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410
SHURA) elma KCInEoKes
Law of Business
Associatiory
‘ow can start @ business on your own. But if you want help with manage-
AY imme ti tt as
limited liability companies, and corporations are other ways of doing
business.
‘This chapter answers the following quettions: How are various business entities
formed? What are the advantages and disadvantages of various entities? What are the
tights, responsibilities, and liabilities of the individuals involved?
Bach of the forms of doing business is examined by reviewing its formation, sources
of funding, the personal liability of owners, tax consequences, management and
control, and the ease of transferring interest, Ewhibit 18.1 presents an overview of the
types of business entities.
Please accept my resignation, | don’t want to belong to any organiza-
tion that will accept me as a member.
Groucho Mane
Although our form is corporate, our attitude is partnership. We do
not view the company itself as the ultimate owner ef our business
assets but instead view the company as a conduit through which our
shareholders own the assets.
Warren bse
CChaieman, Berkshire Hathawa)
urpare &
For up-to-date legal news and real-world business applications,
go to: www.mariannejennings.com CONSIDER...
Michael Esner,then-CEO and chairman of Disney,
hired Michael Ovitz as is secondn-commene! st
Disney. Mr. Bsner had 2 fistory of not working
well with powerful secondsin-command, and. ~
Mr, Ovitz was a powerul Hollywood talent agent
and proctcer In less than one year, Mr. Ovitz and
Mr, Bner were at suck ods that Me. Eisner and
the board agreed 10 pay Mr. Ovitz more than
Sole Propr
Formation
etorships
Senqnnearaen tt!
{$38 milion in eath compensation and 3 milion
shares of Disney stock to leave the company.
‘The sharchalders brought suit against the Disney
board for lax supervision of Mr. Esner, the poor
business decision of hiring Mr. Ovi, and waste
for the amount pald to Mr. Ovite The board says
that just made a mistake. Can the shareholders
A sole proprietorship is not a true business entity because it consists only of an
individual operating a business. According to the U.S. Small Business Association,
‘most small businesses operate as sole proprietorships, with 50 percent operating
as home-based businesses. Often a sole prop!
ielorship is evidenced by the
following language: "Homer Lane d/b/a Green Grower's Grocery"; d/b/a is an
acronym for “doing business as.” There areno formal requicem’
sole proprietorship—it b
a “d/b/a” must be filed
Sources of Funding
F publi
‘Most sole proprictorships are sinall businesses, a
come from loans—through direct loans f
sent agencies as the Small Business Admi
in effect, investing in the sole proprietor.
Liability
‘it begins when an individual-does business, In 60
as a fictitious name for doing business.
for forming a
.nd their small initial capital needs
nes; throtugh loans from govern-
iGh; or from individuals who are,
Because financing for a sole proprietorship is based on the sole proprietor’s credit
‘business loan and his
‘or her assets are subject to attachment should a default occur
rating and assets the proprietor is personally liable for the
Tax Consequences
“The postive side ofa sole proprietors unlimited personal liability is the sight to claim
all tre losses associated with the business. The income of the business is the income
Of the sole proprietor and is reported as Schedule C on the individual's income tax
xretum. Sole proprietors owe all the taxes, but they also get all the business deductions.
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412° Part Four The Legal Environment of Business Operations
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Management and Control
In many businesses, the sole proprietor is both manager and
employee. The pioprietor makes all decisions, THiS fornt of business
operation is truly centralized management.
Transferability of Interest
A sole proprietorship can be transferred only if the owner allows
it. When a sole proprictor’s business is transferred, the transfer
consists of the property, inventory, and goodwill of the business,
‘Upon the owner's death, the heits or devisbés OF the owner inherit
BUSINESS PLANNING TIP
Before you deeide on the type of bs
nets sructure ou vl have, consit your
secountart co that you understard the
tax issves, inching age tex expenses,
Consul your layer to determine what
personal aes you can protect and how.
Ifyou are married, your spouce has certain
property rights that canaot Be taken away
just because you creas a new business
‘orginiztion Spend the time to find out
‘hat business arm wil serve you and
‘the business property. They could choose to operate the business or Your company Best
Hiquidate its assets. \, tree tome as
Partnerships
Partnerships are governed by some version of the Uniform Partnership Act
(GPA) and the 1994 Revised Uniform Partnership Act (RUPA). All states have
‘adopted one or some combination of these two laws. The RUPA. defines a part- .
nership as “the association of two or more persons to éaity on'as co-owners
a business for profit forms a partnership, whether or not the persons intend
to form a partnership.” “Persons” can include corporations as well as natural
persons aac areca
Formation
‘A partnership can be formed voluntarily by direct action of the parties, such as
through a partners i or articles-of partnership, or its formation can be
implied by conduct" However, conduct also creates partnerships.
