Chapter Sixteen | Corporations and Hybrid Forms Of Organization


Corporations have existed throughout history for over 1,000 years. The corporation is the most important type of business organization in the United States. It has existed in its current form for over 100 years. In the United States, a corporation is the creation of statutory law. It is an artificial person and operates as an entity separate from the person or persons who own it. A corporation is created under state law. It issues shares of stock to investors who are the true owners of the corporation. However, some public corporations can be created under special provisions of federal law. Individual state corporate laws are not uniform. A codification of modern corporate law exists — the Model Business Corporation Act (MBCA) and the Revised Model Corporate Business Act (RMBCA)—neither of which has been adopted in their entirety by any state.


A corporation has several advantages which may be reflected in its important characteristics. These characteristics include the fact that a corporation has unlimited duration or perpetual succession. A corporation may continue as an entity “forever” or for a specific period of time, no matter how often ownership of its stock changes. It is characterized by free transferability of interest, limited liability, continuity, and centralized management. In the eyes of the law, a corporation is considered a legal person and can hold title to property in its own name.

Corporate Name

A corporation’s name identifies it. The RMBCA requires that the corporate name contains the word “corporation,” “incorporated,” “company,” “limited,” or an abbreviation of one of these terms. The name cannot be the same as that of another corporation, nor can it be so similar to another’s name so as to deceive the public. Each state keeps a registry of available corporate names. The corporation may sue or be sued in the corporate name, and is taxed as a separate entity—all activities attributable to natural persons.

Constitutional Rights

Because a corporation is recognized under law as a person, it can take advantage of many of the same rights and privileges that U.S. citizens enjoy. The Bill of Rights guarantees certain protections to persons and a corporation is included within its meaning for purposes of “equal protection” under the Fourteenth Amendment. A corporation has full access to the courts and it is entitled to due process before being denied life, liberty, or property. A corporation is also protected from unreasonable search, seizure, and from double jeopardy, as are “other persons.”

The First Amendment likewise applies to a corporation. A corporation is entitled to freedom of speech and other constitutional protections. However, the Fifth Amendment protection against self-incrimination does not apply to a corporation; it applies to the corporation’s individual officers and employees. The privileges and immunities clause of the U.S. Constitution, requiring each state to treat citizens of other states equally with respect to access to courts, travel rights, etc., does not apply to a corporation.

One difficulty existing with respect to the corporate form has to do with criminal acts committed by a corporation. Obviously, a corporation itself cannot be imprisoned, even though it is a “person.” Instead, most courts will levy a fine against a corporation that has violated a criminal statute. In recent years, criminal conduct that is attributable to a corporation’s officers or agents may subject those individuals to possible imprisonment. Violation of the Foreign Corrupt Practices Act or one of the environmental statutes such as CERCLA, for example, may subject an individual corporate officer to criminal liability.

Types of Corporations

Corporations may be categorized in terms of their relationship to the public, the nature of their activities, and the source of their authority. A corporation may be broadly described as for profit, not-for-profit (nonprofit) or public or private. For profit corporations are organized to make a profit, whereas nonprofit corporations are organized for charitable (eleemosynary), scientific, cultural, educational, or other benevolent purposes. They are usually private and may be used in conjunction with a regular corporation in order to facilitate making contracts with the government. Examples include hospitals, nursing homes, universities, sports associations, churches, charities, and fraternal organizations. Many not-for-profit corporations receive tax-deductible donations from third parties. Many are tax-exempt under state law. In some states or localities, some not-for-profit corporations do not pay real estate taxes or may pay such taxes at a reduced rate.

Corporations are considered domestic, foreign or alien depending upon where the corporation was incorporated and where it is doing business. A corporation is domestic with respect to the state under whose laws it is incorporated and foreign in all other states. A foreign corporation cannot automatically do business in another state. It must obtain a certificate of authority in the states in which it plans to operate. An alien corporation is one that is incorporated in a foreign country.

Corporations may be characterized as closely held, publicly held, multinational, Subchapter S (or S corporation), limited liability, or professional. In a closely held corporation (also called a close, closed, family, or privately held corporation), the shares of the corporation are held by one or a few shareholders. In many cases, the shareholders are members of a single family who retain complete control over all corporate-related matters. The stock issued by a closely held corporation is not publicly traded, that is, it is not bought and sold on any national stock exchange, for example, the New York Stock Exchange or NASDAQ. Hobby Lobby is an example of a closely held corporation.

Conversely, the stock of a publicly held corporation is traded on one or more U.S. stock exchanges. The operation of a publicly held corporation is vastly different from that of a closely held corporation. It is subject to national securities laws, the Securities Exchange Commission, and laws of the state in which it is incorporated, does business, or has its headquarters. Although shareholders own a publicly held corporation, effective control lies with the corporation’s directors, officers, and managers. Of all the forms of business discussed, the publicly-held corporation has the largest effect on the public at large, and is subject to many types of government regulation.

A multinational corporation, also called a transnational corporation, is a publicly held corporation that exports, imports, and distributes products or services and often seeks resource necessary to manufacture its product in a number of countries. Its stock may be traded on one or more foreign stock exchanges in addition to an exchange in the United States and its officers and directors may be citizens of several nations. Multinational corporations may have a far larger impact on society than publicly held corporations that “reside” in one country only.

A Subchapter S (or S corporation) is a form of business referred to by the subchapter designation of the Internal Revenue Code which governs its establishment. Shareholders of a corporation who meet the requirements of the IRC may elect Subchapter S status. A Subchapter S corporation is a combination of the features of corporate and partnership entities. S corporations operate as a corporation for liability purposes, but are taxed like a partnership. This allows shareholders to be treated as partners for tax purposes, while retaining the benefit of limited liability provided by the corporate form. An S corporation currently may not have more than 100 shareholders. All shareholders must be U.S. citizens or permanent residents of the United States. The corporation may only issue one class of stock and all shareholders must “elect” the Subchapter S form. Not all domestic general business corporations are eligible for Subchapter S status.

The professional corporation is a corporate entity usually formed by individuals such as doctors, accountants, lawyers, and other professionals. Benefits include tax advantages for deductions such as health benefits and pension plans. However, individuals who incorporate professionally are not protected against personal liability for negligent performance of their professional acts, such as malpractice, which is a form of professional negligence.

Classifications of Corporations

Public, Private, and Quasi-Public Corporations

A public corporation is one established for governmental purposes or for the administration of public affairs. A city is an example of a public or municipal corporation, acting under authority granted to it by the state. A private corporation, on the other hand, is organized for charitable and benevolent purposes or for purposes of finance, industry, and commerce. It is owned by private individuals rather than by the government. A quasi-public corporation, also called a public service corporation or public utility, is a private corporation furnishing services upon which the public is especially dependent, such as providing water, natural gas, or electricity.

Public authorities are created by the government as a service provider. The government can render services directly or through a separate corporation or authority. The Port Authority of New York and New Jersey, The New Jersey Sports and Exhibition Authority, and the Tennessee Valley Authority are examples of public authorities. Municipal parking authorities, sports and recreation facilities, and low-cost public housing projects may operate as public authorities.

Special Service Corporations are created to perform a particular service—transportation, savings and loan operations, insurance, banking and similar specialized purposes—are subject to special statutes with respect their organization. Federal and state laws and administrative agencies also regulate how these businesses are organized and conducted.

Benefit Corporations emerged in the U.S. due to calls for increased corporate awareness of their impact on society. These corporations are known as socially conscious corporations, social purpose corporations (SPC) (Washington), public benefit corporations (Delaware), benefit corporations or B corporations. Presently these types of organizations are authorized in 30 U.S. states and the District of Columbia. According to the comments to the Model Benefit Corporation Legislation (2016), benefit corporations are:

“a form of business corporation that offers entrepreneurs and investors the option to build, and invest in, a business that operates with a corporate purpose broader than maximizing shareholder value and that consciously undertakes a responsibility to maximize the benefits of its operations for all stakeholders, not just shareholders. Enforcement of that purpose and responsibility comes not from governmental oversight, but rather from new provisions on transparency and accountability…”

Benefit corporations may be either for-profit or not-for-profit. Well known U.S. benefit corporations include Patagonia, Kickstarter, Etsy and Seventh Generation. The purpose of a benefit corporation is to create a general or a specific public benefit. Public benefits are determined by considering the interests of various stakeholders or constituencies of the corporation such as shareholders, employees, customers, the community, society, the environment, global concerns, and the short and long-term goals of the corporation. The approach of the socially conscious corporation is recognition of what has been called the triple bottom line: people, planet, profit. These corporations seek to make a difference socially while, at the same time, making a profit.

The organization may have a director (known as the benefit director) or an officer (known as the benefit officer) to oversee the benefit purpose of the corporation. The benefit director/officer prepares the annual benefit report which analyzes the public benefit purpose of the corporation, identifies the benefit purpose standards of an independent third party, and articulates how the actions of the corporation within the past year fulfilled that purpose. Annual reports are filed with the Secretary of State and are provided to all shareholders. Independent third party audits are required in some states, while other states have created their own criteria. Benefit corporations that are certified by the world’s largest third party certifier, B Lab, are called B corporations or certified B corporations.

Socially conscious corporations are gaining popularity around the globe, and in late 2015, Italy became the first country outside of the U.S. to recognize this legal status. In spring 2016, five Italian companies organized as benefit corporations and three of those entities were B certified.

Formation Of A Corporation

As was previously noted, a corporation must be formed in compliance with state law. All fifty states have enacted their own laws to govern incorporation, as has the District of Columbia, Guam, and Puerto Rico. These statutes specify what must be included in the articles of incorporation. Generally, provisions will include identifying the corporation’s name, name and address of the registered agent, its general purpose, the class or classes of stock to be issued, the face value of stock, and the names and addresses of the incorporators of the business. Together with any required fees, this information is filed with the Secretary of State of the incorporating state. The secretary issues a certificate of incorporation (also called a charter) upon satisfaction of all statutory requirements.

Delaware has emerged as the major state of registration of corporations. The Supreme Court of Delaware is the most influential of all the state courts of this country with respect to the governance of corporations. More than half of all publicly traded companies in the U.S. are registered in Delaware and 64% of the nation’s 500 largest corporations are incorporated in Delaware, as are over 40% of the corporations listed on the New York Stock Exchange. Incorporation fees and corporate taxes are comparatively low, and laws are considered favorable to corporations, allowing corporations to operate with minimal state interference. Delaware also maintains a separate Chancery Court that, over time, has developed a staff of judges who have accumulated specialized knowledge in corporation law and who are attuned to their special needs and problems. Almost any conceivable issue involving corporate law has been presented in the Chancery Court. Therefore, corporate directors and managers and their attorneys can rely on the decisional law in planning corporate changes and legal strategies. This is especially true in cases involving corporate takeovers, acquisitions, and mergers.

A corporation is often formed through the use of promoters who arrange the initial plans for financing the corporation and who create the corporate charter or articles of incorporation. Promoters also sell stock subscriptions and obtain loans, materials, and supplies needed to start the corporation. Subscribers agree to invest in the original issue of stock in the proposed corporation. At this point, promoters are personally liable for the contracts executed because the corporation has not yet been “born.” Once the corporation is formed, it may adopt the promoters’ actions and agree to indemnify them for any such actions previously undertaken. Incorporators, who may or may not be the promoters, sign and file the articles of incorporation with the Secretary of State.

Upon successful filing of the articles of incorporation, the state will issue a charter/certificate of incorporation, and the corporation can begin to conduct business. The corporation calls its first board meeting. The board of directors is elected, stock certificates are issued, and a set of bylaws to govern the operation of the corporation is adopted. The board of directors convenes at the second meeting to elect corporate officers and address those issues necessary to begin business.


The rules and regulations enacted by a corporation to govern its business and its shareholders, directors, and officers are called bylaws. They are usually adopted by shareholders, but in some states they may be adopted by the directors. The state of incorporation is not required to approve bylaws or an amendment made to the corporate charter. They are generally private matters for the corporation.

Corporate bylaws are subordinate to the laws of the state of incorporation, the statute under which the corporation is formed, and the charter of the corporation. A bylaw that conflicts with one of these superior controls or that is judged to be unreasonable is invalid. Valid bylaws are binding on all shareholders, but not necessarily on third parties unless they have notice or knowledge of them.

Corporate Seal

A corporation may have its own distinctive seal. Its use is not required unless it is mandated by statute or unless a natural person is required to use it in transacting corporate business. The use of the seal authenticates the power of the officer to conduct business on behalf of the corporation, but is still largely ceremonial.

Improper Formation

Once the formation procedures are complete a de jure corporation results. Neither the state nor any party may question its existence. However, sometimes the incorporators, in making a “good faith effort” to comply with state incorporation laws, fail to do so. A court will then find that a de facto corporation exists. Although there has not been total compliance, the entity will be treated as a corporation for legal and other purposes. In this situation, only the state may challenge its existence. Shareholders in the de facto corporation maintain limited liability, to the extent of their capital contribution.

Sometimes an entity substantially deviates from the prescribed statutory procedure or has been judged not to have acted “in good faith.” In this case, the entity is neither a de jure nor a de facto corporation. As noted, states require a business to file its articles of incorporation before a corporation emerges. Nevertheless, states may still treat the business that has not filed its articles as a corporation by estoppel. A business that acts like a corporation, follows the tax and other laws applicable to corporations, and issues stock as a corporation will not be permitted to deny the existence of the corporate form for purposes of avoiding payment of dividends of its stock.

Piercing the Corporate Veil

There are instances in which individuals will attempt to create a corporation for illegal purposes or to hide the assets of stockholders, thereby shielding them from personal liability. The business acts like a corporation, but exists in name only. Such an entity is considered the alter ego of the shareholders. In such cases, the corporation usually does not hold shareholder meetings, board of director meetings, does not keep minutes of meetings, nor maintain financial books for the corporation. The sham operation attempts to protect the assets of the individuals from creditors. If a creditor sues the “corporation,” the court may be able to pierce the corporate veil and hold the shareholders personally liable for the “corporation’s” debts. A similar result would obtain where the shareholders commingle corporation and business assets or where corporate assets are used to pay the personal, private debt of a shareholder. The corporate form may also be pierced if the corporation fails to file required forms, informational documents, or fails to pay taxes- especially payroll taxes—as required. These actions are termed as a violation of the “corporate formalities” doctrine.

Financing the Corporation

The financial basis of a corporation is normally comprised of portions of both debt and equity. Loans made to the corporation are debt and the sale of interests in the corporation, i.e., ownership of stock, is equity.

