Business Associations Klein Ramseyer Bainbridge
|Taught at||New York University School of Law|
Part I – Introductory Notes
- Types of Business Associations
- Sole proprietorship – one owner. Involves no statute and may be started without formality.
- No co-ownership or assets
- Owner liable for all debts; either business or personal assets can satisfy debts
- Insurance will probably satisfy the owner’s needs
- Limited Liability Company (LLC) – one or more owners
- Corporation – the incorporated form of business entity.
- Choose one based on a blend of legal, business, and tax considerations. These may relate to:
- The level of the activity’s exposure to significant liability
- The management needs of the party(s) involved
- The need for flexibility regarding future transfers of ownership interests
- The desired allocation of risk and loss among the parties
- The financing plans for the activity
- The level of formality necessary to establish the structure within which the activity will operate
- The most efficient manner to transfer assets to the activity’s purpose
- The structure best suited to minimize or defer taxes on profits
- The structure best suited for the use of losses to offset income from other sources
- The expected duration of the venture
- The structure that best insulates any increase in equity value from income or estate tax
- Sole Proprietorships
- Simplest and common form of business structure
- Sole proprietor is the owner of the business assets and is generally responsible for all the debts of the business.
- Personal assets of the sole proprietor are available to satisfy business debts and business assets are available to satisfy personal debts.
- Things to consider:
- There may be low cost insurance available to protect both business and personal assets
- Although a sole proprietor could form an LLC or corp for his biz to avoid personal liability, the business interest would be available to both business and personal creditors and the underlying assets actually may constitute the bulk of the owner’s wealth.
- The sole proprietor is not an employee for purposes of the Internal Revenue Code (IRC)
- Sole proprietor is liable for all taxes on the income of the business whether the income is reinvested or not.
- No federal or state reqs that have to be met to create a sole proprietorship. Anyone engaging in business by himself w/o creating an entity has by default created a sole proprietorship.
- Has an indefinite existence; ceases to exist when owner sells the business, closes the business, or dies.
- Association of two or more persons for the purpose of carrying on a business profit as co-owners. STATUTES ONLY APPLY WHERE PARTNERS FAIL TO ADDRESS AN ISSUE.
- Can be of several different forms.
- General partnership existed at common law and can be created without a legal formality/written agreement (even inadvertently)
- Other partnerships are created by state law. All types of partnership are governed by state law.
- Characteristics historically associated with the aggregate partnership concept include a partner’s
- (1) personal liability for debts of the partnership
- (2) right to participate in management in the partnership
- (3) right to share profits on a per capita basis (unless changed by agreement)
- (4) inability to transfer his or her partnership interest without consent of the other partners
- Sometimes, dissolution is required when a partner leaves or dies if the business continues
- Partner can transfer rights to profit/distribution, but can’t make the transferee a partner.
- Partners owe one another a fiduciary duty of good faith and loyalty, since they have equal rights to management and equal sharing of profits.
- Three types of partnership:
- Partnership per term – partnership for stated period of time
- Partnership at will – ends when parties want it to end
- Limited partnership – one general and one limited partner minimum. Abide by state statutes. General partner has usual rights. Limited partner won’t participate in management, but keeps limited liability.
- Corporations – legal entities created by the state with basically all the rights of a natural person. An entity is separate from its shareholders.
- Great deal of formality in making one…
- Must file Articles of Incorporation with the state, which must include…
- Name of corp, location, purpose, number of shares to be authorized and issued, the voting rights of the shares, the names and addresses of the directors
- Must draft By-laws (which govern internal affairs of the corp)
- Established by feds or state
- Charitable corporations
- Foundation and social or mutual benefit corporations
- Publicly held – have many shareholders and their shares are traded on a public securities market (ex NYSE) or are frequently sold/traded
- Closely held – have one or a few shareholders at most and their shares are rarely traded (treated differently in some jurisdictions)
- Characteristics: a shareholder…
- (1) is not liable for corporate debts
- (2) does not participate directly in the management of the corporation by reason of being a shareholder (management is vested in a board of directors, elected by shareholders
- (3) participates proportionately in the profits of the corp
- (4) may freely transfer ownership interest
- Limited Liability – generally speaking, investors are immune from indebtedness incurred by the corp
- Centralized management – centrally or representatively managed because the statutory rules provide that shareholders don’t participate in management of the corp.