Liv certain circumstances, courts find that a partnership exists because of the
conduct of the parties, a partnership by implication,,/4 partnership by impli-
cation arises because certain behaviors-of the principals léadl
‘third parties to
believe there is a partnership. Courts examine a number of factors to determine
whether a partnership by implication has been created, Section 7 of the RUPA
provides thet if two or more parties share the profits of a business, it is prima
{facie evidence that a partnership exists. (Prima facie evidence means that there is,
‘2 presiumption that a partnership exists.) However, the presumption of partner-
ship by profit sharing can be ovércotne if someone received profits for any of
the following reasons:
1, Profits paid to repay debts * gion
2. Profits paid as wages or rent \ ehainion "gr
3. Profits paid to a widow or an estate fepresentative
4, Profits paid for the sale of business goodwill
‘Many shopping center leases, for example, provide for the payment of both a
fixed amount of rent and a »Enet profits. The owners of the shopping
center profit as the stores do, but the owners profit as landlords, not es pertners
with the shopping center businesses. oak 414 Part Four The Legal Environment of Business Operations
In addition to partnerships by implication, parties can also have partner
ship liability if the conduct of two or more parties leads others to believe that a
partnership exists. A cousin to apparent authority (see Chapter 15), partnerships
by estoppel arise when third parties are led to believe there is a partnership, such
{as when two people act as if they are partners,
Byker v. Marines (Case 18.1) adresses the question of whether a partnership is
implied by the conduct of two principals.
Dumb and Dumbfounded
FACTS
In 1985, David Byker (plaintiff) was doing accounting,
work for Tom Mannes (defendant). The two talked!
about going into business together because they had
complementary business skills. Mr. Mannes could
locate certain ‘properties because of his real estate
background, and Mr Byker could raise money for their
property purchases,
‘The two had investment interests in five real estate
limited partnerships. They shared equally in the com-
missions, financing fees, and termination costs of all
the partnerships. The two also personally guaranteed
loans for these investments from several financial
institutions,
‘The business relationship between the parties
began to deteriorate after they created Pier 1000 Ltd,
in order to own and manage a marina. The marina
had serious financial difficulties, and Byker and
Mannes placed their profits from another partner-
ship, the M & B Limited Partnership Il, into Pier 1000
Ltd. and borrowed money from several: financial
institutions.
When Mr. Mannes refused to make any addi-
tional monetary contributions, Mr. Byker continued
to make loan payments and incurred accounting fees
onbehalf of Pier 1000 Ltd. Mr. Byker also entered into
several individual loans for the benefit of Pier 1000
Lid. Mz. Mannes had no knowledge of these extra
transactions.
The matina was retumed to its previous owners
{in exchange for their assumption of Mr, Byker’s and
‘Mr. Mannes's business obligations. Mr. Byker and
‘Mr. Mannes ended their business ventures together.
Mr. Byker then approached Mr. Mannes to obtain.
hhis share of the payments of the losses from the
various businesses. Mr. Manes testified that he
was “absolutely dumbfounded” by the request for
money.
Mr. Byker then filed suit for the payments,
saying that the two had a partnership. The court
determined that the two had created a general part-
nership that included all of the business entities, The
Court of Appeals reversed that decision, Mr. Byker
appealed.
JUDICIAL OPINION
MARKMAN, Justice
“[iJheve is no necessity that the parties attach the label
‘partnership’ to their relationship as long as they in fact
both mutually agree to assume a relationship that falls
within the definition of a partnership.”
[t]he focus is on whether individuals intend-
ed to jointly cany on a business for profit regard
less of whether they subjectively intended to form a
partnership,
Stated more plainly, the statute does not require
partners to be aware of their status as “partners” in
order to have a legal paztnership,
‘With the language of the statute as our focal point,
we conclude that the intent to create a partnership
is not required if the acts and conduct of the parties
otherwise evidence that the parties carried on as
‘co-owners a business for profit. Thus, we believe that,
to the extent that the Court of Appeals regarded the
absence of subjective intent to create a partnership
8 dispositive regarding whether the parties carried Chapter 18
fon as co-owners a business for profit, it incorrectly
interpreted the statutory (and the common) law of
partnership in Michigan.
‘Accordingly, we remand this matter to the Court of
Appeals for analysis under the proper test for determin-
ing the existence of a partnership under the Michigan
‘Uniform Partnership Act.
CASE QUESTIONS
1. What type of relationship did Mr. Byker and
‘Mr. Mannes have?
2. What does the court say about the type of intent the
parties must have for a partnership?
SE
CONSIDER... .
Richard Chaiken entered into agreements Wit
‘work hours and holidays. The Delawete!
that Mr. Strazella and Me. Spitzer at
tmemployment compensation forthe ta
partners and not employees, Who ls ccecl(Chal
yyment Security Commis
pléyess, not partners, and seeks to collect
Darbess. Ms, Chalken maintains that they are
vi; Entployment Security Comm'n, 274
Business Structure; The Law of Business Associations 415)
. What lessons should Mr. Mannes learn from his
‘experience in having to pay Mr. Byker when he
thought the partnership was over?
“this case created a Bit of a tuselo between the Michigan
Coart of Appeals and its Supreme Court. Following this
decision and remand, the Cour of Appeals found that there
twas no partnership because the parties had to be aware of 3
to be liable, thus defying the Michigan Supreme Court. On.
appeal, the Michigan Supreme Court reversed the Court of
“Appeals, 668 N.W2d 909 (Mich. 2063), not offering an opin
font but explaining it wae reversing forthe reasons stated in
the dissenting opinion of the Court of Appeals on the second
round.
STEN
18.1
fe Strazella and Mr. Spitzer to operate
fa barbershop. Mr. Chaiken. was to” prod. barber chair, supplies, and licenses,
‘Me, Strazella and Mr. Spitzer were t9 bring thelr tools; and the agreements included
jon determined
‘A.28.707 (Del. 1971),] (Analysis appears at the end of the chapter.)
