Corporations Fall, 2004

Corporations ~ Fall, 2004

Professor Mercer Bullard

***NOTE*** Be aware of the following underlying themes & ideas:

Corporate Lawyers always want to anticipate problems and ask, “which ones are worth paying for to solve now?”
Keep in mind the dichotomy between:
Owners v. Owners –AND-

------(“Intra-corporate battles”)

Owners v. Managers

In the really close cases, it’s not about the law, it’s about the politics
“Managerial Capitalism” ~ As corporations grow, you have to disperse your management
Involves retaining of professional managers
Highlights the important conflict between representation of the company/corporation and the shareholder
Remember, executives are usually out for their own interests rather than the interests of the Corporation.

PRINCIPLES OF AGENCY

A)Generally:

1)Agency principals lay the foundations for Corporations

2)Goes to ideas of employer/employee relationships

3)As a principal, you assume liability for your agents! (SO, you’re UN-limiting your liability rather than limiting it)

4)A principal’s duty to agent is often defined contractually

B)Identifying the Agency Relationship:

1)Fiduciary relationship

2)Manifestation of intent

3)Agent shall act on principal’s behalf and subject to principal’s behalf and subject to principal’s control (and agent shall consent so to act)

C)Gay Jensen Farms v. Cargill (ACTUAL AUTHORITY)

1)Cargill financed a grain elevator that went belly up and P’s were creditors going after Cargill

2)ISSUE – did Cargill, as a lender, actually become its debtor’s principal by its course of dealings with it

3)HELD – An Agency Relationship was established

Rules:
A creditor who assumes control of its debtor’s business may become liable as its principal (due to de facto control)
The most “Damning” facts for Cargill:
Active participation in operations (beyond financing)
Claimed right of first refusal to grain
Admitted “paternalistic relationship”
drafts and forms with Cargill’s name imprinted at the top

4)CONTRAST Agency with Buyer/Supplier Relationship:

Factors indicating supplier rather than agent:
he receives fixed price for property
he acts in his own name and has title to property he is to transfer
***He has an independent business*** (this must be shown before it can be concluded that Δ is not an agent)

D)Butler v. McDonalds(APPARENT AUTHORITY)

1)P’s sued McDonalds Corp. after their kid hurt himself on a glass door at a franchise restaurant

2)Key Questions Here:

a.Is an agency relationship formed by being a franchise?

b.How far beyond use of name do you have to go to create apparent authority of principal/agent?

3)B.O.P. ~ Elements required for apparent agency:

Franchisor ran his business such that a RPP would believe the franchise employees were actually employees of Δ Corporation?
The P. actually did believe such
P. thereby relied, to his detriment.

4)Key Facts (determining there WAS agency relationship)

Corporate conducted frequent inspections
Encouraged consistency and cooperation “with McDonalds standards”
Ultimately ~ the means/methods of maintaining an image of uniformity lead a RPP to believe the franchise restaurant was an agent of Δ franchisor
Example: National ads, uniforms, common menus, & appearance

5)Bullard’s Practice Tip: Settle these cases!

E)Recapping Agency Pointers:

1)The KEY to determining Agency ~ Is the relationship one of CONTROL???

2)RE: Apparent Authority:

Can a third party “look to” one specific party as having the image of actual authority?
You likely need to look for more than just the similarities between franchisees and corporate
Be aware of “Public Duty Theory” here:
When should we hold a Co. responsible based on how it presents itself to the public?
Does the nature of the agency go to the harm?
i.e., hot coffee? YES
Cracked glass? NO

PARTNERSHIPS (“A dying breed”)

A)General Partnership ~ any association of two or more people who carry on business for profit as co-owners

1)NOTE – important to know that you may inadvertently form a partnership

2)All partners are individually liable for the obligations of the partnership!

3)Co-Owners ~ means both have an ownership interest and a degree of control

B)Martin v. Peyton ~

1)Issue – whether a general partnership was inadvertently formed between lender and debtor

2)Held – No Partnership

The K documents did not associate the two parties together as co-owners of a business for profit
Δ’s Measures, taken as precautions to safeguard the loan, were ordinary caution . . . NOT an implication of association in the business (simple Lending relationship)
These “measures” included:
in exchange for a loan of liquid securities . . .
P’s turned over its aliquot securities, which couldn’t be used as collateral for bank loans and
P’s were to give Δ’s a % of firm profits and an option to join the firm.

