Chapter 9
Business Organizations and Securities Regulation
CHAPTER GOALS
This chapter is intended to be a straightforward introduction to the legal principles governing the creation and propagation of a business. Part One offers a brief survey of the basic business forms and the advantages and disadvantages of each. The student should simply be encouraged to look at the law of business organizations in a commonsense fashion with a view to understanding how the law can be a useful tool in building a sound foundation for a business. Of course, the student must also understand that the law proscribes certain kinds of conduct that might otherwise facilitate one's profit-seeking goals.
Part Two addresses securities regulation. Initially the student must understand the broad character of the term “security” and, hence, the expansive grasp of the security laws. Presumably the instructor will want to assist the student in exploring the broad goals of the 1933 and 1934 Acts, while giving some attention to the staggering of the past two years. In our view, the mechanics of securities regulation should take a distinct back seat in favor of the larger policy questions including, e.g., whether government regulation could have made a difference in recent events and what our future course should be.
CHAPTER OUTLINE
Part One—Forms of Business Organizations
A. Introduction
Each of the three main forms of business organization—corporate, partnership and sole proprietorship—are presented by evaluating them along eight dimensions.
http://bizfilings.com/learning/comparison.htm
B. Corporations
Nontax Costs
Although the cost of corporate formation is often heard as a criticism of this form of business, but the filing of articles is straightforward, most business lawyers will have “canned” forms that can simply be individualized based on the client’s specific facts and state corporate law is generally well developed for filling in missing or vague bylaw information. The cost of a corporate accounting system has more to do with the scale of operation than the form of business organization chosen.
http://www.lectlaw.com/formb.htm
http://www.state.de.us/corp/corpfee.htm
Centralization of Management
Although not an issue for corporations with sole shareholders, large corporations with thousands of shareholders benefit from the centralization of management that occurs when shareholders annually elect a board of directors, which then oversees the corporation and sets policy. Boards ideally would include both inside and outside directors. The board appoints officers of the corporation, who are agents of the corporation and who take care of business on a day-to-day basis. Directors and officers are fiduciaries and, as such, owe duties of loyalty and due care to the corporation. Whether the duty of due care has been violated is usually evaluated under the business judgment rule.
http://boardmember.com/network/index.pl?section=1022&article_id=11038&show=article [N.B.: The article referenced, “Your Responsibilities as a Director” (January 2002), can be found by accessing http://boardmember.com, clicking on Resource Center, and then selecting Legal.]
Shlensky v. Wrigley (Ill. App. Ct. 1968)
Employee, Officer, Director Liability
If corporate insiders act in such a way as to harm the corporation, shareholders can bring a shareholder derivative suit. Insiders that commit torts or crimes will be personally liable, but so will the corporation, under the doctrine of respondeat superior. But because corporations are regularly sued, these insiders may have agreements with their corporations to be indemnified by the corporation.
http://www.lectlaw.com/files/lws41.htm [N.B.: The cited material is based specifically on Ohio law.]
Limited Liability
This is probably the most cherished characteristic of the corporate entity, protecting the corporation’s owners, that is the shareholders, from personal responsibility for the corporation’s obligations. Closely held corporations may not enjoy the full benefit of this characteristic because creditors may require personal guarantees of corporate debts.
Free Transferability of Interests
Beyond securities regulation, generally there are no restrictions on stock transfers by shareholders. In closely held corporations, however, the parties may create contractual limitations on transfer through a buy-sell agreement.
http://biz.findlaw.com/book/05.html [N.B.: To find the referenced article, go to http://biz.findlaw.com, click on the “See all of Business Organizations” under Articles & Guides: Business Organizations; select “Find Articles” under Business Organizations; enter “buy-sell” in the search box for a list of relevant articles.]
Duration of Existence
In general, a corporation’s existence is perpetual, although it can be terminated either through voluntary or involuntary processes under certain circumstances.
Taxes
Perhaps the greatest disadvantage of the corporate form is double taxation: That is, taxing the corporation on its income and also taxing any of that income that is distributed to shareholders as dividends on the shareholders’ tax returns. Although at the time of this writing, there is legislation before Congress that would eliminate dividends from shareholders’ taxable income.