Sources of Funding
Funding for a partnership comes from partners who.
services to fl
ie property, cash, oF.
inership. Not only are these contributions (the capital) put at the"
risk of the buSiness, buPS6 also are each of the partners’ personal assets: Partners
Partner Liability
of the partnership's obligations, even”
Each partner is both a principal and an agent to the other partners and is liable for
the acts of others and to the others for individial acts. If oh paftner enters into
a contenct for partnership business supplies, all the partners are Hable. Sizllarly;~
if one partner has a motor vehicle accident while on a partiership delivery, the
individual partner is Hable for his or her ovr negligence, but because the accident
‘occurred under the scope of a partnership business, the partners and the partner
ship are also liable, Under the RUPA, partners are jointly and severally Liable for
all obligations.
Tf partnership assets are exhausted, each partner is individually lable, Creditors
can satisfy their claims by looking to the assets of the individual partners after the
partnership ascets are exhausted.
Veabel v. Acri (Case 18.2) deals with an issue of partnership liability. 416 Part Four The Legal Environment of Business Operations
FACTS
On February 17,1947, Stephen Veabel and a companion
went into the Acti Cafe in Youngstown, Ohio, to buy
alcoholic drinks. While Mr. Vrabel and his companion
were sitting at the bar drinking, Michael Acri, without
provocation, drew a 38-caliber gun, shot and killed
‘Mr. Vrabel’s companion, and shot and seriously injured
(Mr. Veabel. Mr. Acti was convicted of murder and sen-
tenced to a life term in the state prison,
Florence and Michael Acri, as partners, had owned
and operated the Acri Cafe since 1983, From the time
of his marriage to Mrs, Acri in 1931 until 1946, Mr. Acri
hhad been in and out of hospitals, clinics, and sanitari-
‘ums for the treatment of mental disorders and nervous-
ness, Although he beat Mrs, Acri when they had marital
difficulties, he had not attacked, abused, or mistreated
anyone else, The Acris separated in September 1946,
and Mis. Acti sued her husband for diverce soon after-
ward. Before their soparation, Mes. Acri had operated
and managed the cafe primarily only when Mr. Acri
“was ill. Following the marital separation and until the
time he shot Mr. Vrabel, Mr. Acti was in exclusive con-
‘ol of the management of the cafe
Mr. Vrabel brought suit against Mrs. Acti to recover
damages for his injuries on the grounds that, as Mr.
Acsi’s partner, she was Tiable for his tort. The trial
‘court ordered her to pay Mr. Vrabel damages of $7,500,
Mars, Acti appealed.
JUDICIAL OPINION
ZIMMERMAN, Judge
‘The authorities are in agreement that whether a tort is
committed by a partner or a joint adventurer, the prin-
ciples of law governing the situation are the same, So,
‘where a partnership or a joint enterprise is shown to
‘exist, each member of such project acts bath as principal
and agent of the others as to those things done within
the apparent scope of the business of the project and
for its benefit
‘However, itis equally true that where one member
of a partnership or joint enterprise commits a wrongful
and malicious tort not within the actual or apparent
scope of the agency, or the common business of the
Particular venture, to which the other members have
hot assented, and which has not been concurred in
or ratified by them, they are not liable for the harm
‘thereby caused.
Because at the time of Vrabel's injuries and for a
Jong time prior thereto Florence had been excluded
from the Acri Cafe and had no voice or control in its
management, and because Florence did aot know or
have good reason to know that Michael was a danger-
ous indiviual prone to assault cufe patrons, the theory
of negligence urged by Vrabel is hardly tenable.
We cannot escape the conclusion, therefore, that the
above rules, relating to the nonliability of a partner or
joint adventurer for wrongful and malicious torts com-
mitted by an associate outside the purposes and scope
(of the business, must be applied in the instant case. The
willful and malicious attack by Michael Acti wpon Vrabel
fn the Acri Cafe cannot zeasonably be said to have come
within the scope of the business of operating the cafe,
80 28 to have rendered the absent Florence accountable.
Since the liability of a partner for the acts of his
associates is founded upon the principles of agency,
the statement isin point that an intentional and willl
attack committed by an agent or employee, to vent his
‘own spleen or malevolence against the injured person,
is a clear departure from his employment and his prin
cipal or employer is not responsible therefore.
Judgment reversed.
CASE QUESTIONS
11. What was the nature ofthe business and the injury?
Why Js this information important for liability
purposes?
2, Why was Mr. Acti nota defendant?
3, Is Mis. Act liable for the injuries? Explain,
8
Tax Consequences in Partnerships
A partnership does not pay taxes. It simply files an informational return. The
partners, however, must report their share of partnership income (or losses) and
deductions on their individual tax retums and pay taxes on the reported share. Chapter 18 Business Structure: The Law of Business Associations
Management and Control
Partnership Authority,
‘Unless agreed otherwise, each partner has a duty to. contribute time to manage the
partnership. Each partner has an equal management say, and each has @ right to
tise partnership property for partnership purposes. No one partner controls the
property, finds, or management of the itm unless the partners agree 10 delegate vw. {ho
authority or even delegate dl day to-day znanagement responsibilities to one or
mora.of the pa Partners are not entitled to compensation for their efforts in
the partnershipunless they agree toi ER BS
Each partner is an agent of the other partners (see Chapter 15), and each has
the authority given in the agceement or implied by custom Some partnership mat-
ter requitelnanimoug sorkanfof the partners and include confessing a judgment
(settling a lawsuit); transferting all the partnership's sets, oF selling its goodwill
Basically, unusual transactionexequirg all the partners! approval. ~~
Partner Fiduciary Duties
Because each partner is an agent for the partnership as well as for the other part-
ners, each partner owes the partnership and the other partners the same fiduciary
duties an agent owes a principal. Partners’ obligations as fiduciaries are the same
as agents’ duties to principals. ~~ dey 8A!