- Management is bested in a board of directiors, elected by shareholders
- Perpetual existence – corps exist in perpetuity without regard to death of shareholders, etc.
- Free transferability of interests – can sell shares w/o restrictions. Need permission to sell your interest. Can sell to whoever you want. However, can structure corp. to change this.
- Shareholders may also vote on major changes to a corporation
- LLCs – relative newcomers to the scene.
- A hybrid in that it enjoys some characteristics of a sole proprietorship or partnership and some characteristics of a corporation. This depends on the desires of the Members
- Owners are called Members
- Unincorporated, but there is limited liability like a corporate shareholder.
- Courts tend to draw from corporate law for LLC issues.
- You can have a member-managed LLC, similar to a partnership, or a manager-managed LLC, similar to a corporation.
- Can be taxed as either a corporation or a partnership.
- “A person who acts through another acts for himself” – qui facit per alium facit per se…
- Governs principals and agents.
- Agency arises when one person manifests assent to another person that the agent shall act on the principal’s behalf and subject to the principal’s control and the agent manifests assent or otherwise consents so to act. – RS3d §1.01
- Actual authority
- Actual express authority… the Principal (P) engages and agent (A) to perform a task and if the A agrees to perform the task and actually does perform the task, the P is bound.
- Actual implied authority – P does not specifically state the specific task that A is to accomplish, but A must undertake the task in order to accomplish the job for which he was hired.
- Apparent Authority – exists when the A is without actual authority, but the principal has manifested his or her consent directly to the third party who is dealing with A
- Inherent Authority – exists where there has been no manifestation by a P either to the agent or third party, but there exists a need to protect unsuspecting third parties
- If agency exists, principal may be liable for the actions of the Agent
- Fiduciary duty – agent owes the utmost loyalty toward the principal. Must work for the principal’s benefit
- The level of control will determine the principal’s Liablity.
Part II – Agency
Who is an Agent?
- RS2d of Agency §82 Ratification' (pg. 4 in supplement) – ratification is affirmance by the person or a prior act which did not bind him but which was done or professedly done ton his account, whereby the act, as to some or all persons, is given effect as if originally authorized by him.'
- Principal may ratify acts of an agent
- When the Agent acts in a way inconsistent with principal’s grant of authority, but the principal likes it anyway, so they ratify it
- Agents have a Fiduciary Duty' – agent owes principal the utmost loyalty. Agent may not earn profit w/ his actions for principal other than was principal agreed to.'
- Failure to disclose' will almost always end up being a breach of fiduciary duty.'
- “Grabbing and Leaving”' – NOT ALLOWED. This is when an agent, after termination of agency agreement, takes the principal’s clients with him to form his own business. '
- RS3d of Agency §83 Affirmance (pg. 4 in supplement)' – affirmance is either (a) a manifestation of an election by or on whose account an unauthorized act has been done to treat the act as authorized, or (b) conduct by him is justifiable only if there were such an election.'
- Makes more sense in RS3d
- RS3d §2.05 page 16' – estoppel to deny the existence of an agency relationship '
- 'RS3d § 4.01-4.08 page 19-20 – covers Ratification'
Gorton v. Doty – How agency may arise inadvertently
|No business relationship here. P football player at a high school and the father of that palyer. D teacher at the school who loaned car to Garst (football coach). Garst crashed car, injuring Ps. Owner of the car was a teacher at the school.
Issue: Was the coach (Garst) an agent of the lender of the car?
Reasoning: An agency relationship can arise outside of business. There needn’t be a K b/w principal and agent for agency to exist, nor is it essential that the agent receive compensation.