But taxation of corporations is a much more complex issue than just double taxation. Because of the size of the tax bite, corporations have significant incentive to undertake tax planning to minimize their taxes (i.e., legal tax avoidance) and some go further to committing fraud to lower their taxes (i.e., illegal tax evasion). A current focus of the IRS is on corporate tax shelters. Congress has also started to concern itself about corporate inversions, that is, major corporations reincorporating themselves in tax haven countries in order to reduce or avoid U.S. taxes.
http://www.irs.gov/businesses/display/0,,i1%3D2%26genericId%3D87119,00.html [N.B.: This link has now been changed to http://www.irs.gov/businesses/corporations/article/0,,id=97384,00.html.]
http://www.escapeartist.com/taxhavens/taxhavens.htm
Some tax characteristics of the corporate form of business are actually advantageous, such as the existence of an extensive array of tax-deductible fringe benefits. Further, by way of tax planning, businesses can at times take advantage of the existence of lower corporate tax rates than may be available to high net worth individual shareholders.
http://www.irs.ustreas.gov/pub/irs-pdf/p15b.pdf
Capital Structure
The choice of business form must take into account the total capital needed and will affect the ratio of debt and equity in the capital structure, although the distinction between these is not always clear. Debt capital may be short or long-term, while equity is generally only has long-term characteristics. On the equity side, distinction is made between common stock and preferred stock, which generally gives up any voting control in favor of preferred access to distributions and preferred treatment on liquidation.
http://www.fasb.org
http://pages.stern.nyu.edu/~adamodar/pdfiles/ovhds/capstr.pdf
Legal Requirements
Venture capitalists and franchisors may require businesses with which they deal to use the corporate form. Further, some assets, such as certain contractual rights, may be very difficult or impossible to transfer unless they are held in corporate form.
http://www.vfinance.com/home.asp?Toolpage=vencaentire.asp
http://www.ftc.gov/bcp/conline/pubs/invest/buyfran.htm
http://www.franchisedirect.com
C. Partnerships
Discussed in this section are general partnerships, for which the equity interest is referred to as a partnership interest. All partners are agents of the partnership and of each of the other partners. Each partner has the right to examine all partnership records and to demand a formal accounting.
Veale v. Rose (Tex. Ct. App. 1983)
Nontax Costs
Partnership agreements are contracts and, therefore, may be oral or written. Oral partnership agreements may create substantial proof problems if any controversies arise after partnership creation. Drafting a quality written partnership agreement tends to be expensive because of the enormous opportunity for customization, less structure provided by state law (in comparison to corporate law provisions) and because the personal risks of partners are so significant. Further, partnership accounting systems may also be expensive, to be account for the customized economic arrangements made among the partners.
Centralization of Management
By default, management in a partnership is dispersed, as every partner has an equal right to participate unless all agree to centralize management through a committee or, sometimes, a managing partner.
Limited Liability
Because a partnership is not a separate legal entity, the partners do not have limited liability. Rather they are jointly or jointly and severally liable for all of the obligations of the partnership.
Free Transferability of Interests
Partnership interests may be transferred only with the unanimous consent of the other partners, although a partnership interest can be assigned, but the assignee will not have the status of partner.
Duration of Existence
Partnerships automatically dissolve on the death, incapacity, bankruptcy, expulsion or withdrawal of any partner. Thus, it is an inherently unstable form of business organization. Careful drafting of the partnership agreement is required to identify how the business will be maintained in the face of any of these events.
Taxes
The greatest advantage of the partnership form is the extraordinary flexibility of the economic relationships that can be created among the partners. Further, as partnerships are not taxable entities, there is no double taxation. However, fringe benefits provided to partners are generally not tax deductible.
Capital Structure
Generally, partnerships are not appropriate vehicles for businesses requiring access to large amounts of capital through the financial markets.
Legal Requirements
In most states, partnerships are allowed to own property in the name of the partnership, allowing some protection of the assets from creditors of individual partners. But, as a form of business, they are less useful for estate planning purposes.
http://www.assetprotection.com
http://www.nolo.com/lawcenter/ency/index.cfm/catID/FD1795A9-8049-422C-9087838F86A2BC2B
D. Sole Proprietorships
Nontax Costs
No legal filings or fees are required.
Centralization of Management
Sole proprietorships inherently have centralized management in the sole proprietor.
Limited Liability
Again, there is no separate legal entity and, therefore, no way to limit the liability of the owner.
Free Transferability of Interests
Transfers are not of the business, but only of the business assets.
Duration of Existence
Sole proprietorships are subject to vagaries of all of the events that impact the sole proprietor’s life.
Taxes
All of the revenues and expenses of the business simply show up on the proprietor’s personal tax return. In general, fringe benefits are not tax deductible.
Capital Structure
Financing opportunities for proprietors are even more limited than for partnerships, given that there are fewer personal assets to draw upon.
Legal Requirements
No ventures are required to use this form of organization and it is a poor choice for estate planning purposes.