Partnership Property
Partnership property is property contributed to the firm as.a capital contribution or
property purchased with partnership funds, Parmers are é0-owners of partnership
‘property in a form of ownership called texancy it partnership. Tendnle'ih’partner-
ship have equal rights in the use and posséssiSA of the property for partnership
purposes. Upon the death of one of the pé rights in the property are trans-
ferred to the surviving partner oF pattniers. The partnership interest inthe property 3,
remains, and the property or a share of the property is not transferred to the estate gu?
of the dectaséd partner. The estate of the deceased paitner simply receives the
value of the partner's interest, not the property.
Partner interests
Partners’ interests in the partnership are different from partnership property.)
‘A partner's interest is a personal:property interest that belongs to the partner. It
ipl eacnres) fel ocala! wee Crore Gerona)
can Sich partners interests to collect debt. ya too,
‘A transfer of a partner's interest does not result in the transferee becoming-a
‘new partner because no person can hecome-a-partner without the.consentof all
the exiting partners. Further, the transfer does not relieve the transferring partner
of personal lability. A transfer-of interest will-not eliminate individual lability to
existing creditors. :
ae
Transferability of Interests
‘A partner cannot transfor partnership status without the ghanimous consent
of the other partners. Absent an agreement from SN acs
remain personally liable for all partnership debts up to the time they leave.
If depatling partners give public notice of their disassociation, their personal.
liability for future contracts and obligations ends once they leave. Incoming.
partners are liable for all contracts after the date they come into the fifm,
aur 418
Part Four
The Legal Enviranment of Business Operations
Incoming partners’ liability for existing debts is limited-to the amount of their
capital contribution. ai
The Byker case also illustrates that partnership liabilities do-Rot énd when-the
partners no longer do business together: ‘The debt Femain arid must be satisfied,
even frost partners no longer involved in running the business,
Por gd Ah hae
Dissolution and Termination of the Partnership
Dissolution, jg not necessarily termination. The UPA defines dissolution as one
partner's cettsig to be associated with carrying on the business, The RUPA refers
to “dissociation” of partners, which may or may not lead to dissolution. When a
partner leaves, retires, or dies, the partnership is dissolved, althougltnot termi-
nated /Dissoliition is Basically ac ige in the of the partnership. The
parinership may be reorganized and’ continue business without the partner who
is gone.
Dissolution car lead, however, to termination of the partnership. Termination
sneans that all business stops, the assets of the firm are liquidated, and the proceeds
are distributed to creditors and partners to repay capital contributions and distrib-
ute profits (if any). Dissolution occurs by agreement, by operation of law (events
such as the death or bankruptcy of a partner result in automatic dissolution), and
by a court order (something a court will order when the partners cannot longer
work together)
Limited Partnerships
A limited partnership is a partnership with a slight variation in the liability of
those involved. Limited partnerships must include at least one general partner
and one limited partner, General partners have the same obligations as partners
in general parmerships—fall liability and full responsibility for the management
of the business. Limited partners have liability up to the amount of their contri-
bution to the partnership, provided they are not involved in management of the
firm. General partners run the limited partnership, and the limited partners are
the investors.
‘The Uniform Limited Partnership Act (ULPA) has been the predominant form
of business organization for oil exploration and real estate development because of
the tax advantages available through limited partnerships. The Revised Uniform
Limited Partnership Act (RULPA) was created in 1985 to update limited partner-
ship law and has been adopted in nearly every state,
Formation
A limited partnership is a statutory creature, and it requires compliance with cer-
tain procedures in order to exist. If these procedures are not followed, the limited
pattners may lose their limited liability protection.
‘The RULPA requires detailed information when individuals file at the appro-
priate government agency for the creation of a limited partnership, including a
name that contains the designation of “limited partnership” as well as complete
information about the general pariner, statutory agent, and addresses for all
‘The certificate of limited partnership is simply public disclosure of the
formation and existence of the limited partnership. The relationships and rights Chapter 18 Business Structure: The Law of Business Associations
of the partners are then addressed in a much longer document called a limited
partnership agreement or the articles of limited partnership.
Sources of Funding
Capital contsibutions supply the initial funding for a limited partnership. Both the
goneral and limited partners make contributions upon entering the partnership.
‘Under the RULPA, the contribution can be in the form of cash, property, services
+ already perforined, ot a promissory note or another obligation to pay money or
property. The RULPA requires that limited partners’ promises to contribute be in
the form of a tangible record in order to be enforceable.
Liability
‘The principal advantage of a limited partnership is the limited personal liebility
To ensure personal limited liability, several requirements must be met. First, 23
already discussed, a certificate of limited partnership must be filed, indicating
the limited liability status of the limited partners. Second, at least one general
partner is required, The genieral partner can be a corporation. Third, the limited
partners must be careful about their activity in the partnership and their appear-
lances with operations of the partnership. Under the RULPA, a limited partner
‘who participates in management of the firm in the same way the general partner
does is liable only to those persons who are led to believe by the limited partner's
‘conduct that the limited partner is a general partner. The RULPA also provides
a list of activities that limited partners can do without losing limited liability
status:
1. Being employed by the general partnership a8 an employee or a contractor
2. Consulting with or advising the general partner
3, Acting as a surety or guarantor for the limited partnership
4. Voting on amendments, dissolution, sale of property, or assumption of debt
[If limited partners comply with these rules on restricted activities their liability
i limited to the amount of their capital contribution. If they have pledged to pay a
certain amount as capital over a period of time, they are liable for the full amount.