Debt is created through the use of three general types of instruments or debt securities: notes (short-term loans), corporate bonds (generally long-term loans which are often secured by a lien or mortgage on corporate assets/collateral), and debentures (unsecured long-term loans). Generally, the corporation will make periodic interest payments on the loans. The corporation is the debtor and the security holder is the creditor. The interest paid on debt securities is tax deductible to the corporation. However, dividend payments to the owners of equity instruments in the corporation are not tax deductible. This makes debt financing an especially appealing means for a corporation in order to obtain financing. Risks are present as well. If a corporation is financed too heavily with debt, the IRS may consider it too thinly capitalized and loans made by shareholder may be characterized as capital contributions or subordinated to other creditors. This is an operation of the “excessive debt to equity” rule.

Equity is raised by corporations through the sale of stock. Stock represents an ownership interest in a corporation. Shareholders (sometimes called stockholders) are the corporation’s owners who possess rights to control the business by voting on numerous corporate matters, including the election of directors. Shareholders receive income through the distribution of dividends, and, if and when a corporation dissolves, share in its net assets, in proportion to the number of shares of stock in a corporation that each person owns. Shareholders enjoy free transferability of their shares of stock, with the possibility exception of shares in a close corporation.

A corporation must authorize the number of shares of stock in its articles of incorporation. However, not all shares will be issued or sold. The Revised Model Business Corporations Act (RMBCA) requires that the articles of incorporation authorize one or more classes of stock entitling owners to unlimited voting rights and one or more classes of stock entitling owners to share the net assets of the corporation upon its dissolution. One class of stock may contain both of these provisions.

Classes Of Stock

Common stock generally gives owners the right to vote on corporate matters, receive income through dividend distribution, and receive compensation upon the sale of stock. No preferential benefits attach to ownership, so shareholders of common stock bear the greater risk of financial downturns or a complete loss of their investment in case a corporation is forced to file bankruptcy or can not pay its debts.

Preferred stock contains some form of dividend payment or asset distribution rights not given to shares of common stock. For example, preferred stock shareholders may receive dividends before common stock shareholders at a specific rate of return expressed in the articles of incorporation. Preferred stock can be issued in different classes or series. Differences or preferences involve dividend, liquidation, and voting rights. Preferred stock is limited in its voting rights and a corporation usually has the right to redeem or exchange it for a previously established or determined amount of money.

A cumulative preferred stockholder will not lose the right to receive dividends in a year when holders of other classes of stock in a corporation do not receive any dividends at all. If they do not receive the dividend in that year, the dividend is postponed (accumulated) to a year in which dividends are distributed. Additionally, holders of cumulative preferred stock will receive all past and current dividends due before holders of common stock receive any dividends.

Participating preferred stock occurs where owners receive dividends first and at a rate higher than the common stock shareholders do. Any remaining income is shared by both classes of shareholders based on the number of shares owned. If there is a corporate liquidation, preferred stock holders may be paid at par (face) value or a previously specified amount first. Then common stock holders may be paid based on the assets remaining in the corporation. Convertible preferred stock may be exchanged for common stock at an established price ratio.

The irrelevance of these classifications may increase as more states adopt the RMBCA. The act states that the articles of incorporation of a company must express the classes of stock and number of shares in each class, but does not refer to specific classes of stock as common or preferred. Thus, under the RMBCA, if only one class of stock is created in the articles of incorporation, the stock carries with it voting rights and participation rights in corporate assets. If more than one class of stock is created, the board of directors of the corporation must authorize or designate the distinguishing elements of each class.

A corporation may issue the right to purchase a specific number of shares of stock at a specific price for a specific period of time in an instrument called a stock warrant. A stock warrant may be traded as is the stock itself. If an employee receives such rights as employment compensation, it is called a stock option. The employee may not trade these rights, however, under current law. It is important to consult with a tax professional as to issues relating to the taxability of any exercised stock warrant or a stock option.

Management Of A Corporation

The management of a corporation is in the hands of shareholders, the board of directors, and corporate officers and managers. To what extent each group has power over the other varies within each corporation and may depend on a corporation’s articles of incorporation or bylaws.


Shareholders own the corporation, yet they have no direct control as one would expect an owner to possess. Shareholders have no agency relationship with a corporation. Shareholders may exercise their right to vote for members of the board of directors. Shareholders’ meetings are usually held annually at a time provided in the corporate bylaws. The board of directors may also call special shareholders’ meetings upon proper notice being given.

Shareholders are not required to attend shareholder meetings in order to cast their votes. They may delegate their power to vote through a proxy, which is a written authorization to cast votes. The SEC has established proxy rules, which provide for the use of a ballot form to solicit proxies. The form must state that the shareholder’s wishes will be carried out with respect to his or her voting instructions. Alternatively, a shareholder may give the proxy committee the power to vote his or her shares as they see fit. The proxy committee sends each shareholder a list of candidates and short biographies of each person up for election. They also send a statement of any resolutions upon which shareholders are expected to vote.

Because most shareholders do not attend annual meetings, power ostensibly rests with the corporation’s management. An individual shareholder of a large corporation normally does not have the power to have a director of his or her choosing placed on a ballot and actually win election. The management team actually selects those individuals it wants to serve on the board. Shareholders provide either tacit approval by voting for them or not. As the proxy committee has access to corporate funds and a shareholder may only resort to personal funds, it is not hard to see who holds the true power in electing a board of directors.

The Board Of Directors and Corporate Officers

Most boards of publicly held corporations do not actually manage a corporation in the true sense of the word. They are more likely to act as overseers and set a corporation’s overall policy. It is in this role that the board authorizes a dividend payment, alters a corporations’ capital structure, selects and removes corporate officers and executive personnel, decides on the amount of compensation payable to executives, approves of executives’ pension plans, and approves changes a corporation’s bylaws. Often, however, the board simply approves the plans put forth by the corporation’s officers and management team. In 2002, in response to several corporate scandals, the Sarbanes-Oxley Act was passed adding additional governance standards for directors.

The power to control a corporation usually lies in the corporate officers and management team. These individuals act on behalf of the corporation as its agents and are directly responsible for day-to-day business operations. As a matter of tradition and business practice, a corporation will have a president (CEO), vice-president, and treasurer, but the RMBCA does not express any particular requirements as to corporate officers.

Corporations – especially very large ones – tend to operate on a more impersonal level than smaller entities such as partnerships or S corporations. However, the law requires that corporate management bear certain responsibilities. Officers and directors of the corporation are fiduciaries. As such, they have a legally enforceable fiduciary obligation to shareholders. The RMBCA sections 8.30 and 8.42 state these duties expressly. Directors’ duties include the duty of care, the duty to become informed, the duty of inquiry, the duty of informed judgment, the duty of attention, the duty of disclosure, the duty of loyalty, and the duty of fair dealing. Officers and directors must exercise their obligations “in good faith,” with the care an ordinarily prudent person in a like position would exercise under similar circumstances and in a manner he or she reasonably believes to be in the best interests of the corporation.

Under the corporate opportunity doctrine, a corporate officer or director may breach his or her fiduciary duty if he or she takes advantage of an opportunity that should belong to the corporation and benefits personally from that action. In such a case, a court might impose a constructive trust on any profits made in breach of this fiduciary duty.


Case Study

Haseotes v. Cumberland Farms, Inc.

284 F.3d 216 (1st Cir. 2002)

Procedural Posture

Appellee, a corporation, filed a Chapter 11 petition for reorganization and appellant, a director, filed claims for pre-petition indebtedness. The bankruptcy court approved the corporation’s set-off claim on the grounds that the director had breached a duty of loyalty. The United States District Court for the District of Massachusetts affirmed. The director appealed the judgment.


In 1992, Cumberland Farms, Inc. (“Cumberland”), a close corporation owned by the six siblings of the Haseotes family, filed a petition for reorganization under Chapter 11 of the Bankruptcy Act. Demetrios B. Haseotes – one of Cumberland’s directors and the appellant here filed claims against the corporation for roughly $3 million of pre-petition indebtedness owed on certain promissory notes. In response, Cumberland asserted a set-off claim of approximately $5.75 million, arguing that Haseotes breached his duty of loyalty when he caused his wholly-owned company to pay down a debt owed to him, while ignoring a much larger debt owed to Cumberland.

The bankruptcy court found that the director had breached a duty of loyalty when he caused his wholly-owned company to pay down a debt owed to him, while ignoring a much large debt owed to the corporation. **** The bankruptcy court correctly found that the disputed repayments fell within the contours of the corporate opportunity doctrine because any funds that became available in the director’s wholly owned corporation provided an opportunity to pay down the large debt owed to the corporation. Moreover, the director had not disclosed the opportunity to the corporation given evidence that the other corporate directors were not aware of the payments. Thus, the bankruptcy court did not err in finding that the director breached his duty of loyalty to the corporation. ****
As a member of Cumberland’s board of directors, Haseotes owed the corporation a fiduciary duty of loyalty and fair dealing. As the bankruptcy court observed, the principles governing a director’s duty of loyalty are “broad and pervasive.” *** Corporate directors must “act with absolute fidelity to the corporation] and must place their duties to the corporation above every other financial or business obligation.” **** The fiduciary duty is “especially exacting where the corporation is closely held.” **** In a close corporation like Cumberland, “the relationship among the stockholders must be one of trust, confidence and absolute loyalty if the enterprise is to succeed…. All participants rely on the fidelity and abilities of those stockholders who hold office. Disloyalty and self-seeking conduct on the part of any stockholder will engender bickering, corporate stalemates, and perhaps, efforts to achieve dissolution.” ****

In an attempt to give substance to the general duty of loyalty, courts have recognized several more specific obligations. We focus here on a particular variant known as the corporate opportunity doctrine, which prohibits a director “from taking, for personal benefit, an opportunity or advantage that belongs to the corporation.” ***

In sum, we conclude that the bankruptcy court did not err in finding that Haseotes breached his duty of loyalty to Cumberland when, without informing Cumberland’s board of directors that money had become available in CCP, he caused CCP to apply the money toward it debt to Haseotes’s shipping operation, rather than its larger debt to Cumberland.


The judgment of the district court was affirmed.

Issues relating to real or apparent conflicts of interest present numerous present possible avenues for litigation. A conflict may arise when an officer or director of a corporation becomes involved in a transaction with the corporation. Under the RMBCA, a transaction in which a conflict of interest exists will not be deemed to be improper under three basic circumstances:

  1. If the material facts of the transaction and those of the director’s or officer’s interest were disclosed or otherwise known to the board or one of its committees and it authorized or otherwise approved the transaction;
  2. If the material facts of the transaction and the director’s or officer’s interest were known to the shareholders entitled to vote and they approved the transaction; and
  3. If the transaction was “fair” to the corporation.

This last component has proven to be problematic in its application. For example, the payment of huge sums of money to board members under a “golden parachute” arrangement or the payment of commissions or “finder’s fees” to a board member which are authorized by the board of directors often raise questions of a conflict of interest.

The Business Judgment Rule

Officers and directors are obligated to control, manage, and invest the corporation’s assets for the benefit of the corporation. They owe both the stockholders and the corporation a duty to act honestly and with due diligence. These are legal duties. The duty of honesty explicitly forbids individuals acting as fiduciaries from personally profiting at the corporation’s expense. As agents of the corporation, they must maintain loyalty to it; they are forbidden from subsuming its interest to their own. Due diligence means that fiduciaries must exercise reasonable care in managing the corporation’s affairs. They may be held personally liable for acting negligently in running the corporation and making irrational or careless decisions on its behalf. However, in performing responsibilities to the corporation with reasonable care, a director will be protected by the business judgment rule.

Officers and directors are legally obligated to perform their duties as they would reasonably believe to be in the corporation’s best interests. They will not be held liable for making an “honest mistake.” If a director or officer makes a business decision in good faith and without consideration of personal gain, courts will refrain from questioning the virtue of the decision and will not impose personal liability on an officer or director.

Guidance is also provided in the RMBCA. A director is entitled to rely on reports and other information obtained from officers or employees of the corporation whom the director reasonably believes are reliable and competent. A director also may rely on the advice of legal advisors or accountants on matters within their respective scopes of expertise or upon a committee of directors (but not a committee upon which the director serves) if the director reasonably believes the committee deserves his or her confidence.

Review Brehm carefully.

Case Study

Brehm v. Eisner

906 A.2d 27 (Del. 2006)

Procedural Posture:

Appellant shareholders brought derivative actions on behalf of appellee corporation against appellees, the corporation’s former president and directors who served at the time of the events complained of. The Court of Chancery of the State of Delaware, in and for New Castle County, ruled in favor of appellees, finding that the director defendants did not breach their fiduciary duties or commit waste. Appellants challenged that judgment.


In August 1995, Michael Ovitz (“Ovitz”) and The Walt Disney Company (“Disney” or the “Company”) entered into an employment agreement under which Ovitz would serve as President of Disney for five years. In December 1996, only fourteen months after he commenced employment, Ovitz was terminated without cause, resulting in a severance payout to Ovitz valued at approximately $130 million. In January 1997, several Disney shareholders brought derivative actions in the Court of Chancery, on behalf of Disney, against Ovitz and the directors of Disney who served at the time of the events complained of (the “Disney defendants”). The plaintiffs claimed that the $130 million severance payout was the product of fiduciary duty and contractual breaches by Ovitz, and breaches of fiduciary duty by the Disney defendants, and a waste of assets. After the disposition of several pretrial motions and an appeal to this Court, the case was tried before the Chancellor over 37 days between October 20, 2004 and January 19, 2005. In August 2005, the Chancellor handed down a well-crafted 174 page Opinion and Order, determining that “the director defendants did not breach their fiduciary duties or commit waste.” The Court entered judgment in favor of all defendants on all claims alleged in the amended complaint. The plaintiffs appealed from that judgment, claiming that the Court of Chancery committed multitudinous errors.

The shareholders claimed that a decision to approve the president’s employment agreement and a decision to terminate him on a non-fault basis resulted from various breaches of fiduciary duty by the president and the corporate directors. The supreme court disagreed. No reasonably prudent fiduciary in the president’s position would have unilaterally called a board meeting to force the corporation’s chief executive officer to reconsider his termination and the terms thereof, with that reconsideration for the benefit of shareholders and potentially to the president’s detriment. The decisions to approve the president’s employment agreement, to hire him as president, and then to terminate him on a no-fault basis were protected business judgments, made without any violations of fiduciary duty. Having so concluded, it was unnecessary to reach the shareholders’ contention that the directors were required to prove that the payment of severance was entirely fair. Because the shareholders failed to show that the approval of the no-fault termination terms of the employment agreement was not a rational business decision, their corporate waste claim failed.


The judgment was affirmed.

Corporate Liability

Because a corporation is a distinct legal entity, it can execute its own contracts. Those individuals working for the corporation – agents, officers, directors, managers, and shareholders – are not personally liable for a breach of the corporation’s contracts. However, if any of these persons personally guaranteed performance of a corporation’s contract, he or she may be held liable if the corporation fails to perform. Frequently, officers or stockholders in small corporations having limited capital resources will be required to make personal guarantees on the corporation’s contracts. If this occurs, the individual is personally liable for the contract so guaranteed, but not for any other corporate debts or contracts. Naturally, an agent acting without the required authorization may be held liable to third parties damaged by the unauthorized acts of the agent.