E. Hybrid Business Forms
S Corporations
S corporation status is relevant only for federal (and some state) tax purposes. It does not change any of the state corporate law that applies to a corporation. Its tax consequence is to allow certain corporations, who both qualify for the election (e.g., fewer than 75 shareholders) and in fact make the election, to be taxed as a pass-through entity, thus avoiding the double tax issue.
Joint Ventures
These entities operate and are taxed like partnerships.
Reading: Verizon Wireless and Microsoft Press Release
Limited Partnerships
These partnerships have two classes of partners: General partners and limited partners. The latter enjoy limited liability as long as they are not actively involved in the management of the business.
Limited Liability Companies (LLCs)
Started in Wyoming in 1977, the availability and use of LLCs did not become widespread in the U.S. until the IRS in 1988 agreed to let them be taxed like partnerships, instead of like corporations. Owners are referred to as members; creation requires the filing of articles of organization; and the structure and terms are set forth in an operating agreement.
Limited Liability Partnerships (LLPs)
These entities were instigated at the behest of the major multinational accounting firms, in order to obtain some degree of limited liability in at least some professional malpractice contexts.
International Hybrids
Other countries support literally dozens of different business forms than those recognized by U.S. law.
http://www.ey.com/global/gcr.nsf/EYPassport/Welcome-Doing_Business_In-EYPassport [N.B.: Since the printing of the text, Ernst & Young has closed public access to its site.]
F. Uniform Acts
In order to aid states in harmonizing issues across state borders, to facilitate interstate business, the National Conference of Commissioners on Uniform State Laws develops both uniform acts and model acts.
http://www.nccusl.org/nccusl/default.asp [N.B.: Since the printing of the text, the information on the NCCUSL is now located on the University of Pennsylvania site listed below.]
http://www.law.upenn.edu/bll/ulc/ulc_final.htm
Part Two—Regulation of the Securities Markets
A. Introduction
The scale of modern business requires access to massive amounts of capital. To amass the capital needed to pursue global business opportunities, a large number of investors must be convinced to entrust their wealth to third parties. Principally since the Great Depression, the U.S. has undertaken to promote the integrity of the capital markets. This regulation, however, did not prevent the great financial reversal experienced in the U.S. beginning in 2000.
B. Initial Public Offerings
Initial public offerings are regulated by the SEC under the Securities Act of 1933. The principle purpose of the Act is to ensure full disclosure of all material facts and eliminate fraudulent conduct. The disclosure goal is accomplished through the filing of a registration statement and prospectus, which includes information on the company and the industry, a risk assessment and audited financial statements.
http://www.sec.gov
“Accenture’s IPO Risk Assessment”
The audited financial statements include an income statement, statement of cash flows and a balance sheet. Management prepares the documents, which are then audited by a certified public accounting firm in accordance with generally accepted auditing standards. The objective is to determine whether the statements are not materially misleading and are in accord with generally accepted accounting principles.
During the prefiling period, no solicitation or sales of the securities are allowed. During the waiting period, while the SEC is reviewing the filing, limited solicitation in the form of tombstone ads are permitted, but no sales may occur. After the registration has been approved, solicitation and sales may proceed, but all purchasers must be provided with the prospectus. Generally, the sales are accomplished through either or both best-efforts underwriters or firm-commitment underwriters.
Some securities and some specific transactions are exempt from full compliance with the registration requirements of the federal securities laws, but none are exempt from the antifraud provisions.
C. Secondary Securities Markets
Once a security is issued, it may be sold repeatedly either on a physical exchange, such as the New York Stock Exchange, or on an over-the-counter market, such as the NASDAQ. These trades are governed by the Securities Exchange Act of 1934. Again, it has two goals: Full disclosure of material information through the filing of annual, quarterly and other reports, and the prevention of fraudulent conduct.
http://www.nyse.com
http://www.nasdr.com
http://www.nasdaq.com
http://www.tenkwizard.com
http://www.findlaw.com/01topics/34securities/index.html
D. Violating Securities Laws
Civil Damages
Perhaps the greatest deterrent to securities law misconduct is the potential civil liability that can accompany a proven violation. Under the 1933 Act, virtually anyone with a significant role in the preparation of the disclosure documents (e.g., corporation, accountants, investment bankers) can be held liable for all damages sustained by any investor. The plaintiff need not prove reliance on the content of the registration statement. The principle defense to such a showing is due diligence—that after a reasonable investigation the defendant reasonably believed the registration statement not misleading. Professional defendants are held to higher standards expected of professionals.