Module III Notes (Chapters 6-8)

BusOrg – Palmiter (Fall 2012)

Module III Notes (chapters 6-8)

Chad Vanderhoef

NOTES – 9/13/12

Organizational Choices

Basic Choices

·  Partnerships

·  Corporations

·  LLCs

Characteristics

·  Formation

·  Liability

·  Mgmt

·  Financial rights

·  Continuity

·  Liquidity

·  Combinations

Considerations

·  Economics of choices - why firms are structured the way they are

·  Tax consequences - disadvantage to corporations

Organizational Issues

·  Formalities of formation

o  Does it have to be in writing

o  Does it have to be filed

·  Liabilities

o  Contractual risk/obligations

o  Tort liabilities

o  Is there a non-recourse structure? - Inability to seek recourse from those in the business

o  Respondeat Superior - doctrine of the principal's liability for agent's behavior

·  Management/Control

o  Voting rights for owners?

o  Who has the ability to bind the business?

·  Financial rights

o  Who gets the rights?

o  How are profits/losses shared?

o  Taxation of entity or individual?

·  Continuity

o  What is the duration?

o  What is the effect of withdrawal?

·  Transferability

o  Permission of others for transfer?

o  Can you transfer financial and/or management interest?

·  Combinations

o  Approval process?

o  Stakeholder protection?

General Partnerships

·  2 or more people share in management and control of the business

·  Carry on as co-owners a business for profit

·  Each partner is personally liable for the obligations of the partnership

o  Each is jointly and severally liable for obligations -- irrespective of investment

o  Indemnification is available internally as a remedy against another partner

LLP - Limited Liability Partnership

·  General partnership in all respects except liability

·  Limited liability for each partner -- only the assets of the LLP are at risk for contractual obligations

o  Partner can be personally liable for partner's own tortious conduct

·  Non-recourse business organization

·  Professional LLPs (attorneys, physicians) may have personal liability for people they supervise

·  Limited liability extends only to the extent a partner is acting as an agent for the partnership -- in the scope of the business of the partnership

·  Limited liability is the default rule -- the partners can contract for individual guarantees

Limited Partnership

·  One or more general partners, and one or more limited partners

·  Main distinction from GP is filing with state

·  Limited partners have no active management voice, and also are liable only to the extent they are invested in the LP

·  General partner conducts the active management of the LP

·  Limited partners do retain some voting rights

LLLP - Limited Liability Limited Partnership

·  Management scheme same as LP, but all partners enjoy limited liability

·  Limited partners still have limited governance rights

·  Popular in real estate

Why would you choose GP over LLP? To provide assurance to customers that you are fully invested because you are totally at risk

Chad Vanderhoef

NOTES – 9/17/12

Entrepreneurs have wide latitude to "mold" their enterprise using default rules to craft the type of organization that best fits their business objectives

Considerations

·  Control

·  Financial

·  Limited liability - allocation of risk

·  Liquidity - dissolution; opt-out procedures

·  Structure

o  Permanent or temporary

o  Board or shared management

·  Tax implications

·  Changes

How are lenders treated?

·  Do they gain any control?

·  Typically no. But can have so many management powers that become “partners”

Corporations

·  Board of directors manage firm

·  Shareholders can vote on major issues

o  Mergers

o  Bylaw amendments

·  File with state

·  Discretion over share allocation -- possible for one person corporation

·  Profits are distributed to shareholders via board approved dividends

·  Absent a previous agreement, a shareholder is permitted to sell shares to anyone to exit the corporation

·  Public v. Closely Held - Public corporations' shares are traded on a public exchange and is subject to SEC disclosure rules. By contrast, closely held companies' shares are not traded on an open market.

o  Public corporations can become private (closely held) by purchasing outstanding shares from majority of shareholders, and is no longer subject to SEC disclosure requirements

o  Closely held companies are taken public via IPO

o  Closely held corps can have no more than 300 shareholders

S-Corp & C-Corp

·  S-Corp has "pass-through" taxation

o  No more than 100 shareholders

o  No foreign ownership

o  No corporation can be a shareholder

·  C-Corp is subject to corporate tax, and therefore double taxation

LLC - Limited Liability Company

·  Pass-through taxation

·  Wyoming solution to prohibition on foreign investment in S-Corp

·  Hybrid of partnership and corporation

o  Limited liability for members (similar to corporation) - only up to amount of investment

o  Members entitled to profits based on member interest

o  Choice between centralized (manager-managed) and decentralized (member-managed) management structure