Torts committed against a third party by a corporate agent or employee will result in personal liability by the tortfeasor (the person who committed the tort) to the third party for any damages suffered. If a tort is committed within the scope of an agent’s or employee’s duties, the corporation is liable for damages under the doctrine of respondeat superior, discussed in detail in the Chapter on Agency. Generally, a court will award punitive damages if an intentional tort is committed by or approved by an employee at the management level. Others within the corporate structure – shareholders, directors, managers, officers, agents, employees – are not personally liable for a tort they did not personally commit or approve. The actual tortfeasor and the corporation itself are liable.

The obligations of majority shareholders to minority shareholders are more difficult to define. Some courts hold that the majority has a fiduciary duty to the minority, but this duty is not absolute. Obviously, all stockholders have the right to vote their shares in their own best interest and as they see fit. If the result is disadvantageous to the minority, not much can be done. This is the premise of majority rule in a corporation.

Nevertheless, some limitations do apply. Where the majority’s decision results in an abuse of the minority shareholders rights or deprives them of a previously agreed upon benefit, a court may intervene. This typically occurs in small, closely-held corporations where an individual shareholder may sue the corporation because of a disagreement with an action taken by the majority. This suit is termed as a derivative suit. However, if damages are awarded as a result of a derivative suit, they are normally paid to the corporation and not to any individual shareholder who has suffered damages.


Publicly traded corporations, also called C Corporations, are separate legal entities and are taxed as such at the state and federal level. The taxation of a corporation results in what is often referred to as “double taxation,” where one might hear the phrase, “corporations are taxed twice.” In essence what this means is that first, the corporation pays a tax on its profits and then second, shareholders will pay a tax on any dividends received from the corporation. The income the corporation earned is taxed twice, once at the corporate level and then again at the shareholder level.

Corporations can elect to be taxed as Sub-S corporations, with the benefit of pass-through taxation, but are subject to restrictions on the number of and type of shareholders.

Powers of Corporations

A corporation becomes a recognized entity upon the filing of its articles of incorporation with the Secretary of State, as long as these articles conform to the state statute governing incorporation. Generally, the statute declares that every corporation formed under the state’s law will have certain powers unless the articles of incorporation expressly exclude some of the listed powers. The statute then lists every possible power necessary to run a business. Some states make a blanket grant of all powers that a natural person running the business would possess. As a result, the modern corporation possesses a broad range of powers, including the power to:

  • Issue Stock: A corporation may issue certificates of stock representing a fractional interest in the ownership of the property possessed by the corporation. Shareholders do not own or hold an interest in any specific property of the corporation.
  • Repurchase Stock: A corporation may repurchase its own stock if it is solvent at the time of purchase and it does not impair capital assets. When repurchased, this type of stock is then typically called treasury stock. Such shares can be then sold by the corporation at a price determined by the corporation. They can be sold at less than par value, unlike original shares, which cannot. The RMBCA has eliminated the concept of par value and the technical differences between original shares and treasury shares.
  • Execute Contracts: A corporation may execute contracts in its own name.
  • Borrow Money: A corporation has the implied power to borrow money for an authorized business purpose. A corporation may issue bonds as a means for borrowing money.
  • Execute Commercial Paper: Corporations are empowered to issue or indorse commercial paper and to accept drafts.
  • Acquire Real and Personal Property: In order for a corporation to carry out its express powers, corporate property may be acquired, leased, assigned for the benefit of creditors, or even sold. A number of states require that a solvent corporation may not transfer all of its property without obtaining the consent of all or a substantial majority of the stockholders. A corporation with the power to incur debts may mortgage or pledge its property as security or collateral for those debts. Franchises or public service companies, such as a public transportation system or a public utility company, cannot mortgage or pledge their property without the approval of state and federal regulatory authorities.
  • Conduct Business in a “Foreign State”: A corporation has the express authority to engage in business in other states. It must adhere to the laws of all foreign states in which it does business.
  • Participate in Other Businesses: A corporation, like a natural person, may participate in joint ventures and partnerships. The RMBCA permits a corporation to be “a promoter, partner, member, associate, or manager of any partnership, joint venture, trust, or other entity.”
  • Provide Employee Benefits: The RMBCA grants a corporation the power “to pay pensions and establish pension plans, pension trusts, profit-sharing plans, share bonus plans, share option plans, and benefit or incentive plans for any or all of its current or former directors, officers, employees, and agents.” The ERISA law may apply in such circumstances.
  • Make Charitable and Political Contributions: The RMBCA authorizes a corporation “to make donations for the public welfare or for charitable, scientific, or educational purposes.” No limit is placed on the amount that may be donated; however, some states through tax provisions may limit the amount that can be deducted from income as a business expense for charitable purposes.

Corporations were generally prohibited from making political contributions to individual candidates for public office, but not to political action committees (PACs). This changed as a result of the 2010 Supreme Court decision in the Citizens United case. In Citizens United v. FEC, the U.S. Supreme Court rejected the notion that political speech protections rest on the identity and wealth of the speaker, and found that First Amendment protections applied to corporations and other associations which contribute to political discussion and debate. The Court held that “the government may regulate corporate speech through disclaimer and disclosure requirements, but it may not suppress that speech altogether.” More specifically, the Court held “the ban imposed … on corporate independent expenditures violated the First Amendment because the Government could not suppress political speech on the basis of the speaker’s identity as a nonprofit or for-profit corporation. Austin v. Michigan Chamber of Commerce, which permitted such restrictions, and the portion of McConnell v. Federal Election Comm’n, that had upheld § 414b were overruled in Citizens United.

The implications of this decision upon corporations and unions and on the American political process are yet to be fully realized and are the subject of sharp differences of opinion and political debate.

Ultra Vires Acts

A corporation acting in excess of or beyond the scope of the powers granted by its charter and the statute under which it was organized is said to be acting ultra vires, which literally means “beyond its powers.” The RMBC and some state statutes provide for such a broad range of corporate powers that it is almost impossible to find an action this is ultra vires, unless the act was specifically excluded.

Not-for-profit corporations are more restricted as to the range of powers granted to them. Certain actions not authorized by the charters of nonprofit corporations may be determined to be ultra vires on their face.

A claim that a corporation has acted ultra vires cannot be raised to attack the validity of any act, contract, or transfer of property unless such act, contract, or transfer of property is extreme. For example, if a garbage removal corporation suddenly began a movie production company, it could be argued that the act was ultra vires. Some states have adopted an extreme position and have determined that an ultra vires contract has no effect because it was not authorized and, as such, went beyond the power of the corporation.

If an ultra vires contract has been completely performed, most states will not allow either party to claim the act was ultra vires in an attempt to rescind the contract. However, if neither party to the ultra vires contract has performed, some courts will not enforce the contract or hold either party liable for its breach.

Every state permits shareholders to obtain an injunction or to file a derivative suit to stop a corporation’s board of directors or other persons involved from entering into an ultra vires transaction. A corporation or a shareholder acting on its behalf may sue those individuals who made or approved a contract in order to recover damages for the loss incurred by the corporation resulting from the ultra vires act. Finally, a state attorney general may bring an action to revoke a corporation’s charter if it repeatedly acts ultra vires. Individual state laws should be consulted relating to the legal effects of a purported ultra vires act.

Government Regulation

Corporations are created by law and regulated at the state and federal levels. State laws govern the creation, organization, and management of this business entity. States also have their own statutes regulating sales of stock and securities within their state, called “Blue Sky” laws. Federal securities laws, for example, the Securities Act of 1933 and the Securities Exchange Act of 1934, regulate the initial issuance and secondary sales of corporate securities, along with such issues as insider trading and whistleblowing. The Sarbanes-Oxley Act created rules regarding accounting and corporate governance that corporations must follow. In addition, and depending upon the service or product offered by the corporation, the entity will have to deal with a host of state and federal administrative agencies. On the international level, corporations must first comply with domestic law that regulates business activities outside the U.S., such as import and export regulations and the Foreign Corrupt Practices Act of 1978, a statute which addresses accounting issues and makes bribery illegal.


Theoretically, a corporation can function in perpetuity. However, corporations will terminate or dissolve under certain circumstances that can be either voluntary or involuntary. Voluntary dissolution occurs when the corporation files a certificate of dissolution with the Secretary of State. The board of directors and shareholders usually must approve the dissolution. This form of dissolution may occur when a company ceases to make a profit or if it is attempting to fend off a hostile takeover.

Involuntary dissolution may result from an administrative or judicial procedure – usually when a corporation fails to comply with administrative requirements, such as paying taxes, failing to maintain a statutory agent, or failing to file required forms. A shareholder also may sue to dissolve a corporation based on an allegation of gross mismanagement or unfair treatment of stockholders.

Once the corporation is dissolved, the board of directors or a court-appointed trustee must wind up its affairs, including liquidating all corporate assets and distributing any proceeds. The proceeds are distributed to creditors first and then to shareholders. In certain cases, debts to shareholders may be subordinated to the debts of other creditors. In other cases, the debt to a shareholder who has acted improperly may be converted to shareholder equity.

Students will learn much more about the nature and function of corporations in their classes in accounting, corporate finance, and individual (personal) and entity taxation.

Hybrid Organizations

Limited Liability Company

A limited liability company (LLC) is a hybrid form of business organization that blends elements of partnership and corporate structures, previously discussed. An LLC shares with a corporation the characteristic of limited liability, and it shares with a partnership is pass-through income taxation and its management structure. LLCs are the creation of state law that must be consulted concerning the particulars of tax treatment. The LLC is considered as a more flexible business vehicle than a corporation, and it is a well-suited business association form for companies with a single owner. However, some states require more than one person to create an LLC.

Much like a corporation, LLCs are created by filing a certificate of organization with the Secretary of State. The owners of the LLC are called members. Once the articles of organization are filed, the members create the operating agreement, which is similar to a partnership agreement. The Revised Uniform Limited Company Act (RULLCA 2006) provides for default provisions for LLCs. LLCs can be member-managed or manager-managed unless specified in the operating agreement to be manager-managed. Members of an LLC owe a fiduciary duty of loyalty and due care to the LLC and to the other members including the obligation to provide an accounting, refraining from self-dealing and competition. In addition, members of the LLC may inspect the business record and must provide information to other members pertaining to the business. In exercising the duty of due care, the member will ordinarily be protected by the Business Judgment Rule and must act with the care that a person in a like position would reasonably exercise under similar circumstances and in a manner the member reasonably believes to be in the best interests of the company.


For purposes of the federal income tax purposes, LLCs are treated as a “pass-through” vehicle or entity. If there is only one member in the company, the owner of the LLC would report the income of the LLC on his or her individual tax return. For those LLCs with multiple members, the LLC is treated as a partnership and will file the IRS Form 1065. The members of the LLC are treated in the same manner as partners and each would receive a K-1 reporting the share of the LLC’s income or loss to be reported on that member’s individual tax return. As an option, LLCs may also elect to be taxed as a corporation by filing IRS Form 8832. As such, an LLC can elect to be treated as a regular C Corporation or as an S Corporation.


Similar to a partnership, members can voluntarily withdraw from an LLC or transfer their interest, or involuntarily disassociate upon death, expulsion, bankruptcy or other judicial decree. Disassociation and dissolution will trigger the termination of the LLC and the winding up of the affairs of the business. Upon completion of winding up, the LLC must file a certificate of dissolution with the Secretary of State.

Advantages and Disadvantages of the LLC

The greatest potential advantage of the LLC is that of limited liability. Owners of the LLC are protected from some or all liability for acts and debts of the LLC depending on state laws. However, the creation of an LLC does not automatically guarantee that owners will be fully protected from personal liabilities. As in the case of some “S Corporations” or closely held corporations, courts may “pierce the corporate veil” of an LLC – especially if there has been some type of fraud or misrepresentation, failure to observe corporate formalities, commingling of assets, or under-capitalization involved.

The LLC is fairly simple to create and once created, requires much less paperwork and record keeping than a corporation. Similar to ownership corporate stock, the owner’s interest in an LLC is considered personal property and is freely transferrable. However, the owner/member does not have any interest in the specific property or assets of the LLC.

On the other hand, while in most states there is no statutory requirement for creating an operating agreement, members of the LLC who operate without an operating agreement may face many potential organizational difficulties. Unlike well-developed state laws regarding corporations that issue stock which provide for detailed rules for the functioning of the corporation or for the protection of shareholder rights, most states do not require detailed governance and protective provisions for the members of a limited liability company. For example, the management structure of an LLC may be unfamiliar to many. Unlike a corporation, an LLC is not required to have a board of directors or corporate officers. The principals or owners of an LLC use many different titles – e.g., member, manager, managing member, managing director, president, chief executive officer (CEO), and even partner. Because of this lack of uniformity, it may be difficult to determine who actually has the authority to enter into a contract on behalf of the LLC.

On the financial side, issues of “risk and return” may be paramount. It may be more difficult to raise capital for an LLC. Investors may be more at ease investing funds in one of the traditional corporate forms with a view toward the eventual launch of an Initial Public Offering (IPO) of stock through a national stock exchange. In addition, many states may level a “franchise tax” or “capital values tax” on an LLC, which is a fee that the LLC pays the state for the benefit of limited liability.

If an LLC decides to “go public” and offer stock ownership for sale, the entity will lose its preferred tax status and will be taxed as a corporation.

Variations of the LLC exist. A “Professional Limited Liability Company” (PLLC or P.L.) is a type of limited liability company organized for the purpose of providing professional services, such as those provided by doctors, chiropractors, lawyers, accountants, architects, or professional engineers. Exact requirements of a PLLC will vary from state to state. Typically, the members of a PLLC must all be licenses professionals practicing the same profession. Based on state law, the limitation of personal liability of LLC members does not generally extend to professional malpractice or professional negligence claims raised against any individual member.

Limited Liability Partnership

A limited liability partnership (LLP) is a hybrid business organization that exhibits characteristics of both a partnership and a corporation. This type of partnership is similar to a corporation as some or all partners (depending on the jurisdiction) have limited liability. In a standard LLP, one partner is not responsible or liable for another partner’s misconduct or negligence. Unlike corporate shareholders or limited partners, LLP partners have the right to manage the business directly. An LLP is generally managed and taxed as a pass-through entity under rules established for partnerships—thus avoiding double taxation. The LLP is well suited for businesses when all investors are professionals and wish to take an active role in management.

LLPs are created by filing articles of limited liability partnership with the Secretary of State. The name of the partnership must include “limited liability partnership” or LLP. Much like corporations, the LLP is domestic to the state where it organized and foreign to all other states in which it does business. The RUPA is the default for matters not addressed in the LLP partnership agreement.