Majority stretched this a bit – driving the car was considered “control.” More of a public policy purpose, because the driver had insurance to pay the damages.
Agency is the relationship which results from
- (1) the manifestation of consent by one person to another
- (2) that the other shall act on his behalf and subject to his control, and
- (3) consent by the other to so act.
A. Gay Jenson Farms Co. v. Cargill, Inc. – Inadvertent creation of agency by creditor exercising control over debtor after debtor has experienced financial difficulties
|Cargill and Warren are Ds. Warren K’d w/ Cargill to buy grain. Warren also stored grain for farmers and bough chems, fertilizer, and steel storage bins.
Cargill agreed w/ Warren that Cargill would loan money to Warren on “open account” up to $175k. This was extended several times. Cargill also was given some authority/control over Warren under this agreement. Warren inevitably went bankrupt after borrowing too much $.
Issue: Is a creditor liable as principle for Ks of debtor when creditor takes control of debtor’s finances?
Reasoning: Cargill had control over Warren because:
(1) they made constant recommendations to Warrant
(2) Warren’s right of first refusal on the grain
(3) Warren’s inability to enter into mortgages to purchase stock and pay dividends without Cargill’s approval, and more (see page 10)
This was a principal-agent relationship
Cargill was the principal because they exercised control over Warren
BLACK LETTER LAW: RS2d §14 – a security holder who takes management of the debtor’s business becomes the principal, with the debtor being its agent.
§14K is about who is a supplier rather than a principal.
Liability of Principal to Third Parties in Contract
Mill Street Church of Christ v. Hogan – Agent’s Authority
|Church hired Hogan to paint. Church also hired an assistant (Petty). Hogan’s brother Sam was previously hired by the Church to assist Hogan. Petty was difficult to reach, so Hogan hired his brother, who fell from a ladder, and was injured. Workers’ comp claim filed, but insurance co. said the brother wasn’t employee of the church
Issue: Did Hogan, as an agent, have the authority to hire his brother to help?
Reasoning: The church allowed Hogan to hire his brother in the past. Church also paid the brother for the time worked. Actual implied authority was proven circumstantially through this.
Hogan also had apparent authority b/c the principal (Church) allowed him to hire the brother before, so he was allowed to do it again.
Types of Authority the Principal may manifest in the Agent
- Actual Implied Authority – circumstantially proven which the principal actually intended the agent to possess and includes such powers as are practically necessary to carry out duties actually delegated
- In establishing implied authority, focus on agent’s understanding of his authority. The agent must reasonably believe, based on past or current conduct of the principal, that he had certain authority. Factors to consider are:
- (1) nature of the job
- (2) prior similar practices of the principal
- (3) specific conduct by the principal in the past permitting the agent to exercise similar powers (crucial!)
- Actual Express Authority – when the principal expressly tells the agent to act on their behalf
- Implied Apparent Authority- can be proven by virtue of custom (ex. Paul told Ann not to hire a janitor, but local custom allows apartment managers to hire janitors)
Estoppel (RS3d §2.05)
- Estoppel is the liability of a principal to a third party for the acts of an agent (or even non-agent – see below). Can be shown by proof disclosing:
- (1) express or real authority, which has been definitely granted
- (2) implied authority, that is, to do all that is proper, customarily incidental and reasonably appropriate to the exercise of the authority granted, and
- '(3) apparent authority, such as where the principal by words, conduct, or other indicative manifestations has held out the person to be his agent.'
Hoddeson v. Koos Bros. – Estoppel
|P went to store. Spoke to salesperson and bought furniture in cash. Didn’t get receipt. Turns out the person was a scammer.
Issue: Is principal liable to customer for money lost to person posing as their agent?