For example, some real estate syndications that are limited partnerships allow the
limited partners to make their investment in installment payments over two to
four years, Limited partners in these arrangements are liable for the full amount
pledged whenever an obligation to a creditor is not paid.
Tax Consequences
Limited partnerships are taxed the same way as general partnerships, The general
and limited pariners report the income and losses on their individual returns and
pay the appropriate taxes. A limited partnership files an information return but
does not pay any taxes itzelf.
Limited partnership interests are closely scrutinized by the IRS to determine
whether they are, in reality, corporations as opposed to true limited partnerships.
Some of the factors examined in determining whether an organization is a corpora-
tion ora limited partnership are (1) the transferability of the interests (2) the assets
of the general partners, and (3) the net worth of the general partners.
a9 ‘The Legal Environment of Business Operations
Management and Control
Profits and Distributions
‘The general partner decides when to distribute funds to limited partners, and
profits and losses are allocated on the basis of capital contributions. Under the
RULPA, the agreement for sharing profits and losses must be evidenced by a
record.
Partner Authority
The authority of the general partner in a limited partnership is the same as the
authority of the partners in a general partnership, There are, however, some gener-
al activities the general partner cannot perform without the consent of the limited
partners, including the following:
1. Admitting a new general partner (also requires consent of other general
partners)
2. Admitting a new limited partner unless the partnership agreement allows it
3. Participating in extraordinary transactions, such as selling all the partner-
ship assets
Limited partners can monitor the general partner's activity with the same rights
provided to partners in general partnerships: the right to inspect the books and
records and the right to an accounting,
‘Transferability of Interests
Although the assignunent of limited partnership interests is not prohibited
by the RULPA, a limited partnership agreement may provide for restrictions
on assignment. Limited partnership interests may have been sold without
registration as exemptions to the federal securities law (see Chapter 19 for
more details on securities registrations). If those exempt interests are read-
ily transferable, the exemption could be lost. Also, for the limited partners to
enjoy the tax benefits of limited partner status, the case of transferability is a
critical issue,
‘The assignment of a partnership interest does not terminate a limited partner
ship. The RULPA allows limited partners to decide whether they want to transfer
their interest or their limited partner status,
Dissolut
n and Termination of a Limited Partnership
A limited partnership can be dissolved in any one of the following ways:
1. Expiration of the time petiod designated in the agreement or the occurrence
of an event causing dissolution, as specified in the agreement
2 Unanimous written consent of all partners
3. Withdrawal of a general partner
4. Court order after application by one of the partners
Upon dissolution, a partnership can continue (assuming that a general partner
remains); but the partnership can also be terminated after dissolution. If termina-
tion occurs, all assets of the partnership are liguidated. The RULPA specifies an
order of distribution, Chapter 18 Business Structure: The Law of Business Associations, 421
Corporations
Corporations are legal entities in and of themselves. Because they are treated as
persons under the law, they can hold title to property, they can sue or be sued
ja the corporate name, and they are taxed separately. The latest U.S. Census
figures (2008) indicate that there are 5,930,132 corporations in the United States
Interestingly, 3,617,764 of those corporations have 0-4 employees, and 5,911,663
have fewer than 500 employees. Small businesses choose the corporation structure
for many reasons, reasons you will understand from the following sections.
Types of Corporations
Corporations aze either profit corporations (those seeking to eam a retum for
investors) or nonprofit corporations, There are domestic corporations and. foreign
corporations. Aéorporation is a domestic corporation in the state in which itis incor-
pporated and a foreign corporation in every other state. Government corporations,
Such as TVA, are organized to advance a social interest, such as the development of
hydro power: Professional corporations are corporations organized by physicians,
dentists, attorneys, and accountants; they exist by statute in most states, Professional
Ef ob oh
‘corporation shareholders have no persorslligility for any corporate debts, asin any‘
rp Ps ability or any corpo! Any oy
other corporation, except for professional malpractice claims,‘The corporate veil or
shield (explained later) will not give individuals personal ifimtnity for professional
negligence despite their general Linbility limitation through incorporation. Close
‘corporations aze the opposite of publiely held corporations; that is the former are ~
corporatisns. with few. shareholders. Close corporations are governed by specific
state statutes and generally have more discretion in theix internal operations, with
less formality. vw de
"The § corporation (sometimes called Subchapter $ or Sub $ corporation)
is formed no differently from any other corporation, but it must meet the IRS
requirements for an $ corporation and must file a special election form with the
TRS indicating that it wants to be treated as an S corporation, The benefit of an S
corporation is that sharcholders’ income and losses are treated like those of part-
ners, but the shareholders enjoy the protection of limited Liability tehind a corpo-
rate Veil, The income eared and losses incurred by an S corporation are reported
‘on the shareholders’ individual returns, but the shareholders’ personal assets are
protected from creditors of the business.
‘The Law of Corporations
‘The Model Business Corporation Act (MBCA), as drafted and revised by the
Corporate, Banking, and Business Section of the American Bar Association, is the
‘uniform law on corporations. The provisions of the MBCA are quite liberal and
give management great latitude in operations. The MBCA tends to follow the
rindiples of corporate law long established in Delaware, a state where many of
the country’s major companies are incorporated. Delaware boasts a sich body of
‘case law on corporate governance that offers the stability companies want as they
incorporate. Despite the ability to draw on the Delaware case law and experience,
the MBCA is not adopted as widely as the UPA or the UCC. Even those states that
have adopted the MBCA have made significant changes in their adopted versions.