Special Forms Of Conducting Business

Once the form of a business organization has been chosen, entities can conduct business using joint ventures, licenses, or as a franchise. These forms of conducting business are not types of business organizations, but rather, they are ways or methods used to carry out the business of the entity. Many business organizations in the United States use these methods in order to achieve special goals or objectives of their organizations. Organizers must understand the differences among these methods and how they can be used to benefit their organization.

Joint Ventures

Joint ventures are not a separate form of business organization. A joint venture is a method used to conduct business based upon a contractual agreement. In a joint venture, existing businesses come together to conduct business. A joint venture is essentially a partnership for some limited purpose or for a limited time-period. The parties share taxes, profits, and liabilities according to the terms of the agreement between the joint venture partners. Typically, businesses use joint ventures in international business in order to gain entry or to penetrate into a foreign market. Due to the complicated nature of international business and different laws found in various countries, organizers must carefully research the implications of using a joint venture to achieve organization goals. For example, China was initially penetrated through the vehicle of a joint venture, with the partner in China often a state-owned-enterprise or SOE.


A license is a contractual agreement between the owner (licensor) of real, personal, or intellectual property (patents, trademarks, copyrights, technology) and the licensee in which the licensee is granted the right to manufacture, produce, or sell, or use a trade name or brand name belonging to the licensor, usually in exchange for a fee called a royalty. The licensing agreement states the terms of the license, including conditions on use, length of term, royalties, dispute resolution, and all other conditions. License agreements can benefit businesses by coming to market with a name, product, or service already recognized by the public.


Franchises are a method of conducting business created by a contractual agreement between the franchisor and the franchisee. The franchisor grants the franchise and the franchisee is the recipient. Franchises are regulated at the state level and at the federal level by the Federal Trade Commission (FTC). The FTC seeks to prevent unfair and deceptive practices in the sale of franchises. The FTC defines a franchise as: “any continuing commercial relationship or arrangement, whatever it may be called, in which the terms of the offer or contract specify, or the franchise seller promises or represents, orally or in writing, that:

  • The franchisee will obtain the right to operate a business that is identified or associated with the franchisor’s trademark, or to offer, sell, or distribute goods, services, or commodities that are identified or associated with the franchisor’s trademark;
  • The franchisor will exert or has authority to exert a significant degree of control over the franchisee’s method of operation, or provide significant assistance in the franchisee’s method of operation; and
  • As a condition of obtaining or commencing operation of the franchise, the franchisee makes a required payment or commits to make a required payment to the franchisor or its affiliate.” (16 C.F.R. 436)

The agreement controls the relationship between the franchisor and the franchisee. Prior to entering into an agreement, the FTC, through the Franchise Disclosure Document or FDD, requires the franchisor to disclose certain material facts to the franchisee in order to aid the franchisee in their decision to enter into the agreement, including the following:

  • The Franchisor and any Parents;
  • Predecessors, and Affiliates;
  • Business Experience;
  • Litigation;
  • Bankruptcy;
  • Initial Fees;
  • Other Fees;
  • Estimated Initial Investment;
  • Restrictions on Sources of Products and Services;
  • Franchisee’s Obligations;
  • Financing;
  • Franchisor’s Assistance, Advertising, Computer Systems, and Training;
  • Territory;
  • Trademarks;
  • Patents, Copyrights, and Proprietary Information;
  • Obligation to Participate in the Actual Operation of the Franchise Business;
  • Restrictions on What the Franchisee May Sell;
  • Renewal, Termination, Transfer, and Dispute Resolution;
  • Public Figures;
  • Financial Performance Representations;
  • Outlets and Franchisee Information;
  • Financial Statements;
  • Contracts; and
  • Receipts. §436.4 (16 C.F.R. 436.4)

There are three main types of franchises:

  1. Manufacturing: the franchisor grants the franchisee authorization to manufacture and sell trademarked products;
  2. Product: the franchisor’s products are sold to a franchisee who then resells to customers in a geographic area (for example, an automobile dealership);
  3. Business format: a type of franchise which includes the ability of a franchisee to use the franchisor’s trademark/trade name, licenses, containing provisions for the purchase of goods or supplies, method of operation, support, marketing, etc. (for example, fast food restaurants). The franchisor must exert “quality control” of the franchise operation as a part of its contractual obligation.

As noted above, the franchise agreement is required to include terms for renewal, termination, transfer, modifications, breach, and dispute resolution. Termination provisions generally include terms relating to early termination by mutual consent of the parties, termination “without cause,” termination “with cause,” and whether or not franchisee can “cure” any deficiencies. The agreement should also provide for assignment of rights, transfers to a third party, the insolvency, bankruptcy or death or disability of the franchisee.

Advantages and Disadvantages of Franchises

Advantages of franchises include the ability of the franchisee to start up a successful business in a relatively short period of time, with a publicly recognized product/service/format; the advantage of corporate support in the forms of management, training, research, development, advertising and marketing pursuant to the “Quality Control” obligation of the franchisor; protection from competition within a territory; reduced costs for purchasing products; and greater capitalization opportunities. Disadvantages may include the payment of large franchise fees (including start up fees), continued royalties, loss of independent control of the management of the business; lack of individualized decision-making; length of the agreement; ties to required suppliers (some of which may be illegal under antitrust law); and exposure to corporate problems.

Additional Business Opportunities

The FTC also regulates other business opportunities separately from franchises. A business opportunity is a commercial agreement in which:

  • A seller solicits a prospective purchaser to enter into a new business; and
  • The prospective purchaser makes a required payment; and
  • The seller, expressly or by implication, orally or in writing, represents that the seller or one or more designated persons will:
    • Provide locations for the use or operation of equipment, displays, vending machines, or similar devices, owned, leased, controlled, or paid for by the purchaser; or
    • Provide outlets, accounts, or customers, including, but not limited to, Internet outlets, accounts, or customers, for the purchaser’s goods or services; or
    • Buy back any or all of the goods or services that the purchaser makes, produces, fabricates, grows, breeds, modifies, or provides, including but not limited to providing payment for such services… (16 C.F.R. 437)

Types of business opportunities include: rack jobber (the buyer purchases a route from the company; the buyer then services the company’s clients by restocking the client with the company’s products (for example, vending machines); distributorship (the buyer purchases the rights to sell the company’s product within a territory and the buyer may or may not use the company’s name/logo in identifying the business); license (the buyer obtains the right to access to proprietary data or technology from which products or services can be offered to the public); work-at-home (for example, stuffing envelopes for a marketing company); and network marketing or multilevel marketing. Business opportunities differ from franchise agreements in that business opportunities offer greater flexibility, control, and lower start-up costs, but do not offer the long-term relationship or corporate support enjoyed by franchise owners. Business owners must also be careful to research business opportunities in order to avoid the potential of fraud.

As with any of the previously discussed business organizations and methods, prior to entering into a franchise agreement or a business opportunity, the business owner/franchisee should thoroughly research state and federal law, and consider the implications of start-up, costs, taxes, management and control, capitalization, and liability. Consulting an experienced business attorney would be prudent!

Ethical Considerations

Hybrids and Liability

Many “hybrid” forms of business organization are designed to limit the liability of owners for debt. Is this “fair” for creditors who have advanced a business money upon the premise that it would be repaid? Have courts or legislatures gone “too far” in creating business vehicles that permit parties to avoid their financial obligations?

Golden Parachutes

Should corporate directors be able to negotiate generous “severance” packages that obligate their corporations to pay hundreds of thousands of dollars in the form of a “golden parachute?” Should these agreements be subject to some sort of outside judicial review to assure their fairness?


  1. Why is the corporate form the most popular means for conducting a business?
  2. What constitutional benefits are conferred on a corporation?
  3. How is a corporation formed?
  4. What are the powers of a corporation?
  5. What is meant by “piercing the corporate veil”?
  6. When may a director of a corporation be held personally liable for wrongful act committed against a third party in the name of the corporation?
  7. Mark Stone signed articles of incorporation for the Lume-A-Star Corporation. The articles did not fully conform to the state’s laws of incorporation, and, therefore, the Secretary of State did not issue a certificate of incorporation. The Acme Earth-Moving Company leased equipment to Lume-A-Star Corporation, which then refused to pay for the equipment. May Acme sue Lume-A-Star Corp. for nonpayment of the rented equipment? Why or why not? May ACME sue Mark individually?
  8. What obligations do officers and directors of a corporation owe to the corporation and to its shareholders?
  9. What is meant by acting ultra vires?
  10. When may an involuntary dissolution of a corporation occur?
  11. What is the difference between a de jure and a de facto corporation?
  12. Discuss several ways the federal government regulates corporations in the U.S.
  13. What is the business judgment rule? What is it designed to accomplish?
  14. What is an LLP? An LLC?
  15. What is a joint venture? Licensing? A franchise?

Chapter Fourteen | Agency


Agency is an important area of the law that involves a special relationship between two parties: a principal and the person, who represents the principal, termed the agent.  In the Restatement (Third) of Agency, agency is defined as a “fiduciary relationship that arises when one person (a “principal”) manifests assent to another person (an “agent”) that the agent shall act on the principal’s behalf and subject to the principal’s control, and the agent manifests assent or otherwise consents so to act.”  In essence, the agent “steps into the shoes” of the principal in a business transaction.
The principal hires an agent to act on his or her behalf who is subject to the principal’s instructions and control.  The agent is the individual authorized to act for and on behalf of a principal.  This legal arrangement creates a fiduciary relationship (a relationship of trust and confidence) in which the agent has the duty to act primarily for the principal’s benefit.  For example, a fiduciary relationship exists between the client (the principal) and an attorney (the agent); or the owner of a piece of property (the principal) and a rental or sales agent (the agent).
Each state enacts its own laws concerning agency, many of which are similar in scope and import.   However, some differences do exist.  The application of agency law is especially important for U.S. interests doing business in other countries.  Numerous American businesses are entering international markets through joint ventures or foreign direct investment activities.  To avoid problems that arise from language differences and unfamiliarity with foreign laws and customs, many U.S. companies hire agents who are knowledgeable in these matters resulting in smoother operation of the business in the foreign market.

Creating The Agency Relationship

The extent of the authority in an agency relationship may be governed by an express agreement between the parties or may be implied from the circumstances of the agency.  Like any contractual relationship, an agency relationship can only be created for a legal purpose. Further, the formation of an agency must meet two requirements: The principal must not be a minor or be incompetent; likewise, the agent cannot be a minor or be incompetent.  If these basic requirements are met, an agency relationship may be created in any of four ways: 1) by agreement; 2) by implied authority; 3) by estoppel (called apparent agency) or 4) by ratification. The agency contract is not required to be found in writing, unless a provision of the Statute of Frauds stipulates that the contract must be written—for example, a real estate broker’s contract to sell real property. The contract need not follow any special format, or even involve payment to the agent.

Agency By Agreement

The relationship that is created pursuant to a written or oral contract is termed an agency by agreement or an express agency, under which the principal gives the agent the authority to act on his or her behalf.  If the principal does not hire an additional party to carry out the same or similar duties, the principal and agent have formed an exclusive agency contract.
A specific legal document, called a power of attorney, gives an agent the power to sign legal documents on behalf of the principal.  A power of attorney creates an agency relationship.  A power of attorney may be general or special.  A general power of attorney is very broad in the authority it gives to the agent.  A special power of attorney gives an agent limited powers to act in specific ways for specific purposes or for a specified period of time as enumerated in the document creating the agency relationship.  The agent is called an attorney-in-fact, although the agent does not have to be an attorney.
A special type of a power of attorney, called a “medical power of attorney” or “advance directive,” is commonly used in relation to health care matters.  If the principal is unable to make health-related decisions, the agent will have the legal power to act on his or her behalf.

Agency By Implied Authority

An agency relationship can also be created by the conduct of the parties, similar to the creation of an implied-in-fact contract.  The specific circumstances surrounding the relationship determine the extent to which an agent may conduct business on behalf of the principal.  In general, an agency by implied authority may not conflict with an agency by agreement.  Courts will permit an agent to receive payments owed to the principal, hire and discharge employees, buy equipment and supplies, and enter into contracts.  Case law demonstrates how far various courts will allow implied authority to stretch.  If the express agency does not provide sufficient details to cover the many contingencies that might arise during the course of the agency relationship, the agent is said to possess certain implied authority to act on behalf of the principal.  This implied authority is referred to as incidental authority.  In addition, under certain circumstances where the agent is unable to contact the principal for specific instructions, the agent has implied emergency authority to take “all reasonable actions to protect the principal’s property and rights.”

Case Study

Helene A. Gordon Et Al, v. Andrew Tobias

Supreme Court Of Connecticut, 262 CONN. 844; 817 A.2D 683 (2003)

Plaintiff landowners filed an action to quiet title on the subject property in their favor. The Superior Court in the Judicial District of New Haven (Connecticut) entered judgment for the landowners after finding that payments made to the original mortgagee on the property constituted payment to defendant assignee, and consequently discharged the landowners’ obligation under the mortgage. The assignee appealed.
The landowners purchased a condominium subject to a mortgage in favor of the original mortgagee. The mortgage was later assigned, but the landowners continued to make payments to the original mortgagee. The original mortgagee received full payment from the landowners but continued to make periodic payments to the assignee until the original mortgagee’s president died, after which the assignee refused to release the mortgage. On appeal, the assignee claimed that there was insufficient evidence in the record to support the trial court’s finding that the original mortgagee was an agent of the assignee for the purposes of collecting payments on the mortgage that he held on the subject property. The supreme court held that the trial court properly found that the mortgagee had apparent authority to collect the mortgage payment due on the mortgage held by the assignee. The assignee collected payments for more than two years knowing that the loan had matured, yet he neither objected to nor demanded full payment on the amount due. Rather, the assignee requested invocation of a higher interest rate to provide the landowners incentive to pay off the loan.

The trial court’s judgment was affirmed.
Regarding whether the agency relationship that was created was an implied agency, the court stated, “Implied authority is actual authority circumstantially proved. It is the authority which the principal intended his agent to possess. . . Implied authority is a fact to be proven by deductions or inferences from the manifestations of consent of the principal and from the acts of the principal and [the] agent.” Connecticut National Bank v. Giacomi, 242 Conn. 17, 70, 699 A.2d 101 (1997). The court found that the defendant had authorized Mutual to collect monthly payments on the note secured by the mortgage on the plaintiffs’ property and remit those payments to him. The court stated, “Apparent authority is that semblance of authority which a principal, through his own acts or inadvertences, causes or allows third persons to believe his agent possesses. . . Consequently, apparent authority is to be determined, not by the agent’s own acts, but by the acts of the agent’s principal. . . The issue of apparent authority is one of fact to be determined based on two criteria. . . First, it must appear from the principal’s conduct that the principal held the agent out as possessing sufficient authority to embrace the act in question, or knowingly permitted [the agent] to act as having such authority. . . Second, the party dealing with the agent must have, acting in good faith, reasonably believed, under all the circumstances, that the agent had the necessary authority to bind the principal to the agent’s action”  Tomlinson v. Board of Education, 226 Conn. 704, 734-35, 629 A.2d 333 (1993).