Reasoning: Businesses have a duty of care to customers, and is liable for monetary loss caused by unauthorized person
Estoppel: in this case, the P was estopped from avoiding liability. They were prevented from denying an agency relationship exists, even here, where this was done by a non-agent
Agent’s Liability on the Contract – Partially disclosed Principal
'Black Letter Rule: If the principal is only partially disclosed, the agent is liable on the contract '
Atlantic Salmon A/S v. Curran – Partially disclosed or undisclosed principal
|Curran bought Salmon from Atlantic, holding himself out to be an agent of two Boston Seafood Companies that didn’t really exist. A company Curran owned called MDI, which had been dissolved, had filed w/ Boston clerks that they were d/b/a Boston International Seafood Exchange, Inc. He didn’t disclose this to Atlantic, and paid for $250k worth of Salmon with checks that were not honored.
Issue: Is a person liable for K he made on behalf of a principal that was not revealed to the other party?
Reasoning: The agent never fully disclosed to the third party that he was acting on behalf of a particular principal. Disclosure that he was an agent by itself was not enough. It is the duty of the agent to affirmatively disclose the identity of his principal. The agent is liable here.
Principal’s Liability to Third Parties in Tort for Actions of Agent
- Principals are not bound to their agent (servants) unless they controlled that agent at the time
- Either intentional or unintentional torts
- Employer/employee relationship
- This is all about CONTROL
- In Franchises…
- Look at who has the right to control the instrumentality that caused the injury
- You can generally find this in the franchise agreement. Whoever has control over whatever caused the injury is liable.
- This is really a policy issue.
- The tort must be committed “in the scope of employment” and not “on a frolic”
- The tort is committed by the employee must be foreseeable as part of the operation of employer’s business.
- In the scope of employment depends on (1) the time, place, purpose of the act; (2) its similarity to the acts which the servant is authorized to perform; (3) whether the act is commonly performed by servants; (4) the extent of departure from normal methods, and; (5) whether the master would reasonably expect such act to be performed
Tort Liability and Apparent Agency
Miller v. McDonald’s Corp. – Apparent Agency
|P bit into a Big Mac, and was injured by a sapphire that was inside the sandwich. 3K owned and operated McDonalds under a franchise agreement that said it must be “owned and operated under the McDonalds System” – included business practices and policies.
Issue: Whether there was apparent agency or apparent authority between McDonalds and 3K?
|Held: Yes, there was apparent agency
Reasoning: Apparent agency is not the same as apparent authority.
Apparent Agency creates an agency that doesn’t otherwise exist. Apparent authority simply expands the authority of the agent. Here, apparent agency existed, because McDonalds controlled the day-to-day business practices and procedures of 3K.
Black Letter Rule: A person who holds out another as an agent and causes a third party to reasonably rely on the care or skill of the apparent agent is liable for injuries to the third person for harm caused by that apparent agent.
Remember: Courts use corporate precedent for LLCs
Corporate Formation and Structure (MBCA §2.01-2.03)
- Formation is done under state law. Must file Articles of Incorporation w/ the state.
- After this, incorporators or initial directors draft bylaws of the corp. Bylaws set forth provisions for managing the business and regulating corporate affairs, consistent with state law and the articles of incorporation.
- Articles of incorporation set forth:
- Corporate name that indicates their status (inc., co., ltd.)
- The number and classes of authorized shares that may be issued by the corp
- The registered office and agent of the corp
- The name and address of each incorporator
- MCBA 4.01
Piercing the Corporate Veil
- Alter Ego – someone acts as an “alter ego” to the corp. The dominant shareholder or group of shareholders are using the corporation for personal dealings. The Alter Ego Test (NetJets):
- (1) If there is overall injustice or unfairness
- (2) The corp. is a mere instrumentality or alter ego of its owner, in that the corp. and the owner operate as a single economic unit. Factors to consider for this (totality of the circumstances test):
- Interests of company not distinguishable to those of the owner
- Failure to maintain adequate corporate records
- Commingling of funds/assets
- Management is vested in a Board of Directors – NOT in the shareholders
- Board of directors has a Duty of Loyalty (Duty of Good Faith)
- Relates to conflict of interest; must act in best interest of the corp
- Board of directors has a Duty of Care (relates to negligence) – director has a duty of a basic understanding of what the company does; being informed on how the company is performing; monitoring corporate affairs and policies; attending board meetings regularly; and making inquiries into questionable matters.