3)Arguments/Factors for each side ~

Supporting the judgment
Securities were segregated
Trustees’ interest was in their OWN securities
Supporting partnership:
financial terms of the deal
negotiating 40% profits up front ~ looks like a profit-based relationship
NOTE – the Uniform Partnership Act says there’s a prima facie argument that receipt of profits makes a partnership (but not if it’s just interest payments)

C)Fiduciary Obligations in Partnerships

1)Meinhard v. Salmon ~

P & Δ were joint venturers, leasing a building for shops and offices. Δ secretly entered into a new agreement with a third partner to purchase surrounding property as a leasehold estate, but he never told P.
Held – Δ breached his K with P.
Important to keep in mind that:
This deal was intrinsically enter-twined with the original lease, in which P. WAS involved
Thus, Δ would not have been in the rewarding position were it not for the joint venture.
Δ Should have at least TOLD P. about the opportunity (i.e., disclosure)

General Rules working here:
Partners owe each other fiduciary duties of loyalty
That duty includes conceding and revealing any business opportunities coming to one partner alone by virtue of his agency
“A trustee is held to something stricter than the morals of the marketplace”

D)Partnership Authority (conflicts between partners)

1)Summers v. Dooley ~ despite Δ’s repeated objections to P’s requests to hire a third man to work for the partnership, P. hired a new guy, paid him out of his own pocket and wanted Δ to reimburse him.

Be aware that:
when you take on a partner, you’re responsible for the decisions your partner makes
in the absence of agreement otherwise, the Uniform Act defaults to a 50/50 split
Generally ~ business differences must be decided by a majority of the partners, provided no other agreement between them addresses the problem

2)National Biscuit v. Stroud ~

Here, 1 of 2 general partners wanted to stop selling bread, but the other partner kept selling. In bankruptcy, the bread supplier was owed $171 and the refusing partner didn’t want to pay
Held – Δ had to pay the bread guy, plus interest
Rule – under N.C. statute, activities within the scope of the business of the partnership could not be limited except by a majority decision . . . ½ of the partners don’t equal a majority

OTHER LIMITED LIABILITY ORGANIZATIONAL STRUCTURES

***Running Concepts: (1) “limited liability” is limited to your K investment; (2) in cases where you’re trying to “pierce the veil,” the key question will be “how much control did X have?” ***

A)Limited Partnerships

1)The “essentials” ~

At least one general partner, with unlimited personal liability
Limited partners, liable only for the amount of their capital investment, if actively participating in management, lose their limited liability
Created by state ~ must take affirmative step: FILING (otherwise, the “default” rules of general partnerships are the same
In Bankruptcy proceedings, limited partnerships are at the end of the line . . . behind:
Secured creditors are first
followed by unsecured creditors ~ two big groups:
lenders/banks
trade creditors
NOTE – these are all in the same pool; share what’s left pro-rata . . . UNLESS
Subordinated Debt ~ unsecured creditors with terms in their K’s allowing them to “up their standing” in line before some other unsecured creditors

To lose limited liability protection ~ participate in running the business

2)Gateway Potato Sales v. G.B. Investment Co. ~

Creditor sold goods on credit to Δ, a limited partnership. After default, P. sought recovery from the limited partner based on an affidavit from Δ’s president, describing Δ’s active business participation
Held: Limited Partner held liable
Statutory Construction here is key:
Two ways to interpret loss of limited liability
Was there actual knowledge (by the creditor) of Δ’s participation in control of the company?
Was there exercise of control without actual knowledge?
Grappling with the policy issue ~ should you be liable for control even though the creditors have no knowledge of that?
Ultimately:
Court decided to impose liability whenever the limited partner exercised control “Substantially the same as” the general partner UNLESS it fell within the purview of the safe harbor provision of the state statute.
“Control substantially the same as” is a question of fact for the jury.
Advice for client:
it’s not just want you do, it’s what the outside world perceives you to be doing
Keep an activity log day-to-day to suggest that you don’t exercise control, despite your “functions”