·  Member-Managed: absent agreement, each member has power to bind LLC

·  Manager-Managed: manager acts as agent of LLC

·  Members can transfer financial interest without approval, but transferability of membership interest must be approved

·  Limited liability corporation is non-existent

Partnership Rule - Absent agreement to the contrary, when one partner leaves, the partnership is dissolved.

Equity Owner - Owner in a business who has a right to profits

Planning Considerations (Posner)

·  Opportunism

o  Partnership can suffer when one partner binds partnership wrongfully (can be offset by fiduciary duty)or exits and forces other partner to buy out exiting partner to keep business going

·  Economics of firm

o  Borrowing money is not realistic due to high borrowing costs; this makes equity partnership more attractive

Business Taxation

·  Corporate tax

o  Problem of double taxation

·  Pass-through tax

o  No double taxation

o  Can use pass-through loss from business to offset income and reduce taxable income

o  Advantageous regardless if you have positive or negative income

o  One possible disadvantage -- owner decides to reinvest earnings and still has to pay the tax despite not recognizing the profits personally

Chad Vanderhoef

NOTES – 9/18/12

Business Taxation Continued

·  When you are in practice, you will need to understand the calculation behind the tax consequences

· 

Corp Tax / Pass Through
1st: Business Income taxed first
2nd: Distributions to shareholders taxed / One single taxation -- member level tax

·  In nearly all cases, pass-through taxation will result in less tax paid

·  Losses: C-Corp can deduct loss in future periods, but the deduction does not extend to shareholder

·  "Check the box" provision can be changed on a yearly basis

·  Zeroing out income - making “dividends” in the form of salaries

o  Effectively making the corporation tax consequence similar to LLCs

o  Laws were put in place to require payments be made at market value

Anita & Brandon

·  If 2 or more persons associate in a manner with shared profits and ownership, they have formed a partnership irrespective of what label they use

·  Each partner has power to bind the partnership as long as acting within the scope of the business

o  Jointly and severally liable

·  Acting beyond the scope of the business requires indemnification

·  Dissolution / Withdrawal is at will

o  Assets are liquidated

o  Proceeds are distributed 50/50 or according to agreement

·  Corporation formation requires state filing (federal filing with SEC if publicly traded)

·  Limited liability could be jeopardized by "piercing the corporate veil" - most litigated topic in corporate law

·  Shareholder agreement can provide for withdrawal of unhappy shareholder

·  Why S-Corp over LLC? S-Corp in some instances as better tax treatment, but those advantages are deteriorating. Also, S-Corp prohibits foreign and corporate investors

·  For LLCs, operating agreement is not filed. Articles of Organization is the document filed.

·  Operating agreement details management and structure of LLC

o  Examples can be found on Westlaw and other sources

·  LLCs could go public, but would be highly unconventional

·  Conversion provisions allow LLCs to convert to corporation, and vice versa

Chad Vanderhoef

NOTES – 9/19/12

·  One can manage multiple companies where statutory provisions allow contracting around, or opting out of, fiduciary duties

·  A person can be both a general and limited partner

·  Almost any form of structure can be modified to meet the needs of the participants

Chapter 7

Process of incorporation and the role of the lawyer

·  Articles of Incorporation to be filed with state

o  Must include

·  Name of the corporation

§  Name must contain Inc., Corp., etc.

