is in control. Only one level of income tax - proprietor reports income and loss on personal returns. Proprietor receives all the profits and other benefits.

Incorporation

Incorporation refers to the process through which a corporation is formed. Each state stipulates the steps to be taken for incorporation. A corporation is not limited in its business by the state where it is incorporated. It can transact business in other states as a foreign corporation by filing the appropriate documents with the designated authority. The state in which a corporation is incorporated is called the corporate domicile. Factors affecting incorporation in a state are the costs of incorporationand the advantages and disadvantages of a state's corporate laws.

Limitations of General Proprietorship

Individual partners are personally liable, just as in a proprietorship. When the partnership cannot repay its debts, honor its contracts, or fulfill its tort liabilities, aggrieved parties can proceed against the partners in their individual capacity. A partnership too faces difficulty in raising capital. Thus, the opportunities for growth may be limited by the ability of the partners to invest.

LLC continued

LLC combines the advantage of a pass-through entity (from a tax perspective) with the limited liability concept of a corporation. An LLC can be formed by filing a charter document with the designated authority (usually the office of the secretary of state). The LLC charter is called articles of organization or certificate offormation. The owners of a LLC are referred to as members. The rights and obligations of members are outlined in the operating agreement.

Limited Liability Partnership (LLP)

LLP is designed primarily for groups of professionals such as consultants, lawyers, and accountants. LLP can be created by filing the appropriate forms with a central state authority. LLP retains the pass-through treatment of taxes.

De Jure Corporation

Lawful corporation that has met the substantial elements of incorporation process If an incorporation is done correctly, a de jure corporation is formed. The entity becomes a corporation by right and cannot be challenged. Most states will accept de jure status if a corporation has substantially met the requirements.

Advantages of corporations

Liability of shareholders is limited to their investment. Corporations can raise large amounts through a public issue of shares. Cap on liability encourages risk-taking. Corporations have perpetual life. The "going concern" concept is one of the foundations of corporations.

Limitations of a Limited Partnership

More difficult to create than a general partnership. Comes into existence only when a certificate of limited partnership has been filed with the appropriate state authority. Unless all provisions have been met, courts tend to treat these as general partnerships.

Sole trader

Ownership and control of business: by one owner

Partnership

Ownership: by partners Control of business: by partners although senior partners may have more decision making power

Franchise

Ownership: franchisee holds license but only for a given period Control of business: franchisee but must operate in framework set out by franchisor.

Company

Ownership: shareholders Control of business: by directors and paid managers. Some will have more control.

limitations of sole proprietorship

Proprietor is personally liable for business obligations. The risk is high. Difficult to raise capital. Can borrow from relatives and friends and from institutions as an individual.

Advantages of LLP

Protects partnership from vicarious liability arising out of malpractice or negligence of one partner. Limited personal liability - a judgment against a partnership for damages cannot be recovered through the individual partners. Partners of a LLP have unlimited liability for their malpractice. Many states protect LLP partners from commercial liability. Some states offer wider protections that blur the distinction between a LLP and a limited liability company (LLC).

Duty of care

Requires directors and officers to arrive at decisions based on accurate information and sound reasoning. There is no scope for impulsive decisions.

Duty of loyalty

Requires directors and officers to place the best interests of the corporation ahead of their own. Thus, any act that is selfish in nature would be contrary to the duty of loyalty Directors and officers must act in the best interests of the corporationand not their own interest. The foundational principle here is that directors and officers should not use any business opportunity to further their own interests. This is called the corporate opportunity doctrine. To test whether an opportunity belongs to the corporation, the line-of-business test is applied. If a business opportunity is in the corporation's stated line of business, directors or officers cannot use the opportunity to serve their own ends.

Business organizations:

Sole trader Partnership Company Franchise

Limitations of Corporations

Subject to dual taxation - the corporation has to pay a tax on the profits earned; shareholders have to pay tax on those earnings when they are distributed as dividends. Unless otherwise stated, corporations are called C-Corporations since they are governed by the rules outlined in Subchapter C of the Internal Revenue Code.