- Shareholders may vote on: directors, bylaws, changes in corp strcture
- How can shareholders be protected?
- Derivative Suit – A representative suit… The corporation is nominally the defendant, but is really the plaintiff. This type of suit arises when a corporation is harmed by bad decisions from the board of directors. – MAY REQUIRE DEMAND (see next page)
- Direct Suit – shareholders are directly harmed (Grimes)
- Easiest way to tell whether direct or derivative?
- If asking for money, probably a derivative suit. If no money, direct suit. But these are all over the place.
- Shareholders and directors of both corps must approve (with exceptions)
- Surviving corporation shareholders don’t vote unless they need to amend their articles of incorporation
- Directors can avoid shareholder vote by a triangular merger… Corporation Y merges into a subsidiary of corporation X, thus avoiding shareholders of Corp X from voting.
Derivative Suits – The Demand Requirement
See last page for what a direct suit is…
- Derivative suits require first that Demand is made on the board of directors UNLESS…
- The Barr Demand/Futility Standard
- Demand is excused because of futility when the complaint alleges with particularity that a majority of the board of directors is interested in the challenged transaction at issue, or a loss of independence because a director with no direct interest in the transaction is “controlled” by a self-interested director
- Demand is excused because of futility when a complaint alleges with particularity that the board of directors did not fully inform themselves about the challenged transaction to the extent reasonably appropriate under the circumstances
- Demand is excsed because of futility when complaint alleges with particularity that the challenged transaction was so egregious on its face that it could not have been the product of sound business judgement of the directors
- Assuming Demand is made, and accepted by the board of directors, OR assuming the Board of Directors thought demand was futile…
- A special committee will be appointed. They have the power of the entire board in bringing/not bringing a lawsuit. They look at whether the suit is in the best interest of the corporation.
- The Special Committee must…
- (1) Did the committee act independently,
- (2) in good faith, and
- (3) with reasonable investigation?
- The court is permitted to undertake an independent inquiry into whether the suit should be dismissed.
- Best plan: get disinterested, independent folks to be on your special committee.
The Business Judgement Rule
- A presumption that the directors act (or through inaction) on an informed basis, in a good manner, in good faith, and in a way that’s best for the corp. Party bringing suit must rebut this presumption. (Van Gorkem)
- Directors aren’t liable for judgements
- A duty of care issue arises.
- Exists because courts don’t want to second-guess the judgement of a business
- Doesn’t apply when directors have abdicated their responsibilities, or where there is a conflict of interest (this instead involves duty of loyalty, not duty of care.
- The burden of proof is on the P – must prove directors didn’t meet their duty of care. The standard under the Delaware Code is gross negligence
- Profit Maximization Rule – the purpose of a corporation is to make money for its shareholders. All actions taken by the corporation must further that purpose (Dodge v. Ford Motor Co.)
- Procedural Requirements for the Business Judgement Rule:
- (1) No Fraud
- (2) No illegality
- (3) No conflicts of interest
- (4) No Negligence
- (5) Decision isn’t irrational
The Duty of Loyalty
- Directors have an obligation not to put their own interests before the interests of the corporation.
- If a director wants to vote in his own interest it must be disclosed to the board of directors. The disinterested members of the board may then vote in good faith in the affirmative on what the interested member wants.
- Corporate Opportunity Doctrine – if someone on the board of directors is presented an opportunity to do something for the corporation, it is not required that they formally present the opportunity to the corporation’s directors if the corporation does not have an interest in or the financial ability to undertake the opportunity.
- Board of Directors personally accepting private stock allocations of an IPO of their own company when it enters the market, it is not allowed if the corporation itself could have purchased said stock.