§  Must be distinguishable from other company names

·  Number of shares issued

§  DE assesses filing fee based on number of shares issued. Other states, such as NC, charge a flat fee

§  Amendable only by shareholders -- not board

·  Name and address of each incorporator

·  Name and address of corporation's registered office and registered agent

§  Person and place to receive service of process or other official notices

·  How to amend articles of incorporation

o  Board authorizes

o  Shareholders vote

·  Formalities after articles filed

o  Organizational meeting - no actual meeting need be held, only a signed document

o  Actions

·  Elect directors

·  Adopt bylaws

·  Appoint officers

·  Designate bank account

·  Sell stock

·  Approve shareholders' agreement

o  Minutes of meeting

·  Role as a lawyer

o  Entity theory - lawyer represents corporation, not the individuals

o  Aggregate theory - lawyer represents both the individuals and the corporation (more common in partnerships)

o  Review rules of professional responsibility

o  Duty to disclose conflicts of interest

Chad Vanderhoef

NOTES – 9/20/12

Typically, a lawyer represents the corporation first and foremost. This should be made clear to the individual shareholders, and any conflicts of interest need to be disclosed.

·  A lawyer is obligated to report potential/ongoing harm to management

·  If management takes no action, a lawyer can report to outside authorities

When your firm can represent a conflicting party to a suit involving a corporation's shareholder:

·  The shareholder is one of many investors

·  They knew you were representing only the corporation

·  You do not disclose any information obtained through your representation of the corporation

Lawyer as a director for a client

·  Not barred by ethics rules

·  Can result in inconsistent responsibilities- one offering legal advice, and one offering business advice

Defective Incorporation

·  Parties aware corporation not formed

o  Promoter generally liable, unless agreement otherwise

o  Novation - corporation, once formed, replaces promoter in contract -- should be communicated expressly

·  Parties unaware corporation not formed

o  Judicial doctrines - equitable doctrines to supply limited liability to promoter

·  De Facto - promoter made good faith effort to incorporate

·  Corporation by estoppel - prevents third party from imposing personal liability on promoter where third party intended to do business only with corporation -- prevents windfall

·  Study showed that, in fact, both situations need to be satisfied (good faith and third party intended to contract only with corporation)

o  Statutory approach - MBCA 2.04 - to impose personal liability, person acting on behalf of corporation must know that no corporation has been formed

·  Dissolution of corporation

o  Reinstatement of corporation is retroactive along with all corporate attributes including limited liability

·  Retroactivity encourages payment of delinquent taxes

·  In NC, retroactivity is subject to those who relied on dissolution

o  Reinstatement must occur within two years

·  Piercing the corporate veil

o  Those who act for the corporation, believing they have limited liability, may not be protected where there is evidence of abuse

·  Misrepresentation of solvency

·  Misuse of funds

Chad Vanderhoef

NOTES – 9/24/12

Revisiting Promoter Liability

Pre-incorporation

1.  Parties aware no incorporation. Can avoid liability if:

a.  Expressly stated no liability in contract

b.  Novation

2.  Parties unaware no corporation. Promoter liable unless court exercises judicial doctrines: de facto or estoppel

Post-incorporation

1.  Administrative dissolution. Reincorporation retroactive if within 2 yrs.

2.  Piercing the corporate veil

Agency Theory

·  Shareholder are the electorate -- choose their representatives (the Board)

·  Board is legislative organ

·  Officers are the executive/bureaucracy

·  "The Little Republic"

o  Michael Jensen - Firm is like political government. Should approach motivational issues in the same manner by creating carrots and sticks so agents act on behalf of principals (Stock options / Bonuses)

o  Notion of agency costs.

o  People guided by sticks and carrots.

·  Allocation of corporate powers

o  Shareholders

·  Elect, remove directors

·  Approve fundamental transactions - power to deny

·  Amend bylaws, pass resolutions - power to create

o  Board

·  Exercise corporate powers

·  Manage business and affairs

§  Affairs - dividends, mergers

o  Officers

·  Described in bylaws / appointed by Board

·  Authority in bylaws or prescribed by Board

·  Carry out Board directives

·  Agent Authority

o  Actual authority

·  Express - explicit words or conduct granting agent power to bind principal

·  Implied - inferred by words or conduct by interaction of agent and principal

o  Apparent authority

·  Words or conduct that leads third party to reasonably believe agent has authority to act on behalf of principal

o  Inherent authority

·  Agent can bind principal if

1.  Agent is generally authorized to conduct transactions

2.  Third party reasonably believes agent has authority

3.  Third party has no notice otherwise

o  Ratification

·  Retroactive actual authority

·  Authority of corporate officers

o  General rule = agent cannot create his own authority

·  Exception to the rule = inherent authority