B)Limited Liability Partnerships (LLP)

1)The “Essentials”

created by statute; requires affirmative act of FILING with the Secretary of State
allows participation in management without incurring liability
great model for law firms and service type businesses
Management structure is NOT a centralized, top-down structure
Covers basically any type of liability a partner may incur (ex: Torts OR K claims, etc . . . )
These are now recognized in most states

2)Lewis v. Rosenfeld ~ stands for the straightforward principle that partners of an LLP are not liable for the debts or liabilities (in Tort or K) of the partnership solely by reason of their membership in that partnership.

C)Limited Liability Companies (LLC)

1)The “Essentials”

neither a corporation or a partnership . . . but it has aspects of each
similar, in principle, to an LLP; made of “members”
Focus is on allowing K-based rules govern the Co., while keeping certain default rules

2)“Advantages”

limited liability
taxed as a partnership
flexibility in operations

3)Disadvantages

Complexity in formation ~ requires an “operating agreement”
Veil Piercing ~ potentially more of a threat b/c LLC’s are a new form of business entity, without an extensive body of law
State taxes, where they exist

4)Jaffari Case ~

Here, P’s were bringing a derivative suit on behalf of an LLC, but there was a Q. of whether the LLC was bound by its Operating Agreement (and provisions therein), which it did not itself sign
Held – Yes, the company was bound.
In deciding these cases, courts tend to look for anything showing the intent of the parties
The Delaware Statute governing LLC’s was intended to foster flexibility with LLC formation and nothing in the Act prohibited the creation and binding nature of forum selection clauses contained in the operating agreement.

CORPORATIONS ~ FORMATION AND FINANCES

A)Practical Rules for the Corporate Lawyer:

1)Don’t do anything you wouldn’t want published on the front page of a national newspaper

2)If you can’t afford to lose a client, you can’t afford to keep the client.

3)If it’s too good to be true, it’s too good to be true.

B)Mechanics of Incorporation:

1)Preparatory Steps ~ handle in pre-incorporation shareholder agreement

make sure client developed a business plan describing the capitalization of the business
allocate ownership interests
How will the company be managed/hired/fired/compensated?
What happens if the owner dies?

2)Select a corporate name (lawyer does a copyright check)

3)Maintain an office in the state of incorporation and pick a registered agent for service of process (in that state)

4)Preparation and filing of the Corporate Charter (“Articles of Incorp’n”)

Simple form setting forth:
Name of business
address
number of shares of stock to be issued
names and addresses of incorporators
Re: Additional provisions:
You can have them, but be wary . . . they may “curb the scope of the company’s business and affect the rights of shareholders.”
May address power to adopt and amend by-laws (rules governing the operations of the corporation)
General Default – MBCA provides that the board of directors and the shareholders share power to adopt/amend by-laws unless the articles of incorporation provide otherwise

5)To operate in other states, qualify for doing business by filing with the Secretaries of State in each respective location

6)Conduct an organizational meeting

Used to (1) issue stock to owners and (2) appoint initial directors, who will appoint officers
Minutes must be maintained

C)Pre-Incorporation Liability

1)Three major issues at work:

personal liability of promoters for their acts
determining when corporate liability attaches to pre-incorporation activities
corporate liability to investors for fraudulent promoters’ activities

2)5 Theories of how the liability of a corporation can arise off of the promoters’ contracts

Adoption ~ Corp. takes the K rights and obligations of the promoter and makes them its own
Ratification ~ only properly applied in post-incorporation K’s
Acceptance of a Continuing Offer ~ i.e., the Corp. simply accepts the promoter’s original K when it comes into existence
Formation of a new K ~ adoption is nothing more than formation of a new K for new consideration
Novation ~ All parties anticipate that the formed corporation will accept the promoters’ K’s, upon which time the corporation is substituted for the promoter (after assenting)

3)O’Rorke v. Geary: (responsibility accompanying the pre-corporate life of a firm)