‘As a result, each state's law on corporations is different. The following sections
‘cover the revised MBCA rules, but each state may have its own variations.
lose
able b
gonetti on
u
et vonpor Part Four The Legal Environment of Business Operations
Formation
A corporation is a statutory entity. Formal public filing is required to create a cor
oration. The following procedures for corporate formation are those of the MBCA,
Where to Incorporate
‘The following factors should be considered when determining in which state to
incorporate:
1. The status of the state's corporation laws (see the preceding discussion about
Delaware; also, some'states’ laws and judicial decisions are oriented more
toward management than shareholders)
2, State tax laws
3. The ability to attract employees to the state
4, The incentives that states offer to attract the business (new freeways, office
space, attractive urban renewal)
The Formation Document
All states require that articles of incorporation be filed to create a corpore-
tion, Under the MBCA, the articles of incorporation must include the following
information: 7 .
1. The Haine of the corporation
2. The names and addresses of all incorporators (in addition, each incorporator
must sign the articles of incorporation)
3. ‘The share structure of the corporation: (a) the common and preferred classes;
(©) which shares vote; and (c) the rights of shareholders, or preemptive righ's
4. The statutory agent (the party who will be served with any lawsuits against
the corporation)
Who Is Incorporating
‘The incorporators (required to be listed in the articles of incorporation) are the par-
ties forming the corparation, Under the MBCA, only one incorporator is required,
and that person may bea natural person, a corporation, a partnéiship,a limiled
Partnership, or an. association. ieee raeee eee
Incorporators are perdonally liable for any contracts entered into or actions
taken during the pre-incorporation stage. After incorporation, the corporation
could agree to assume Lability through a novation of the incotporators’ acts. For
example, f an incorporator of a lumberyard entered into a contract for the pur-
chase of lumber and the corporate boars ate formation agreed tat the contrat
was a good ane, the corporation could fatify itor enter into a novation to assume
ability. In rovation, the lumberyard agrees to substitute the corporation as the
contracting party. In a ratification, the corporation assumes primary liability for
payment, but the incorporator still remains liable,
Postformation ae
After the paperwork of incorporating is complete, a corporation must begin
its day-to-day operations with an initial meeting. At this meeting, the officers
of the corporation are elected and bylaws aze adopted to govern corporate
Procedures, The bylaws proscribe meeting processes (that is, quorum numbers
0 Chapter 18 Business Structure: The Law of Business Associations
and voting numbers) and set the terms of officers and directors. Articles of
incorporation give an overview of a corporate entity; the bylaws constitute the
operational rules.
Capital and Sources of Corporate Funds
‘A corporation has a variety of sources for funds. It may use short-term financing,
hich consists of loans from banks or credit lines, The other forms of financing
used most frequently by corporations ate debt and equity.
Debt Financing: The Bond Market
Long-term debt financing is available to corporations when they issue bonds
Bonds are, in effect, long-term promissory notes from a corporation to the bond
buyers. The corporation pays the holders interest on the bonds until the maturity
date, which is when the bonds are due or must be paid. The interest is fixed and
is a fixed-payment responsibility regardless of the corporation's profitability. The
benefits of debt financing include the tax deductibility of interest as an expense.
Bondholders have the benefit of first rights in corporate assets in the event of
insolvency. 24 28 SS :
Equity Financing: Shareholders
Equity financing comes through the sale of stock in a corporation. Shareholders are
given shares of stock in exchange for their money. To avoid personal liability, the
shareholders must pay at least par value for their shares and must! ee
of their subscrintion agreement (Ghare purchase agreement), A shareholder who
hhas not paid-at least par value holds.watered shares and is liable to creditors for
the amount not paid. For example, if a shareholder paic $500 for shavés with a par
value of $1,000, the shareholder would be personally liable for the $500 difference
‘The rights of sharcholders depend on the type of stock purchased. A discussion of
the various types of stock follows.
Common Stock Common stock is the typical stock in a corporation, and it gener-
ally cates voting yights so that common shareholders have a voice in the election
of directors, the amendment of articles and bylaws, and other major corporate mat~
ters. Common stock dividends depend on profitability and decisions of the board
directors. If corporation is dissolved, the comurion shareholders have a right ®O
a proporlignate share of the assets (after creditors and preferzed stockholders have
been paid).
Preferred Stock Preferred stock is appropriately named because its owners
enjoy preferred status over holders of a corporation's common stock. For example,
preferred stockholders have priority in the payment of dividends. Some preferred
Gividends even have a fixed rate, and cumulative preferred stock guarantees the
payment of a dividend so that if a dividend is not paid in one year, the holder's
ight to be paid carries over until funds are available, Preferred shareholders also
have priority over common shareholders in the assets in the event the corporation
is dissolved.
Shareholder Liability Sharcholders’ personal liability is limited to the amount of
their investment in the corporation. The personal assets of shareholders are not
a3 424 Part Four The Legal Environment of Business Operations
subject to the claims of corporate creditors. In some circumstances, however, such
as watered shares (discussed earlier), a shareholder is personally liable.