Agency By Estoppel (Apparent Agency)

Agency by estoppel or apparent agency arises when the principal creates the “appearance of an agency” that in actuality does not exist in fact.  When an apparent agency is created, the principal will be estopped from denying the existence of the agency relationship and will be bound to any contracts entered by the apparent agent while acting within the scope of the apparent agency.

Case Study

Robert M. Bailey v. Richard Worton D/B/A Worton Asphalt & Paving

752 SO.2D 470 (2000)

Procedural Posture:
Appellant developer appealed from ruling of the DeSoto County (Mississippi) Chancery Court deeming appellee’s construction lien enforceable against appellant on grounds appellant’s agent had the apparent authority to act for appellant in dealings with appellee.
Appellant developer, Bailey, hired general contractor Ray and Associates to build and sell a house on appellant’s property (with the proceeds divided between them); in the course of building the house, the contractor hired appellee, Worton – an asphalt company – to pave the driveway. When financial problems resulted in the contractor being unable to pay appellee for services rendered, appellee (Worton) sought and was granted a construction lien on appellant’s property. Appellant objected, arguing he had not entered into any agreement with appellee, but to no avail in trial court. On appeal, the state intermediate appellate court affirmed; the court reasoned that application of three-prong test for an agent’s apparent authority – acts or conduct of the principal indicating the agent’s authority, reliance thereon by a third person, and a change of position by the third person to his detriment – showed that contractor, Ray Associates, appeared to be acting on appellant’s behalf, and thus his (Ray’s) contract with appellee bound appellant.

Judgment affirmed; application of three-prong test governing apparent authority by an agent established that appellant was bound by agent’s agreement with appellee, and thus was liable for payment.
The court noted, looking at the facts in a light most favorable to the decision of the court below, it is not unreasonable to conclude that Worton relied on Ray and no one else because of her apparent authority. So far as third persons are concerned, the apparent powers of an agent are his real powers. The power of an agent to bind his principal is not limited to the authority actually conferred upon the agent, but the principal is bound if the conduct of the principal is such that persons of reasonable prudence, ordinarily familiar with business practices, dealing with the agent might rightfully believe the agent to have the power he assumes to have. The agent’s authority as to those with whom he deals is what it reasonably appears to be. Where the relationship of principal and agent exists, if the principal places his agent in a position where he appears, with reasonable certainty, to be acting for the principal, and his acts are within the apparent scope of his authority, such acts bind the principal. On principles of estoppel, a principal, having clothed an agent with semblance of authority, will not be permitted, after others have been led to act in reliance on appearances thus produce, to deny, to the prejudice of such others, what he has theretofore tacitly affirmed as to the agent’s powers. Where an agent, with the knowledge and consent of his principal, holds himself out as having certain powers and transacts business with a third person, the principal is estopped from denying the authority of the agent. Under Mississippi agency law, a principal is bound by the actions of its agent within the scope of that agent’s real or apparent authority. Finding no error, we affirm the judgment of the chancellor.

Agency By Ratification

In a case where a person misrepresents him or herself to be an agent when in fact he or she is not, and the purported principal later accepts the benefits of or ratifies the unauthorized acts, the principal is said to have ratified the agency relationship.  The ratification is tantamount to the principal authorizing the agent’s acts on the principal’s behalf in the first instance.  In order for ratification to occur, the principal must have complete knowledge of the agent’s action.  In addition, at the time the agent’s unauthorized acts occur, the third party with whom the agent dealt must know of the existence of the principal.

Duties Created by the Agency Relationship

Extensive case law on the subject and the Restatement 3rd of Agency recognize that an agency relationship creates duties, or legal obligations, on the part of both the principal and the agent.  If either the principal or the agent breaches the agency agreement, the non-breaching party can sue to enforce these duties, seek monetary damages for breach of the agreement, or seek suitable remedies in a Court of Equity.

Duties Of An Agent To A Principal

An agent owes certain duties to the principal.  The duties of the agent to the principal may be set forth in the agency agreement itself or may be implied by law.  On the most basic level, the agent has a duty to notify the principal of information that the agent learns from a third party or from another source that will help effect the purposes of the relationship.  This is known as the duty of notification.
An agent owes the principal certain duties of performance in which the agent must meet the standards of “reasonable care, skill, competence, and diligence.”  An agent who does not perform his or her express duties, or who fails to exercise the standard of care, diligence, and skill, or who acts in a negligent or intentional manner will be liable to the principal for breach of the agency contract.
The primary duty the agent owes the principal arises from the agent’s fiduciary duty to act loyally for the principal’s benefit in all matters connected to the agency relationship and not to act adversely to the interests of the principal.
An agent might breach this duty of loyalty by acting in the following ways:
  • Undisclosed self-dealing;
  • Usurping an obligation that belongs to the principal;
  • Competing with the principal without the consent of the principal during the course of the agency relationship;
  • Improperly disclosing or misusing confidential information;
  • Engaging in a dual agency relationship without consent of all parties.
In normal circumstances, the agent owes a duty to the principal to maintain a complete and accurate record of all transactions undertaken on behalf of the principal.  This is referred to as the duty of accountability, which encompasses the following:
  • Keeping records of all property and money received and expended during the course of the agency relationship;
  • Maintaining a separate account (no commingling) for the principal; and
  • Using the property of the principal is a manner authorized by the agency contract.
If an agent breaches the agency agreement, the principal may seek monetary damages, including asking a court to impose a constructive trust on any profits the agent earned as a breach of the duty of loyalty.  A principal may also seek to rescind a transaction entered into with third parties because of the breach of loyalty by an agent.

Case Summary

Carl Shen v. Leo A. Daly Company

222 F.3D 472 (2000)
Carl Shen, was a former employee and designated agent of Leo A. Daly Company’s (Daly) Republic of China (Taiwan) office. When Daly refused to pay taxes assessed by the Taiwanese government, the government restricted Shen’s travel, forbidding him from leaving the country. Shen then sued Daly on multiple theories of liability for damages and injunctive relief. Shen prevailed in part in the district court. Both he and Daly appeal the judgment. We affirm in part and reverse in part.
Shen, a United States citizen with dual Taiwanese citizenship moved to Taiwan in 1989 to become managing director of Daly’s operation there. To conduct business in Taiwan, Daly was required to designate a “responsible person,” or legal representative in the country, and Shen was so designated. In November 1992, Daly decided to withdraw from Taiwan because of business setbacks. As a result, Daly terminated Shen, but Shen chose to remain in Taiwan. Daly, however, failed to remove Shen as its responsible person and failed to inform Shen that he was still registered as the company agent.
In December 1993, Shen received a notice from the Taiwan Tax Authority that it wanted to audit Daly’s 1992 Taiwan tax returns. Shen, in turn, notified Daly’s accounting firm in Taiwan and informed them he was concerned he could be held responsible for any deficiency because his “chop,” the Taiwanese equivalent of a signature, was affixed to the returns. Daly responded that it was “inconceivable” any tax could be owed because Daly had suffered large losses in Taiwan. In January 1994 through mid-October 1995, Shen requested Daly to indemnify him should the Taiwan Tax Authority impose the tax liability on him directly, to resolve the tax dispute and remove him as the responsible person. In May 1994, the Taiwan Tax Authority assessed a tax liability of approximately $80,000 against Daly for 1991 and 1992. Daly did not appeal the assessment, and it became final in June 1995. In October 1995, the Taiwan Ministry of Finance and the Bureau of Entry and Exit forbid Shen from leaving the country until resolution of the Daly tax issue. Daly’s attempt to extricate Shen through diplomatic channels failed. Shen sued for a declaratory judgment in Taiwan to remove himself as Daly’s responsible person. Although the court recognized Shen was no longer an employee of Daly, it denied relief because Daly had not replaced him as the responsible person. The Ministry of Finance also denied an appeal by Shen.
In 1997, Shen sued Daly in the United States District Court for the District of Nebraska. He requested a preliminary injunction to force Daly to pay the taxes. The district court entered such an injunction on December 31, 1997. We assume Daly then paid the taxes because Taiwan lifted the travel restriction. The district court held a bench trial in February 1999 on the issue of a permanent injunction and damages. The district court found a violation of the implied covenant of good faith and fair dealing and granted a permanent injunction. Shen was also awarded attorney’s fees and $4,760 in damages on his contractual claims. Both sides now appeal and we affirm in part and reverse in part.
The district court held that Daly breached the implied covenant of good faith and fair dealing based on the agency relationship between Daly and Shen. We agree. Under Nebraska law, whether a person is an agent is a question of fact. The existence of an agency relationship does not depend on the terminology the parties use to characterize their relationship, but depends on the facts underlying the relationship. An agency relationship can be implied from words, conduct or circumstances that evidence an intent to create on. For example, under agency principles, an agent can be given apparent or ostensible authority to act if the “alleged principal affirmatively, intentionally, or by lack of ordinary care causes third persons to act upon the apparent authority.” That is what happened in this case. After Daly terminated Shen in December 1992, Daly did not remove Shen as its responsible person. 
A principal and an agent are in a fiduciary relationship. Because of the fiduciary relationship, the principal owes the agent a duty of good faith and fair dealing in the incidents of their relationship. Moreover, “‘[c]orrelative with the duties of the agent to serve loyally and obediently are the principal’s duties of compensation, indemnity, and protection.’ ” Daly breached its duty as a fiduciary in the following ways:  (1) Daly did not pay the tax when it was assessed; (2) it chose not to appeal the assessment through proper channels; and (3) Daly did not find a replacement for Shen as responsible person.

Duties Of A Principal To An Agent

The principal likewise owes duties to an agent arising either from the agency contract or which are implied by law.  These duties include:
  • A duty to cooperate and to deal with the agent fairly and in good faith;
  • A duty to provide the agent with information about risks of physical harm or pecuniary loss that the principal knows, has reason to know, or should know are present in the agent’s work, but which are unknown to the agent.
  • A duty to compensate the agent for services provided either according to the terms of the agency contract or, in the absence of an express agreement, a customary fee ordinarily paid, reflecting the reasonable value of the agent’s services based on a theory of quantum meruit;
  • A duty to reimburse the agent for all expenses, provided they were authorized by the principal, were incurred “within the scope of the agency relationship,” and were necessary to carry out the purpose of the agency relationship;
  • A duty to indemnify the agent for any losses the agent might suffer because of the actions of the principal.

Principal And Agent – Liability To Third Parties

Liability For Contracts

A major purpose of the agency relationship is to provide a principal with the means to conduct or perhaps expand their business dealings.  An agent is authorized to contact third parties on behalf of their principal, enter into contracts on behalf of the principal with third parties, and figuratively put the principal in several places at one time.
While generally a principal who authorizes an agent to enter into a contract with a third party is liable on the contract, the agent may be held liable on the contract under certain circumstances, depending upon whether the agency is classified as fully disclosed, partially disclosed, or undisclosed.  The status of the principal will determine the extent of any liability.
A disclosed principal is one whose identity a third party knows at the time he or she enters into an agreement; i.e., the third party knows the agent with whom he or she is dealing is acting on behalf of a known principal.  A disclosed principal operates in a fully disclosed agency.  In a fully disclosed agency, the contract is between the principal and the third party; thus, the fully disclosed principal and not the agent is liable on the contract unless the agent has guaranteed that the principal will perform on the contract in what is sometimes known as a suretyship.
A partially disclosed principal is an individual whose identity is unknown to the third party at the time an agreement is reached; however, the third party does know the agent is representing some principal.  A partially disclosed principal operates in a partially disclosed agency.  Under Section 321 of the Restatement (Second) of Agency, in a partially disclosed agency, both the principal and the agent are liable on third-party contracts.  In this case, the third party is relying on the reputation, integrity and credit of the agent because the principal is unidentified.  If an agent is required to “pay on the contract,” the agent can seek indemnification from the principal.
An undisclosed principal operates in an agency relationship when a third party is unaware of either the existence of the agency or the identity of the principal.  An undisclosed principal operates in an undisclosed agency.  In an undisclosed agency, both the principal and the agent are liable on the contract with a third party.  In essence, by not divulging that he or she is acting as an agent, the agent has become a principal to the contract.  The third party is essentially relying exclusively on the reputation and credit of the agent in entering into the contract.  However, should an agent be held liable and be required to “pay on the contract,” the agent can seek indemnification from the principal.

Tort Liability

In general, the principal and the agent are each personally liable for their own tortuous conduct.  However, a principal may be held liable for the negligent or intentional acts their agent if the actions of the agent are committed within the scope of the agent’s employment under a doctrine known as Respondeat Superior, providing for what is termed as vicarious liability.
The following are factors a court will employ in order to determine whether an agent’s conduct occurred “within the scope of employment”:
  • Was the act specifically requested or authorized by the principal?
  • Was the act the kind of act that the agent was employed to perform?
  • Did the act occur substantially within the time period of employment authorized by the principal?
  • Did the act take place substantially within the location of employment authorized by the principal?
  • Was the agent “advancing the principal’s purpose” when the act took place?
In analyzing these factors, Restatement Third of Agency Sec. 7.07 provides the following practical guidelines:
“the extent of control that the agent and the principal have agreed the principal may exercise over details of the work; whether the agent is engaged in a distinct occupation or business; whether the type of work done by the agent is customarily done under a principal’s direction or without supervision; the skill required in the agent’s occupation; whether the agent or the principal supplies the tools and other instrumentalities required for the work and the place in which to perform it; the length of time during which the agent is engaged by a principal; whether the agent is paid by the job or by the time worked; whether the agent’s work is part of the principal’s regular business; whether the principal and the agent believe that they are creating an employment relationship; and whether the principal is or is not in business.  Also relevant is the extent of control that the principal has exercised in practice over the details of the agent’s work.”
Joe, a mechanic for ABC Transmissions, owned by Mr. Carville, goes to Bob’s house on behalf of Mr. Carville to pick up Bob’s car and return it to the shop.  On the way back to the shop, Joe stops at a bar, has two drinks and then hits another car parked legally in the bar’s parking lot.  Bob sues ABC Transmissions and Joe for damages to his car.  Are either or both ABC Transmissions and Bob liable?
Joe, while on a sales trip to South Dakota for his employer, ABC Transmission, gets into a car accident when he stops at Mount Rushmore to sightsee.   Might either or both ABC Transmissions liable under these circumstances?  Might a court apply what is known as the “frolic and detour” doctrine to determine liability?  

Criminal Liability

A principal is not generally liable for the criminal conduct of an agent for such crimes as murder, robbery, bribery, etc.  It may be too difficult or even impossible to prove the requisite intent (“mens rea”) on the part of a principal.  Several exceptions exist.  If a principal participates directly in an agent’s crime, or if a principal knows or has reason to know his agent or employee is violating a law, the principal may incur criminal liability as an abettor to the criminal activity.  Several environmental statutes or actions under the Foreign Corrupt Practices Act have provided for the criminal responsibility of “responsible parties” under limited circumstances as a matter of public policy.