Piercing the Corporate Veil

The action of a court to disregard the corporate entity and hold the shareholders personally liable for corporate debts and obligations. The general principle of a corporation is that of limited liability. Under certain conditions, courts may override this principle and hold the shareholders personally liable for claims against the corporation.

Fiduciary Duties

The duties of obedience, care, and loyalty owed by directors and officers to their corporation and its shareholders. Directors and officers are agents of shareholders. They act on behalf of the shareholders and are expected, at all times, to act in the best interests of shareholders.

Sole Proprietorship

This is the simplest and also the most prevalent form of business in the United States. As the name implies, in a sole proprietorship, one individual owns all the assets and is responsible for all liabilities - debt, contracts, and tort liabilities. The proprietor is the business. The business is not different from the proprietor. If the business has to be conducted in a name other than that of the proprietor, the name must be registered with the appropriate state authority. A sole proprietorship ceases to exist when the proprietor decides to wind up the business, or on the death of the proprietor, whichever is earlier.

General Proprietorship

Two or more persons agree to invest their money, time, and skills in a business, and to share the profits/losses. Essentially, a GP is sole proprietorship with multiple proprietors. Thus, the partners are personally liable for all partnership obligations. The partnership agreement may be explicit or implied, but sharing of profit/loss must be real. In other words, partners cannot merely receive wages or salaries. Unless specified otherwise, each partner has some authority and a corresponding responsibility. A partnership exists as an entity by itself and separate from its partners. It can acquire property.

Advantages of a Limited Partnership

Useful for raising capital. Since limited partners' liability is limited to their investment, a limited partnership has greater potential to raise capital than a general partnership.

De Facto Corporation

Where substantial compliance is missing, a court may treat the corporation as de facto, that is, a corporation in fact although not one in law. To avoid this, the incorporators need to demonstrate that they took adequate measures to incorporate correctly.

Corporation by Estoppel

a defective corporation that has conducted business with a third party and therefore cannot deny its status as a corporation to escape liability Consider a third party transacting business with the entity as if it were a corporation. The third party is prevented or estopped from treating the entity not as a corporation. In other words, when the third party has transacted business considering the entity to be a corporation, it would be unfair to subject the entity's members to unlimited liability.

Requirements to qualify as an S Corporation:

1. Must have no more than 100 shareholders (U.S. Citizens, Resident Aliens, Trusts, or Estates). 2. Must have only one class of stock. 3. May not own 80% or more of any other corporation. 4. Must file in a timely manner to be treated as an S Corporation. 5. Otherwise, will automatically be treated as a C Corporation.

Incorporation (continued)

Corporate laws of states may favor either the management or the shareholders. For example, California laws are considered pro-shareholder. Delaware and Nevada laws are considered pro-management. 50% of the companies listed on the New York and NASDAQ exchanges are incorporated in Delaware. Two-thirds of the Fortune 500 companies are incorporated in Delaware. Thus, Delaware corporate law is considered to be the standard not only in the USA but also in many parts of the world. Delaware law allows (but does not require) cumulative voting that affords a greater opportunity to a minority shareholder to elect a person to the board. Delaware law also allows a staggered or classified board. That is, directors serve a three-year term, with only a fraction of the directors coming up for re-election at any one time. A classified board makes it difficult to change the entire board at once. Delaware law prohibits the removal of a director on a classified board without cause. California law requires cumulative voting and prohibits a staggered board. Delaware law permits broader limitations on directors' personal liability than California.

Close Corporation

Has a small number of shareholders - typically no more than thirty - is treated more like a partnership, and is able to avoid some of the more cumbersome formalities of traditional large corporations. To be treated as a close corporation, the corporation must meet its state's close corporation laws of incorporation. This typically includes electing close corporation status in its charter. If the state's incorporation laws are not met, irrespective of the number of shareholders, it will not be treated as a close corporation. Individual state close corporation laws provide significant flexibility to close corporations.

Limited Partnership

Has general partners and limited partners. General partners have the same rights and responsibilities as in a general partnership, and operate the business day-to-day. Limited partners' liability is limited to the amount of capital investedby them. Limited partners do not participate in the management of the business.