Jn other moze serious circumstances, shareholders can, be ligld lble for the
full amount of corporate debts. A creditor who successfully’ pierces the corporate
veil can collect from the personal assets of shareholders. The corporate veil can
be pierced for several reasons. One is inadequate capitalization, The owners of a
corporation are required to place as much capital at risk in the corporation as is
necessary to cover reasonably anticipated expenses of the business, The purpose of
this requirement is to ensure that someone does not use the corporation to avoid
liability without actually transferring assets to the corporation,
Another theory a court can use to pierce the corporate veil is the alter ego
theory; Whichimeans that the owners and managers of thé Corporation Rave not —
treated the cosporation as a separate entity but have used the structure more as a
personal réSource. Personal and corporate asseis and debi ave mixed, no formality ——
is observed with regard to operations and meetings, and transfers of property are
made without explanation or authorization,
U.S. v. Bestfoads, Ino. (Case 18.3) deals with an issue of piercing the corporate
veil in a situatior
Lifting the Veil Is Best for Cleanup, but Not for Shareholders
FACTS
{in 1987, Ott Chemical Co. manufactured chemicals atits
plant near Muskegon, Michigan, and both intentionally
and unintentionally dumped hazardous substances in
the soil and groundwater near the plant. Ott sold the
plant #o CPC Internationa, Inc.
In 1965, CPC incorporated a wholly owned subsid-
iary (Ott I) to buy Ott’s assets. Ott LI then continued
both the chemical production and dumping. Ott I's
officers and directors had positions and duties at both
+ CPCand Ott
In 1972, CPC (now Bestfoods) sold Ott It to Story
(Chemical, which operated the plant until its bankrupt-
cy in 1977, Acrojet-General Corp. bought the plant from
the bankruptcy trustee and manufactured chemicals
there until 1986, 7
Tn 1989, the EPA filed sult to recover the costs of
cleanup on the plant site and named CPC, Aerojet, and
the officers of the now defunct Ott and Of I
‘The District Court hold both CPC and Aerojet
liable. After a divided panel of the Court of Appeals
for the Sixth Circuit reversed in part, the court granted
@ rehearing en hone and vacated the panel decision.
wolving CERCLA liability (see Chapter 9).
‘This time, seven judges to sx, the court again reversed.
the Distzict Court in part. Bestfoods appealed (Ott
settled prior to the appeal)
JUDICIAL OPINION
SOUTER, Justice
The issue before us, under the Comprehensive
Environmental Response, Compensation, and Liability
‘Act of 1980 (CERCLA), is whether a parent corpora:
tion that actively participated in, and exercised contzol
over, the operations of a subsidiary may, without
‘more, be held liable as an operator of a polluting facl-
ity owned or operated by the subsidiary. We answer
no, unless the corporate veil may be pierced. But a
corporate parent that actively participated in, and
exercised control over, the operations of the facility
itself may be held dizectly linble in its own right as an
operator of the facility,
Tt is a general principle of corporate law deeply
“ingrained in our economic and legal systems” that
@ parent corporation (so-called because of control
through ownership of another conporation’s stock) is
not liable for the acts ofits subsidiary.
conTiNUED Chapter 18 Business Structure: The Law of Business Associations 425
But there is an equally fundamental principle of
corporate law, applicable to the parent-subsidiaryrela-
tionship as well s generally, that the corporate veil
may be pierced and the sharcholder held liable fr the
corporation's conduct when, inter alia, the corporate
form would otherwise be misused to accomplish certain
‘wrongful purposes, most notably fraud, on the share-
holder's behall
"Nothing in CERCLA purports to rewrite this well
settled rule ether. If a subsidiary that operate, but
dloes not ovrn, a facility is so pervasively controled by
its parent fora sufficiently improper purpose to war-
rant veil piercing, the parent may be held desivatively
liable forthe subsidiary’s act as an operator.
‘The fact that a corporate subsidiary happens to own
«polluting faclty operated by its parent does nothing,
then, fo displace the mule thatthe parent “corporation
is [tell] responsible for the wrongs committed by its
‘agents in the course of its business." It is this direct
liability that is properly seen as being at issue here.
Under the plain language ofthe statute, any person
who operates a polluting facility is directly lable for
the costs of cleaning up the pollution. This is 0 ragard-
Jess of whether that person is the facility's owner, the
‘owner's parent corporation or business partner, ot
even a saboteur who sneaks into the facility at night
to discharge its poisons out of malice. If any such act
of operating a corporate subsidiary’s facility is done
con behalf of a parent coxporatian, the existence of the
parent-subsidiary relationship under state corporate
lav is simply izelevant tothe issue of direct liability.
With this understanding, we are satisfied that the
Couzt of Appeals cosrectly rejected the District Court's
analysis of direct lisbilty. But we also think thatthe
appeals court erred in imiting direct lability under the
statute to a parent's sole or joint venture operation, 80
as to climinate any possible finding that CPC is liable as
an operator onthe facts ofthis case
Jn sum, the District Court's foes on the relation:
ship between parent and subsidiary (eather than parent
and facility), combined with its automatic attibution of
Corporate Tax Consequences
an
the actions of dual officers and directors to the corpo-
rate parent, erroneously, even if unintentionally, treat-
ed CERCLA as though it displaced or fundamentally
altered common-law standards of limited lability...
‘There i, in fact, some evidence that CPC engaged
injust this type and degree of activity at the Muskegon
plant. The District Couct’s opinion speaks of an agent
‘Of CPC alone who played a conspicuous part in deal-
ing with the toxie risks emanating from the operation
of the plant. G.RD. Williams worked only for CPC;
he was not an employee, officer, or director of Ott,
and thus, his actions were of necessity taken only om.
behalf of CPC. The District Court found that “CPC
became directly involved in environmental and regu-
latory matters through the work of...Williams, CPC's
governmental and environmental affairs director.