Termination Of An Agency Relationship

The agency relationship may end in two ways, by agreement or by operation of law.

Termination by Agreement

Either a principal or an agent may terminate the agency relationship. Termination may occur mutually by agreement; upon notice by either the principal or the agent to the other party; upon expiration (lapse) of the time period stated in the agency agreement time; or upon completion of the purpose of the agency relationship.  When the relationship is terminated, the principal should provide actual notice to all third parties who dealt with the agent that the termination has occurred.  Constructive notice may be provided to other parties by placing appropriate advertisements in publications located where the agency relationship operated; or otherwise providing notice to “the world” that the agency relationship was terminated by appropriate means.

Termination By Operation Of Law

An agency relationship may also be terminated by operation of law.  Circumstances include the death of either the principal or agent; insanity of either the principal or the agent; bankruptcy of the principal; impossibility of performance of the agency relationship (such as through a change in the law; absence of qualification through a failure to obtain a regulatory-type license required to perform duties or the revocation of a required regulatory license; or the loss or destruction of the subject matter of the relationship); and the outbreak of war, where the principal or agent is located in a nation at war and where the agent’s country terminates the agency relationship between the parties.
Certain types of agency relationships created for the benefit of an agent are termed “an agency coupled with an interest.”  An “agency coupled with an interest” typically occurs in a security interest to secure a loan.  The principal may not legally terminate the agency relationship during the term of the agency relationship without the consent of the agent if the agent has provided the security (funding) to effectuate the loan.  Should the principal terminate the agency unlawfully, the principal may be required to pay damages to an agent that has been wrongfully terminated.

Ethical Considerations

Limiting Compensation
In the arena of sports, agents are often limited in their compensation to an amount determined by the League’s collective bargaining agreement. At the same time, a lawyer’s compensation may be four to five times higher. Should a collective bargaining agreement between players and their sports league have the ability to limit the compensation of a sports agent who is not a party to that agreement?
Maria Aripova runs a dance studio and frequently acts as an agent for booking recitals in the field of modern dance. She has two “up-and-coming” dancers in her studio. Should Maria be permitted to represent both dancers at the same time even though their interest may be quite different and even adverse on occasion? Upon what showing?


  1. How is an agency relationship created?
  2. Explain the legal principle of agency by estoppel.
  3. What are the duties of a principal to an agent? An agent to a principal?
  4. Under what circumstances might an agent be liable to a third party?
  5. What is the difference between a disclosed and undisclosed principal?
  6. Describe how an agency relationship may terminate or be terminated?
  7. Give an example of an “agency coupled with an interest.”
  8. Research Questions
  9. What is an independent contractor?
  10. What is CERCLA?
  11. What are the two most important aspects of the Foreign Corrupt Practices Act?

Chapter Fifteen | Sole Proprietorships and Partnerships


When deciding to create a business, the founder(s) must consider the purpose of the business and its short-term and long-term goals. Immediate issues for consideration when analyzing the different types of business organizations include ease of formation, management control, taxation, legal liability, ability to raise capital, governmental rules, transferability of ownership, and termination. Understanding the goals of the business will help the founder(s) determine which type of business organization to choose. Business organization choices in the United States include sole proprietorships, general partnerships, limited partnerships, limited liability partnerships, C-corporations, Sub-S corporations, and limited liability companies. Understanding and analyzing the advantages and disadvantages of each type of organization will help the business organizers to determine which type of organization is the best for their business.

Sole Proprietorships

The simplest form of business organization is a sole proprietorship. A sole proprietorship is the oldest and most traditional means to create a business in the United States. As its name implies, individuals, or sole proprietors, who wish to own and run a business by themselves will select this form of business organization. The sole proprietorship is merely an extension of its owner. No one else owns any part of the business. The sole proprietor has complete managerial authority and may employ as many individuals as are needed to run the business. Businesses that commonly choose this form of organization are retail establishments, service businesses, and those businesses involved in agriculture. In most states, a husband and wife may operate a sole proprietorship together, but will be considered as a single owner for legal and accounting purposes.


A sole proprietorship is not a separate business entity, but rather, it is an extension of its owner. Few legal requirements exist to establish a sole proprietorship, and those that do exist are not complicated. However, in most states if an individual is “doing business as” or “d/b/a” (ex: Edward Barnes d/b/a Ed’s Auto Body Shop), in a name other than his own (called a trade name), he or she must file a disclosure form with the proper state authority to identify that party as the owner of the business. For example, if a creditor sues Ed’s Auto Body Shop, owned by Edward Barnes, the creditor addresses the complaint to “Edward Barnes, d/b/a Ed’s Auto Body Shop.” Further, certain types of businesses and businesses hiring employees may be required to obtain special licenses or follow other legal or regulatory requirements. For example, a delicatessen must obtain a special operating license and adhere to strict health code laws. If a sole proprietorship hires employees, the Internal Revenue Service will issue an employer identification (EIN) number in order to have the income and social security taxes withheld from the employees’ wages properly credited. The owner will also be required to follow state laws regarding workers’ compensation and unemployment insurance. These general requirements are not specific to sole proprietorships alone; they apply to other business entities as well.


A sole proprietorship accounts for business income and expenses on Federal Schedule C, the individual’s federal tax return (the 1040), and on the appropriate state income tax return. In addition, the sole proprietor is required to file Federal Schedule SE (self-employment tax) if the proprietorship makes a profit over the threshold amount.


A proprietorship will be terminated when the proprietor closes the business, sells the business, or upon the death, insanity, or bankruptcy of the proprietor.


The creation of a sole proprietorship is a simple and inexpensive process. A sole proprietor normally will not have to pay any large fees for organizing his or her business as a sole proprietorship. The owner (proprietor) makes all the decisions and retains all profits accruing to the business. The net earnings are taxable as personal income and not subject to the corporate income tax. A sole proprietor may freely sell the business—including inventory and the good will of the business—to another individual. However, because a sole proprietorship is merely an extension of the individual owner, the sole proprietorship itself cannot be transferred from one person to another. The buyer must create his or her own form of business in order to conduct the business that has been transferred.


As a sole proprietorship is not a separate legal entity from the proprietor, it cannot sue or be sued in its own name. As such, the primary negative aspect of a sole proprietorship is the liability assumed by the owner. Liability is complete and unlimited. The proprietor is personally liable for all of the obligations and debts of the business. If the assets of the business are not sufficient to pay the claims of creditors, creditors may seek payment directly from the owner’s personal assets. Therefore, the sole proprietor risks insolvency and may be exposed to personal bankruptcy. On the other hand, the proprietor must sue those who have caused damage to the proprietorship or who are debtors of the proprietorship in his or her own name.

The sole proprietor may be limited with regard to raising capital to run his or her business. Without any partners or the ability to sell ownership interests in the business, the sole proprietor’s capital is limited to available cash and assets, and the ability to obtain a business loan based upon the sole proprietor’s credit worthiness.

The sole proprietor who hires employees may be responsible for the torts or other wrongful acts of employees committed in the course of their employment. The proprietor is also liable for contracts entered into by an employee who has the authority to do so. The rules of agency apply in these situations. The legal theory termed Respondeat superior is used to determine the legal liability of a sole proprietor for the torts of an employee committed “within the scope of employment.”

A proprietor may argue that the tortuous act should not be imputed to him or her because the employee is an independent contractor. An independent contractor controls his or her own “methods and means” of work and does not work under the control of the proprietor. The employer may also claim that the employee was pursuing his or her own business or personal interests, under the “independent frolic” doctrine. Even if a court agrees that the employee was an independent contractor, the proprietor may still be held liable in his or her own right under a separate theory of “negligent selection” or “negligent hiring,” as where the employer fails to check employment records, or because the duty was “non-delegable.”


The Uniform Partnership Act (UPA) or the Revised Uniform Partnership Act of 1997 (RUPA) defines a partnership as “the association of two or more persons to carry on as co-owners of a business for profit.” The UPA and RUPA have been adopted by the majority of states and provide the basic law applicable to partnerships. The RUPA is composed of a set of rules that will apply to a partnership unless the partnership agreement states a provision contrary to that stated in the Act.

Essentially, a partnership requires that individuals will pool capital resources or professional talents in order to obtain a profit. For this purpose, a “person” may include a natural person, corporation, business trust, estate, trust, partnership, association, joint venture, government, governmental subdivision, agency, instrumentality, or any other legal or commercial entity.

Law, architectural, engineering, and accounting firms, as well as medical associations, will frequently operate as partnerships; however, a trend is emerging for such businesses to incorporate as professional corporations or to become limited liability partnerships, or limited liability companies. Retail and service businesses may use the partnership form, as well as many individuals who intend to hold and manage real property together. When discussing partnerships, it is important to differentiate among various types of partnerships: the general partnership, the limited partnership and the limited liability partnership. Partnerships may be “at-will,” established for an indefinite period of time; but if a partnership is established for a definite period of time or for a particular undertaking, there must be clear evidence of the intent of the partners to limit the time period or purpose of the partnership

Attributes of a General Partnership

The UPA defines a partnership as an “association.” Implicit in this concept is the voluntary nature of this business form. Therefore, a partnership is created by consent of the parties and is usually formed by executing a contract called the partnership agreement or “Articles of Partnership.” In some states, the partnership is treated as a distinct entity; for others, the partners are treated as individuals. In the former case, a partnership may buy, sell, and own property in the partnership’s name and the partnership will file a federal income tax return (the 1065) for informational purposes in its own name to account for the income generated. At common law, a suit could never be brought by or against a partnership in its own name; each partner had to sue or be sued. However, while this principle is still generally true, many states now provide that a partnership can be treated as an entity for purposes of suing others or for being sued or for filing bankruptcy. State law must be consulted on this important matter.

A basic element of the partnership form requires partners to carry on as co-owners of the business. This is demonstrated by sharing profits, joint ownership of property, making contributions of capital to the business, and joint participation in management decision-making. Each partner is also an agent of the partnership. Finally, the partnership must be formed for the purpose of making a profit. Therefore, businesses formed for religious, charitable, or fraternal purposes may not be a partnership. The RUPA also establishes broader protective measures for limited liability partners. Limited partnerships are not governed by the RUPA; rather, the provisions of the Revised Uniform Limited Partnership Act (RULPA) ally to these entities. Limited partnerships are discussed later in this chapter.

Formation of a Partnership

A partnership may be formed by the voluntary actions or agreement of the parties or implied by the conduct of the parties. The establishment of a partnership by voluntary means is usually most desirable because the rights and liabilities of each partner are best protected by specific agreement of the parties, found in the Articles of Partnership.  


Case Summary

Reilly v. Meffe

6 F. Supp. 3d 760 (S.D. Ohio 2014)


The Plaintiff, Brian Reilly, is a principal in the company Transact Partners International LLC (Transact). *** The Defendants, Domenick Meffe and Richard Hoffman, are principals in the company Wellington Resources LLC (Wellington). On January 31, 2011, Wellington and Transact, non-parties in the present suit, executed a co-brokerage agreement that promised Transact 2% of the total transaction price of the sale of Beck Energy Corporation assets if Transact identified and presented a successful buyer of those assets. Transact successfully procured a buyer for the Beck Energy assets.

Following the success of this transaction, the business relationship between Reilly, Meffe, and Hoffman (the parties) developed through the exchange of industry information and contacts. On May 31, 2011, the parties discussed creating a more formal partnership in which they would split profits from any transaction equally between the three members. The parties allegedly confirmed the partnership agreement through an exchange of e-mails.

After May 2011, the alleged partnership executed a number of business transactions involving the sale of oil and gas rights throughout Ohio. The Plaintiff worked to market the partnership deals among his industry contacts. During the course of 2011, the Plaintiff marketed twelve deals on behalf of the alleged partnership. Meanwhile, the Defendants solicited oil and gas leases from leaseholders and executed the sale of oil and gas leases owned by the alleged partnership. From May through November 2011, Defendant Meffe and the Plaintiff were in contact on a daily basis. All three members of the alleged partnership met in person or held conference calls at least twice a week to discuss partnership business and to calculate prospective profits that would be distributed to each member of the alleged partnership.

The alleged partnership’s first transaction involved the transfer of oil and gas rights for land in the City of Girard, Ohio. On November 26, 2011, the net proceeds from the transaction were split three ways between the parties. In the fall of 2011, the Defendants purchased oil and gas rights to approximately 4,400 acres of land in Monroe County, Ohio (the Massey Assets) from an Ohio limited liability company. The Plaintiff then marketed the Massey Assets and a number of smaller leases in Belmont County (the Belmont Assets) to a variety of oil and gas companies.

On December 19, 2011, the Defendants conveyed the Massey Assets to XTO/EXXON without notice to the Plaintiff. The sale of the Monroe County leases resulted in a profit of $7,321,107.00 for the alleged partnership. Also in late 2011, the Defendants sold the Belmont Assets without notice to the Plaintiff. The sale of the Belmont Assets resulted in a profit in excess of $600,000.00 for the alleged partnership. The Defendants did not split the profits from the sale of the Massey Assets or the Belmont Assets with the Plaintiff. After learning of the closing of the Massey Assets in January 2012, the Plaintiff confronted the Defendants regarding the distribution of the alleged partnership’s profits. Defendant Meffe informed the Plaintiff that he would not be paid a partnership share, which Defendant Meffe’s counsel subsequently confirmed after discussions with the Plaintiff.

On July 29, 2013, the Plaintiff filed a six count Complaint (doc. 2) against the Defendants alleging: (1) Breach of Contract; (2) Breach of Fiduciary Duty; (3) Conversion; (4) Intentional and/or Fraudulent Nondisclosure; (5) Unjust Enrichment; and (6) Accounting. In lieu of an Answer, the Defendants have filed multiple Motions to Dismiss. The Defendants move to dismiss the Complaint, arguing that: (1) the Plaintiff’s Complaint fails to state a viable partnership claim against the Defendants; (2) in the alternative, the present lawsuit is covered by a private arbitration agreement; and (3) in the alternative, the Southern District of Ohio is an improper venue for the present action.


The Defendants argue that the Plaintiff’s allegations are insufficient to establish a viable partnership claim under Ohio law. According to the Defendants, the Plaintiff has no written partnership agreement with them. In their view, the e-mails attached to the Plaintiff’s Complaint demonstrate “something far short of a ‘formal partnership’ document and only underscore *** the absence of any meeting of the minds on the essential terms of the alleged partnership agreement.”

The Defendants also maintain that the parties’ course of conduct demonstrates the lack of a partnership agreement—the parties did not share profits, did not have mutuality of agency, did not have joint ownership of property, and were not treated as a partnership for tax purposes. Therefore, the Defendants conclude that the Plaintiff has failed to state a claim upon which relief may be granted.