- A parent corporation must pass the intrinsic fairness test in transactions with its subsidiary, IF AND ONLY IF that transaction with the subsidiary constitutes self-dealing. Otherwise, the BJR applies.
- Intrinsic fairness Standard provides that when a parent corp engages in self-dealing with its subsidiary, the burden is on the parent to prove that its dealing with the subsidiary is objectively fair
- Intrinsic Fairness Test – shareholder ratification of a transaction in which directors are personally interested will not shift the burden of proof to an objecting shareholder when the majority of shares that voted in favor of the transaction were held by the interested director.
- This is part of the BJR.
- Directors may not declare dividends for the purpose of personal profit.
Breach of fiduciary duty''''
Breaches of duty of loyalty
Breaches of duty of care
Breach of Duty to Monitor
Usurpation of corp. opportunity
(ex. Guth v. Loft, Broz v. Celluar)
Conflict of interest
Conflict alone is not a breach if cleansed (Del. § 144)
Breach of Procedural Care
Extreme failure to be informed before acting
(Ex. Smith v. Van Gorkom)
“Waste” (a.k.a. Substantive Due Care)
Corporate assets given for consideration so low no reasonable person would have agreed
|Directors ultimately monitor officers and employees on behalf of shareholders. However, Directors must delegate: esp. in larger corporations, the duty is to establish monitoring procedures, not spy on employees
Rule 10b-5 (tabbed in your supplement) – Think Insider Trading
It shall be unlawful for any person, directly or indirectly, by use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange…
- (a) to employ any device, scheme, or artifice to defraud
- (b) To make any untrue statement of a material fact or omit to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading or,
- (c) To engage in any pact, practice, or course of business which operates or would operate as a fraud or deceit upon any person
- … in connection with the purchase or sale of any security.
- A security is
- Stocks, notes, bonds'
- Evidence of indebtedness, investment contracts, or any instrument commonly known as a security.
- An INVESTMENT CONTRACT is a security if it meets these reqs:
- (1) Cash or property
- (2) Common enterprise (ex. LLC)
- (3) Reasonable expectation of profits – (depends on whether you participate in the efforts to make profits)
- Must be based on management efforts of others
- Corporate stock is always a security.
- Registration of Securities is required w/ the SEC. Three basic rules:
- (1) A security may not be offered for sale through the mails or by use of other means of interstate commerce unless a registration statement has been filed with the SEC
- (2) Securities may not be sold until the registration statement has become effective, and
- (3) The prospectus (a disclosure document) must be delivered to the purchaser before sale.
- Requirements for Private offerings
- Limited number of offerees
- Relationship b/w offerees and issuer must be attenuated
- Must disclose number of units offered >>>>>
- Size of offering must be disclosed
- Manner of the offering must be disclosed (AKA “did they advertise?”
- Overlaying all this is the real concern on the part of the court: Did the SEC have access to the information?
Fraud on the Market Theory (Proving Fraud Under 10b-5)
- Fraud on the Market Theory- no trader needs to prove they were influenced by a misleading statement made by a company in order to prove fraud. Do not need to prove reliance on the statement, just that the statement was made. STILL NEED TO PROVE THE FACTORS FOR FRAUD, THOUGH!
- Requires the Strong Form view of the Efficient Market Hypothesis – the market reflects all info, private and public. All stock prices reflect all info.
- Fraud factors:
- (1) Misrepresentation occurred
- (2) Misrepresentation was material
- Materiality depends on the probability actually happening and the totality of the magnitude of its impact.
- (3) Stock was traded in an efficient market
- (4) Stock was traded at the right time
- Rebuttable: “Price went up/down for some other reason!”
- Also need scienter (knowledge – recklessness is enough) and causation (the statement caused the transaction to occur, and caused the loss – “but for” causation)
- Fraud on the market theory does not apply to nonpublic statements (West v. Prudential)
- Rule 14e-3 – creates a duty to disclose to the public or abstain from trading on insider information.