Williames...became heavily involved in environmen
tal issues at Ott TL” He “actively participated in and
exerted control over a variety of Ott If environmental
matters,” and he “issued directives regarding Ott I's
responses to regulatory inquiries.”
‘We think that these findings are enough to raise
fan issue of CPC's operation of the facility through
‘Williams's actions, though we would draw no ultimate
conclusion from these findings at this point, Prudence
thus counsels us to remand [to determine} who might
be said to have had a part in operating the Muskegon,
faelity.
‘The judgment of the Court of Appeals for the Sixth
Circuit is vacated, and the case is remanded
CASE QUESTIONS
1. Describe the corporate ownership history that
surrounds the Muskegon facility
2, Is there a special CERCLA rule for piercing the
corporate veil?
3, What must be shown to hold a parent liable for the
actions of the subsidiary? Are joint directors of par-
cent and corporate suibsidiaries alone evidence of a
need to plerce the corporate veil?
SISTA
qual to Age
Although corporations have the benefit of limited liability, they have the detriment
of. double taxation. In addition to the corporation paying taX85"On its-eamings;~
shareholders must report their dividend income on their separate returns and pay
individual taxes on their dividend income. However, these shareholders pay taxes
only if the dividends ace paid. Unlike partnerships in which the partners pay taxes
on earnings regardless of whether they are distributed, shareholders pay taxes on
corporate earnings only when those earnings are distributed to them. One way to
resolve the problem of the cost of double taxation is the S corporation (see p. 421). 426 Part Four The Lega! Environment of Business Operations
Corporate Management and Control:
/ Directors and Officers
ade controled 45 -¥97A corporation might be owned by a million shareholders, but is o eration will be
CVF gonperete, polis nol controlled by the hands of a fev, the board of directors, The shaTeholdlers elect those”
bared plor Oo. Greciors, who SAE ee ae
bec’ dsculc s° corporation. They also provide insi fe perspectives orrcurfeiit manage. >
yy )"“ment practices. In addition, they serve a watchdog role, as with the now mandatory) “°"n
audit committees required ofall stock exchange companies. Audit committees, made
‘up of independent outside directors and at least one financial expert under Sarbanes-
Oxley wha hive no tortrscis ot former ialay for with fe smpany, are responsible
£
Ss and stategic planners for the
ay
for ensuring that the financial reports issued by management are accurate.
Institutional investors and other groups have been placing increasing pressure
‘on boards for accountability. One director responsibility that receives ongoing
attention is that of officers’ compensation. Directors not only elect the officers of the
corporation but also decide the salaries for these officers and themselves. The issue
of officer compensation has received cong?éssional attention with the deductibility
of officer compensation limited to $1 million annually and ongoing attention from,
shareholders in terms of limits on compensation. The issue of executive compensa-
tion was front and center in the fall 2008 financial bailout legislation and has been
the subject of additional regulation since the market collapse. (See Chapter 19 for
‘more information on such proposals, and see p. 430 for a summaty of the changes.)
Director Liability tay Ahote
Officers and directors are fiduciaries of the corporation, which means they are
to act in the best interests of the corporation and not profit at the corporation's
‘expense. They are subject to the business judgment rule, a standard of corporate
behavior under which it is understood that officers and directors Can make mis-
takes, but they are required to show that their decisions yere,made after careful
study and discussion. In those decisions, they may 26Abult’éeperts (for example,
attorneys, accountants, and financial analysts), but again, they need to show that
these experts were well-chosen and reliable individuals.
Brelim v. Eisner (Case 18.4) deals with the business judgment rule and provides
the answer for the chapter-opening “Consider” problem.
Kind of a Mickey Mouse Judgment Call
FACTS Sempany, other companies with entrainment oper
: sons had been intersted i hiring him for high-evel
cl Hane en-CED at haan of Dey, Smead Bn tte ng hn ox he
trae along ne ee poney es Presklent Mr. Ove Sy unalerally negotiated by Biser ond oppeoved by
on importon let bees nein ataett® the “Old Board” The Olt Bod fal tat Orta
Fe Icke experi ce alyarond AlouER auabe perm hte as pesident ef Disney. Docy
Somat ‘coNTNUED Chapter 18 Business Structure: The Law of Business Associations 427
agreed to give Ovitz a base selary of $1 million per year,
a discretionary bonus, and two sets of stock options.
Disney needed a strong second-in-command
because Me. Bisner’s health, due to major heart surgery,
‘was in question, and there really was no succession
plan, Mr. Eisner also had a rugged history when it
‘came to working with important or well-known subor-
dinate executives who wanted to position themselves
to succeed him, Over the past five years, Disney execu-
tives Jeffrey Katzenberg, Richard Frank, and Stephen
Bollenbach had all left after short tenures under Bisner.
Following a tumultuous year and legendary battles
between the two, Mr, Ovitz and Mr. Eisner negotiated
‘Mr. Ovit's departure, Mr. Ovitz was given a "Non-
Fault Termination” that carried $38,888,230.77 as well
‘a the option to purchase 3 million Disney shares.
“The shareholders (plaintifis) filed suit against the
dizectors for its failure to adequately consider the Ovits,
contract initially, for not considering the issues susround-
ing that hiting as well asthe employment package itse!f,
‘and for committing waste in giving Ovitz what amount
fed to a $140 million severance package (when the value
of the options were indluded). The Court of Chancery