In response, the Plaintiff asserts that the Defendants misrepresent Ohio partnership law. The Plaintiff cites the parties’ e-mails as evidence demonstrating the intent of the parties to form the alleged partnership. According to the Plaintiff, after the May 31, 2011 e-mail exchange, the parties “actively worked together on over a dozen deals for the next six months, never questioning the terms of the partnership up to and after the first consummated deal.”

The Court is not persuaded by the Defendants’ arguments. Under Ohio law, a partnership is “an association of two or more persons to carry on as co-owners a business for-profit formed under section 1776.22 of the Revised Code, a predecessor law, or a comparable law of another jurisdiction.” Section 1776.22 provides “any association of two or more persons to carry on as co-owners a business for-profit forms a partnership, whether or not the persons intend to form a partnership.” A partnership agreement is “[an] agreement among the partners concerning the partnership, whether written, oral, or implied.”

Courts consider a number of factors in determining the existence of a partnership, including: the sharing of profits, “the existence of a written or oral partnership agreement; the joint ownership and control of property; the ability of members to bind the business entity; and the nature of the tax returns filed by the business entity.” *** However, “‘[s]ince every business relationship is unique, no single fact or circumstance can operate as a conclusive test for the existence of a partnership,’ particularly when the parties have dealt casually with each other.”

Although the Defendants emphasize that there is no written partnership agreement in this instance, under Ohio law, a partnership agreement is not required to be in writing. *** (defining a partnership agreement as “[an] agreement among the partners concerning the partnership, whether written, oral, or implied.”).

The Defendants’ better argument is that the Plaintiff has failed to allege sufficient facts demonstrating a “meeting of the minds” and that therefore no partnership was formed between the parties. According to the Defendants, the Plaintiff’s Complaint and the e-mails attached as exhibits to the Complaint demonstrate the vague nature of any alleged partnership discussions between the parties. The Defendants point out that the parties “‘discussed forming a more formal partnership’—suggesting some future action to be performed in the future, which would be formalized.” *** Although the Plaintiff alleges that the parties confirmed their oral agreement through the exchange of written e-mails, the Defendants maintain that these e-mails “underscore *** the absence of any meetings of the minds on the essential terms of the alleged partnership agreement.” The Defendants note that Defendant Meffe’s e-mail referred to an agreement “between [the parties’] respective companies.” In contrast, the Defendants observe, the Plaintiff’s response referred to an agreement concerning a single transaction related to the Jefferson County leases and purportedly between the parties as individuals, rather than their companies. Based on this comparison, the Defendants contend that the parties did not agree to the essential terms of the alleged partnership agreement.

If the Plaintiff’s Complaint only included allegations of the May 31, 2011 phone call and e-mails, the Court would be inclined to agree with the Defendants’ conclusion. The Plaintiff alleges that on May 31, 2011, the Defendants called him and proposed forming a partnership and splitting the profits from that partnership equally. Although the splitting of profits is indicative of a partnership, ***, from the Plaintiff’s account of the phone call it does not appear that the parties agreed to other essential terms of the alleged partnership agreement.

The e-mails between the parties are similarly ambiguous. Shortly after the phone conversation on May 31, Defendant Meffe e-mailed the Plaintiff, stating, “Bryan [the Plaintiff], list of names which you will need to understand the map. Should we have an agreement between our respective companies?” Exhibit C at 2, doc. 18-3. The Plaintiff responded, “Dom, Rick [the Defendants]: This e-mail is to confirm our understanding that we intend to split the profits on this transaction (Jefferson County leases) equally 3 ways between us — Thanks — Brian.” While Defendant Meffe referred to an agreement between the parties’ companies (Wellington and Transact), the Plaintiff’s response purported to confirm an agreement to work together as individuals to complete a single transaction (the sale of Jefferson County leases) and split the profits equally. In short, the Plaintiff’s allegations concerning the May 31 phone call and the e-mail suggest a general intent to have an agreement between the parties, but the essential terms of that agreement are unclear based on the May 31, 2011 telephone call and e-mails.***

*** Nonetheless, as alleged by the Plaintiff, the parties’ course of conduct following May 31, 2011 is sufficient to demonstrate a “meeting of the minds” between the parties and to support the existence of an implied partnership agreement. *** (“A court may find an implied partnership from the totality of attendant facts and circumstances”). Under Ohio law, “‘[a] court can properly find a partnership exists from evidence that there has been a sharing of net profits from a continuing business operated by two or more persons, where each is capable of binding the business entity.'” *** Here, the Plaintiff explicitly alleges that, after six months of working together to buy, market, and sell oil and gas leases throughout Eastern Ohio, the parties split the profits from the City of Girard transaction. Significantly, “[a] person who receives a share of the profits of a business is presumed to be a partner in the business[.]”***

***Further, as alleged by the Plaintiff, the totality of facts and circumstances support a finding that the Plaintiff was a co-owner of a continuing business with the Defendants. Construing the Complaint in the light most favorable to the Plaintiff and accepting all well-pleaded material allegations in the Complaint as true as the Court must *** the parties worked together from June through December 2011 to buy, market, and sell oil and gas rights in Eastern Ohio. The parties communicated with one another on a daily basis to discuss potential business deals and to calculate prospective profits from those deals. While the Defendants bought and sold the actual oil and gas leases, the Plaintiff (1) marketed at least twelve oil and gas deals to various energy companies, (2) secured buyers for approximately eight of those deals, and (3) obtained multiple letters of intent from buyers on behalf of the alleged partnership. Most significantly, as the Plaintiff became more active in the alleged partnership, “[the Defendants] had very little or no direct contact with the leaseholders as [the Plaintiff] increasingly handled both sides of the transactions directly.” Drawing all reasonable inferences in favor of the Plaintiff, the Plaintiff’s conduct as described above, particularly handling both sides of various transactions, was consistent with that of a co-owner of a business.

The Court concludes that the Plaintiff has alleged sufficient facts to support his partnership claims. As alleged by the Plaintiff, the parties worked together on numerous oil and gas transactions and split the profits from the City of Girard transaction which creates the presumption under Ohio law that the Plaintiff was a partner in business with the Defendants. The totality of the facts and circumstances in this case buttress this presumption as the Plaintiff’s behavior was consistent with that of a co-owner. Consequently, the Court will deny the Defendants’ Motion to Dismiss for Failure to State a Claim. Outcome Defendants’ motions to dismiss denied; plaintiff’s motions to strike denied.

Management And Control

If, at the outset of a partnership, there is no written partnership agreement, partners determine their capital contributions and decide upon the duties each will perform. Without a written agreement, the default provisions of RUPA control and all partners will share equally in all partnership profits and losses. Therefore, without a partnership agreement, if the partnership consists of two partners and one does 70% of the work and the other only does 30%, or one partner provides 70% of the capital, and the other 30%, each partner will nonetheless receive 50% of the profits according to the RUPA, no matter what the two partners may have otherwise intended.

In order to avoid this and numerous other problems relating to management responsibilities, profit distribution, borrowing authority, etc., a comprehensive partnership agreement should be drawn up specifying each partner’s rights, obligations, and responsibilities. This agreement, called Articles of Partnership, fixes the expectations of the individuals by an express agreement between the parties.

Specific issues to consider in the creation of the partnership agreement run from the basic to the more complex: the name and address of the partnership, its purpose, the amount and type of investment each partner will contribute, managerial and voting power, dispute resolution, partner insurance (“key man” insurance), bookkeeping methods, banking responsibilities, borrowing rights, and employee issues.

A partnership can also be created involuntarily, i.e., when no express agreement exists and where the parties may not even call themselves partners. This is called a partnership by estoppel. In certain situations, a court may infer that a partnership exists despite the fact that the persons involved deny it. Courts will look beyond the form to the substance of the activities in making a determination and will refer to these persons as “purported partners.” Section 308 of the RUPA provides:

“If a person, by words or conduct, purports to be a partner, or consents to being represented by another as a partner, in a partnership or with one or more persons not partners, the purported partner is liable to a person to whom the representation is made, if that person, relying on the representation, enters into a transaction with the actual or purported partnership.” The purpose of finding a partnership by estoppel is to protect a third party that relied to their detriment upon the representations or actions of a purported partner.

Section 308 of the RUPA also deals with a partnership by estoppel from the standpoint of profit sharing. The fact that two or more parties share the profits of a business gives rise to the rebuttable presumption that a partnership exists. This presumption may be overcome by evidence that the receipt of profits was for the purpose of repaying debts, repayment of interest or other charges on loans, paying wages or rent, paying a widow or personal representative of an estate, or paying for business goodwill—and not as the result of any partnership relationship.


Case Study

In Re Ranch

492 B.R. 545 (Bankr. D. Or. 2013)

Procedural Posture

A creditor filed a motion to dismiss a Chapter 12 case on the grounds that it was not properly authorized because under Oregon general partnership law, Or. Rev. Stat. §§ 67.005-67.365, unanimous consent of the partners was required to authorize a bankruptcy filing on behalf of the partnership.


The bankruptcy petition was signed by one partner. Initially, the court determined that the partnership was a general partnership despite the fact that the partnership agreement identified certain partners as limited partners because no certificate of limited partnership was filed as required under Or. Rev. Stat. § 70.075. Pursuant to Or. Rev. Stat. § 67.140(11), the general rule was that actions outside the ordinary course of partnership business could only be undertaken on behalf of the partnership with the consent of all partners. Filing a voluntary bankruptcy case was a paradigm action outside the ordinary course of partnership business. However, pursuant to Or. Rev. Stat. § 67.015(1), partners could provide in a partnership agreement that decisions outside the ordinary course of business could be made with less than unanimous consent of the partners. No provision in the debtor’s partnership agreement generally authorized the partners to make decisions outside the ordinary course of partnership business by majority vote, and there was no specific provision authorizing the partners to approve a voluntary bankruptcy filing by majority vote.


The court granted the motion to dismiss the Chapter 12 case.


Relationship of The Partners

The RUPA states that each partner has a fiduciary relationship to the partnership itself and to each other. Usually each partner has one vote with respect to the management of a general partnership. Routine decisions are commonly made by a majority vote. Major decisions, such as whether to dissolve a partnership, dissociate a partner, merge with another business, or change the form of organization, may require a unanimous vote of all of the partners. The following rights and duties of partners should be specifically addressed in a partnership agreement:

  1. The right to be repaid the partner’s contribution and to share equally in the partnership profits after partnership debts are paid;
  2. The duty to contribute toward partnership losses (capital or other), generally according to the partner’s share in the profits;
  3. The right to be indemnified respecting any personal liability reasonably incurred by a partner in the ordinary and proper conduct or preservation of the partnership business or property;
  4. The right to be repaid, with interest, any payment or advance beyond the amount of capital contribution;
  5. The right to manage the partnership along with the other partners;
  6. The right to use partnership property;
  7. The duty to keep partnership books and the right to inspect and copy such books;
  8. The duty to render information to co-partners regarding all matters affecting the partnership;
  9. The fiduciary duty to co-partners of the duty of loyalty and the duty of care (much the same as that owed by an agent to a principal) in good faith and fair dealing; and
  10. The right to a formal accounting of partnership affairs if a partner is wrongfully excluded from the partnership business or possession of its property by the co-partners; or if the right to an accounting is provided in the partnership agreement; or any other circumstances rendering an accounting just and reasonable.

Partnership Property and Partner Interests

Every partner has a right to possess partnership property in furtherance of the partnership. Each partner also has an equal right to the use or possession of the property in order to advance the partnership business. Therefore, each partner’s right in partnership property is not divisible; each has a full right in the whole.

Capital contributions are the initial funds (or property) invested by the partners and comprise the partnership property. Additional property acquired during the existence of the partnership is also partnership property. The intent of the parties determines if a partner owns an item personally or if the property is owned by the partnership. According to RUPA, “property acquired by a partnership is property of the partnership and not of the partners individually.” RUPA provides two rebuttable presumptions regarding property that property purchased with partnership funds is presumed to be partnership property regardless of title; and property acquired in the name of a partner or partners without the use of partnership funds is presumed to be the individual’s property, even if used for partnership purposes.

A partner’s interest in the partnership must be differentiated from partnership property. The partner’s interest is a personal property interest that is owned by the partner. It may be sold or pledged as collateral to a creditor. Personal creditors may attach a partner’s interest in order to collect debts.

The transfer of a partner’s interest affects the partnership in several ways. Such a transfer, however, does not cause the transferee to become a new partner in the business because all existing partners must agree to the addition of a new partner. Also, the transfer does not exempt the transferring partner from personal liability. Nor will a transfer of an interest eliminate individual liability to the partnership’s existing creditors.

The partnership agreement may state limitations and restrictions on transfers of property. The partnership may have a “right of first refusal” if a partner wishes to transfer his or her interest in the business to an outside party.

Sharing Of Profits

Unless otherwise stated in the partnership agreement, partners share profits and losses equally. This may be modified by agreement of the partners where, for example, partners may share profits in proportion to the individual capital contributions made to the partnership. The same principle may be applied to the losses incurred, if any; losses are normally shared in the same proportion as are profits, but the partnership agreement will control in this situation.

Normally, partners do not receive a “salary” unless the partnership agreement specifies the contrary. This holds even if one partner performs most or even all of the work in running the business. A partner who is responsible for winding up (ending) the partnership is entitled to reasonable compensation for performing these services.


Case Study

Sriraman v. Patel

761 F. Supp. 2d 7 (E.D.N.Y. 2011)

Procedural Posture

Plaintiff asked for an accounting. Defendant claimed income from a chief of medicine contract at FH-ICU was not partnership property because defendant never considered the income to be partnership property, defendant retained the contract as his own property, and plaintiff had not proved he had any intent or reasonable expectation to the contrary. Both parties intended that the revenue from two other contracts would be a partnership asset, and plaintiff rendered services under them. Plaintiff claimed he did not receive his full share of profits and sought an accounting upon the dissolution of the partnership. Under N.Y. P’ship Law §74, the claim accrued as of the date of dissolution and was timely.


In the instant case, there can be no dispute that plaintiff, as a partner, became entitled to an accounting upon his withdrawal from the partnership and its dissolution thereupon as a matter of law. *** (“New York law provides that partners are entitled to an accounting of a partnership following its dissolution.”). The first step is therefore satisfied. The remaining issue for this Court is to reconcile the individual partners’ accounts to make sure that each receives the distribution to which he is entitled. *** The question whether or not personal property owned or acquired by a partner has been contributed by him or her to the firm so as to become partnership property depends on the intention of the parties as revealed by their conduct; by the provisions of the partnership agreement or agreement preliminary thereto; by the terms of written instruments relative to the transfer of the property to or for use of the firm; by entries in the firm books; and by the use of the property in the firm business, although the mere fact that property is used in the firm business will not of itself show that it is firm property. *** Where there is no oral or written partnership agreement, the partnership’s profits are split equally and all the partnership property is considered an asset. *** (“[i]n settling accounts between the partners after dissolution … subject to any agreement to the contrary … [t]he assets of the partnership” include the “partnership property”). This includes any secret profits a partner earned over the course of the partnership.