P. and Δ contract to build a bridge and Δ is a promoter for “the bridge company to be formed . . .”
Issue – who is liable for the K breach? Δ can’t be an agent to a not-yet-existing corporation, so who is bound by the K?
3-Prong approach/rule here: A promoter cannot bind the proposed corporation to pre-incorporation contracts, BUT he may:
take on its behalf an offer to be accepted upon formation
Drawback – this is very hot/cold. Great for the promoter but inefficient for the company
Enter into a K binding himself with the understanding that the corporation will take his place upon formation
Drawback – competing interest of promoters and corporations

-i.e., promoters: don’t want to be bound at all

-corporation: wants everybody “on the hook”

Personally bind himself and look to the corporation, when formed, for indemnity

4)Old Dominion v. Lewisohn ~ (The “Watered Stock” Case)

This case addresses the question: To what extent can the shareholders of a corporation complain of promoters’ fraud in the reincorporation stage?
Ultimately ~ (because this case is pre-securities law)
Holmes is trying to preserve the corporation as a legal entity
he says there is no fiduciary duty between promoters and future shareholders
“Watered Stock” ~ selling assets to corporations at inflated prices in exchange for stock with a par value that was set at the inflated price . . . Then, stock is sold to unsuspecting investors who thought the corporation’s assets were properly valued
Note ~ diluted stock becomes an issue when a corporation liquidates because shareholders end up getting screwed.
NOTE ~ other cases have held there IS a fiduciary a fiduciary duty by the promoter to the corporation . . . (for argument purposes)

D)Defective Incorporation

1)De Facto Corporation

applies where elements show:
existence of law authorizing corporation
effort in good faith to incorporate under that law
actual use or exercise of corporate records
5 Classes of cases where this issue may arise (MBCA):
honest, reasonable belief that articles were filed (but they in fact weren’t)
delay or error in mailing articles to the secretary of state
passive investor gives $$$ w/ instruction not to do business until articles are filed, but business commences anyway
third party agrees to K w/ a company in its corporate name even though third party knows the articles haven’t been filed and the other K party deals with the corporation (not the individual Δ)

2)Incorporation by Estoppel ~ Generally employed where:

person seeking to hold officer personally liable:
has contracted/dealt with the association
in such a manner as to recognize/effectively admit its existence as a corporate body
Thus, it’s a reliance argument

3)Consequences of Defective Incorporation:

If your company is not a de jure or de facto corporation . . .
The default is likely a General Partnership
Thus, exposure to unlimited joint and several liability

4)Cranson v. I.B.M. ~ (officer for corporation personally sued for debts due on electric typewriters purchased by the corporation)

Important: this was not a de Facto Corporation because the Company failed/neglected to make a good faith effort to incorporate
Doctrine of Estoppel Applied
based on the inequity of allowing people to deny a corporation’s existence after they’ve dealt with it as such
The incorporation problem here ~
wasn’t really a Pre-Incorporation issue . . .
The corporation had legal existence, it just failed to comply with a condition subsequent
ALSO – P’s are dealing with the corporation AS a corporation . . . NOT a promoter of the corporation!
Be able to distinguish this from true pre-incorporation issues

E)Corporate Structure:

1)Bonds/Bondholders:

Bond – a certificate with a corporate promise to repay the lender the principle, plus interest, at a future date
Usually first in line in bankruptcy proceedings
Secured Debt ~ goes very first . . . you’re subject to less risk but you get a lower interest rate
Unsecured Debt ~ goes next . . . may be subordinated to other debt; more risk but higher interest rate/level of return
If subordinated – the credit agreement would provide for it; higher risk and higher return
Trust Agreement – will contain terms to protect the creditors

2)Stocks/Stockholders: Piece of corporate ownership interest

Inherently more volatility, but also a possibility for a bigger “up-side.”
Two Broad Categories:
Common Stocks – an aliquot ownership position in the corporation
rights may be varied by the corporate charter
generally (1) can vote and (2) share dividends pro-rate, but they may be divided into (example) dual class categories.
Preferred Stock: includes basic preferences over common stockholders
ahead in line in liquidation proceedings (to get their guaranteed % and then step back . . . join the common stockholders)
Get dividends before C/S holders

-Cumulative Dividends ~ each year, the % of preferred stock dividends accumulates and P/S holders have to be paid before any common stockholders