[The] FH-ICU Contract was, in fact, originally drafted so that all of the partners at that time — Chadha, Silverman, defendant, and plaintiff — were supposed to be signatories, and that was only changed because Silverman and Chadha left the group. Indeed, even though defendant was the only signatory to the final agreement on the doctors’ side, the short-hand reference to him was “the Group,” just as it had referred to the partnership in the initial draft. The agreement itself clearly contemplated its performance by more than one physician; it expressly required 24/7 coverage in the ICU, which could only be performed by more than one doctor. Plaintiff, in fact, did render services under that agreement, unlike the Chief of Medicine Contract. The objective indicia of intent thus indicate that both parties regarded it as a partnership asset, and I therefore find that both parties intended the revenue from that contract to be partnership income.


Clerk directed to enter judgment in favor of plaintiff in the amount of $222,300.


Disassociation of Partners

A partner can leave or withdraw from a partnership in three different ways: voluntarily; disassociation according to the terms of the partnership agreement; or involuntarily. Involuntary withdrawal may be accomplished through expulsion upon the vote by the other partners or pursuant to a judicial decree; personal bankruptcy; executing an assignment for the benefit of creditors; a partner’s incapacity or death; the termination of a partner that is in the form of a trust, estate, or other business entity (such as a partner that is corporation that loses its corporate charter).


The partnership as a separate entity does not pay income taxes. Instead, the income or losses incurred by it are “passed through” the partnership to the partners. Therefore, partnerships are called “pass-through” entities. Each partner is responsible for paying his or her portion of the taxes due on the profits received or may take deductions on his or her portion of losses incurred. An individual partner will receive a document called a “K 1” reflecting their individual share of partnership income or loss based on the partnership agreement.


RUPA states that the partnership is liable for

“(a) the for loss or injury caused to a person, or for a penalty incurred, as a result of a wrongful act or omission, or other actionable conduct, of a partner acting in the ordinary course of business of the partnership or with authority of the partnership. (b) If, in the course of the partnership’s business or while acting with authority of the partnership, a partner receives or causes the partnership to receive money or property of a person not a partner, and the money or property is misapplied by a partner, the partnership is liable for the loss.”

All partners are jointly and severally liable for all obligations of the partnership. This means that a creditor may sue all of the partners together in case of an unpaid debt or may choose one partner (“tag you’re it!!!!) as a defendant. It would then be up to that partner to implead his or her other partners under a doctrine called the “right of contribution.” Partners are not liable for any obligations that arose prior to becoming a partner. General partnerships may provide for the liability of partners for partnership debt in the partnership agreement, but all such provisions must be clearly stated. Judgments obtained against the partnership are not effective against individual partners’ assets unless the judgment is also against the individual partners.

Dissolution and Termination of the Partnership

A partnership does not exist in perpetuity, as may a corporation. A partnership can terminate as the result of voluntary or involuntary actions. A partnership will dissolve on the withdrawal of a partner in a partnership at will; the conclusion of a period of time in a fixed term partnership; the achievement of the purpose for which the partnership was specifically created; the occurrence of an event agreed upon in the partnership agreement; or the occurrence of an event that makes it illegal to continue the partnership.

The Revised Uniform Partnership Act (RUPA), however, provides that a partnership does not automatically dissolve if a partner dies or if a partner leaves (disassociates from) the business. The structure of the partnership changes, but this may or may not affect the business itself. The partnership may reorganize and continue without the exiting partner. RUPA also specifies fiduciary duties of the partners during the dissolution; and establishes a formula by which partnership interests may be valued in a buyout or dissolution. Also, if a partnership is created for a fixed term (two years, for example), and the partnership continues beyond the term without any express agreement, the UPA declares that the rights and duties of the partners remain the same as before the expiration of the stated term.

The process of terminating a partnership is called dissolution and winding up. Dissolution begins the process of winding up and precludes the commencement of new business. Winding up ends all business activity, resulting in the payment of outstanding debts and the liquidation of assets; the remaining amounts, if any, are distributed to partners to reimburse capital contributions followed by the distribution of any profits and assets that remain.

Dissolution by Agreement

The partnership agreement may include a limitation on the duration of the partnership. At the end of the time period, the partnership is dissolved. Without such a limitation, or if no partnership agreement exists, the partners can unanimously consent to dissolve the partnership. In international business, parties frequently enter into relationships, termed “joint ventures,” which are organized for a set time period and for a limited, specified purpose. At the end of that period or at the attainment of the purpose for which the joint venture was formed, the joint venture may be terminated.

Dissolution by Operation of Law

Certain events may occur that cause dissolution. As noted, the death of one partner no longer automatically dissolves a partnership. The partnership buys out the deceased partner’s interest with an amount paid to the estate of the deceased partner. Bankruptcy of the partnership will dissolve the partnership, but the bankruptcy of an individual partner does not. Laws on partnership dissolution vary from state to state and should be consulted concerning these issues. “Buy-sell” agreements, sometimes funded by the purchase of so-called “Key Man” insurance, are often concerned with the dissolution of the partnership.


Case Study

Laplace v. Laplace

Civil Action No. 03-4291 (JAG), 2006

U.S. Dist. LEXIS 768 (D.N.J. Jan. 11, 2006)

Procedural Posture

Plaintiffs, the wife and daughter of a deceased partner, sued defendant, the only remaining partner in a family partnership, claiming that the deceased partner’s estate was entitled to a larger share of the partnership than a $100,000 share that was stated in the partnership agreement for buyout after death of a partner. The remaining partner filed a motion for summary judgment.


This case involved whether to enforce the buyout provisions of a partnership agreement, and how those provisions should be interpreted. The agreement, first signed in 1959, provided for a $100,000 buyout at the time of death of any partner. The wife and daughter [claiming that the buyout was worth $3.5 million] however, contended that the buyout provision was unenforceable due to the provisions of the New Jersey Uniform Partnership Act (RUPA), ***. The court held that the partnership agreement clearly showed that the partners contemplated and provided for the eventuality of a partner’s death and therefore, pursuant to N.J. Stat. Ann. § 42:1A-4(a), the agreement terms governed. The court further held that there was insufficient evidence that the partners had adopted a course of conduct that waived the agreement’s buyout terms. While the estates of certain partners in the past received more than $100,000, the provisions were made pursuant to a decision of the remaining partners, as provided for in the agreement. Finally, there was no basis for the argument that the buyout provision’s reference to “partnership business” did not include the partnership’s real estate assets.


The court granted the motion for summary judgment filed by the remaining partner.

Dissolution by Judicial Decree

If members of the partnership are no longer able to work together, they may petition a court for dissolution in the interest of preserving their investment and the property of the partnership.

Limited Liability Partnerships

Depending on the jurisdiction, a limited liability partnership (LLP) is a partnership in which some or all partners have limited liability. A partnership must file a certificate of limited liability partnership with the Secretary of State. Rules and regulations on limited liability partnerships vary from state to state. As a hybrid vehicle, an LLP exhibits characteristics of both a partnership and a corporation. In a standard LLP, one partner is not responsible or liable for another partner’s misconduct or negligence. In an LLP, some of the partners enjoy a form of limited liability similar to that of the shareholders of a corporation. Unlike corporate shareholders or limited partners, LLP partners have the right to manage the business directly. An LLP will also be taxed as a pass-through entity, generally under rules established for partnership vehicles—thus avoiding double taxation. The LLP is well suited for businesses where all investors are professionals and who may wish to take an active role in management. LLPs are discussed further in the Chapter on Corporations.

Limited Partnerships

The primary law governing limited partnerships (LPs) is contained in the revised Uniform Limited Partnership Act 2001 (ULPA), adopted by almost every state, either in total or revised format. Limited partnerships (LPs) may be created for any lawful profit-making purpose. According to the Commission on Uniform Laws, limited partnerships “targets two types of enterprises that seem largely beyond the scope of LLPs and LLCs:

  • sophisticated, manager-entrenched commercial deals whose participants commit for the long term, and
  • estate planning arrangements (family limited partnerships).”

The ULPA assumes that, more often than not, people utilizing this form will desire:

  • “strong centralized management which is strongly entrenched in the business, and
  • passive investors with little control over or right to exit the entity.”

LPs are created when partners in a general partnership accept investments from one or more parties, called limited partner(s), and file a certificate of limited partnership with the appropriate Secretary of State.

As with the general partnership, the partnership agreement controls the legal relationship among the partners, and between the partners and the partnership. Unlike the general partnership, it is characteristic of the LP to have two classes of partners and to have at least two partners. An LP must have a least one general partner and one or more limited partners. In addition, the words “limited” or “L.P.” or “LP” must be spelled out or abbreviated in the partnership’s name. The partnership name may also contain the name of any partner.

The general partner(s) manages the partnership and assumes responsibility – unlimited liability- for the debts of the partnership. The limited partner(s) contributes cash or other property and owns an interest in the business, but does not participate in its management. Limited partners are essentially passive investors who do not incur unlimited liability in the partnership: they are not personally liable for the debts of the partnership beyond any amount invested—termed their ca[pital contribution. Some family owned businesses are created as family limited partnerships (FLPs) in order to keep the business within the family or to manage a family investment asset. For some families, FLPs are often used for estate planning purposes.

With the exception of the treatment of limited partners and the need for adherence to state law in the formation of limited partnerships, general and limited partnerships function in much the same way.

Creating a Limited Partnership

Forming a limited partnership requires a formal and public proceeding and adherence to the legal requirements of a specific statute. Its existence requires state approval. The partners must sign a certificate of limited partnership that includes information similar to that found in a corporate charter. The certificate is then filed with the appropriate state official, usually with the Secretary of State. The certificate is public information, subject to open inspection. The certificate must contain the following information:

  • The name of the limited partnership, which must include the words “limited partnership” or “limited” or “L.P.” or “LP” without any abbreviations;
  • The address of the limited partnership’s principal office;
  • The name and address of a statutory agent of the partnership;
  • The business address of the general partner; and
  • The latest date for dissolution of the partnership.

Limited Partners: Liability

General partners are personally liable to the partnership’s creditors for partnership debt. Limited partners are not. For this reason, at least one general partner is necessary to form a limited partnership. The limited liability protection afforded to limited partners may be forfeited if a limited partner engages in the “management and control” of the business. Each state provides definitions of “management and control” and safe harbors defining when limited partners are not considered to be participating in the management and control of the business. The fact that limited partners avoid personal liability for the debts of the business provides the main advantage of a limited partnership over that of a partnership. Note that the 2001 revision to the ULPA, if adopted by states, eliminates this “management and control” analysis and provides full limited liability to limited partners.

Today, many companies address issues surrounding the unlimited liability of a general partner by creating an LLC or a corporation to serve as the general partner. As the LLC or corporation has limited liability because of the rules of incorporation, no one in the limited partnership would have personal liability, unless state law provides to the contrary. However, this creates additional expense. In response, currently half of the states in the U.S. have adopted laws that create a business entity called a limited liability limited partnership (LLLP) which gives all partners—both limited and general — the protection of limited liability. LLLPs are currently used most often in real estate and the entertainment and communications industries. Cable News Network, LP, LLLP (CNN) is an example. The revised Uniform Limited Partnership Act (2001) also recognizes LLLPs. Whereas the advantage of limited liability protection in the LLLP for general and limited partners is obvious, business owners should also be aware of the disadvantages. These include increased complication in creating this format, increased cost in filing fees, and the potential for incurring unplanned tax consequences such as state taxes and federal taxes (relating to passive income vs. earned income).

Limited Partners: Rights and Liabilities

The rights of limited partners are very much the same as those of general partners. Limited partners have a right to review the books of the partnership and to an accounting of the partnership business. Upon dissolution, limited partners have a right to the return of their capital contributions in accordance with the partnership certificate. Limited partners may assign their interest, subject to specific provisions in the certificate.

In some jurisdictions, courts have recognized the absolute right of limited partners to sue, individually or on behalf of the firm, for economic injury to the firm caused by the general partners or outsiders. In order to protect the limited liability of the limited partners, there are several additional requirements, in addition to the creation of the entity discussed above. Some states may require a specific dollar amount to establish an LP. The limited partners cannot take part in the management of the firm. The limited partners cannot use their individual names in the name of the partnership, otherwise giving the wrong impression to outsiders and resulting in the possibility of creating a general partnership by estoppel.

The RULPA has eliminated the limited liability that attaches to limited partners when a limited partner performs duties ascribed generally by general partners. Under such circumstances, the liability of a limited partner would extend to those persons who are led to believe that, by the conduct of the limited partner, he or she is in fact a general partner.

However, a limited partner may perform the following duties and activities without losing the protection of limited liability:

  • They may be employees of the general partnership;
  • They may consult with or advise the general partner;
  • They may act as a surety or guarantor for the limited partnership; and/or
  • They may vote on amendments, dissolution, sales of property, or assumption of debt.

Limited partners who follow these rules and who do not engage in the “management and control of a business” will be liable up to the amount of capital contributed to the limited partnership. A pledge to pay a certain amount as capital over a time period causes a limited partner to be liable for the full amount pledged.


Case Summary

Bartlett v. Pickford

Civil Action No. ELH-13-3919, 2014

U.S. Dist. LEXIS 178682 (D. Md. Dec. 31, 2014)


This intra-family dispute pits siblings against each other with respect to valuable real estate located in Talbot County, Maryland. Christy Pickford Bartlett, as General and Limited Partner of Pickwick Farm Limited Partnership, Trustee of the Patricia Pickford Revocable Trust, and Co-Trustee of the Stephen Pickford and April Pickford Trust; Barbara “Bobbe” P. Mundt; and Judith “Gigi” Pickford Barse, plaintiffs, filed suit against defendant Cecile E. Pickford, as General Partner of Pickwick Farm Limited Partnership. At the center of the controversy is a 76-acre farm (“Farm”) located in Maryland, owned by the Pickwick Farm Limited Partnership (“Pickwick Farm LP”).

From its inception, Pickwick Farm LP has been managed by its two general partners, Bartlett and Pickford. Barse and Mundt, as limited partners of Pickwick Farm LP, do not have responsibility for the management or operation of the entity’s business. With respect to any sale of the Farm, such a transaction requires, inter alia, joint consent of Pickwick Farm LP’s two general partners. ***

In May 2013, the Pickwick Farm LP “received an offer” of $2.7 million for the purchase of the Farm. Despite the desire of Bartlett, Barse, and Mundt to pursue the sale, Pickford withheld her consent and effectively blocked the transaction.

Because of Ms. Pickford’s unwillingness to sell the Farm and the failure of Pickwick Farm LP to operate with a profit, plaintiffs filed suit against defendant. The Complaint contains four counts: Count I, “Specific Performance”; Count II, “Declaratory Judgment – Injunctive Relief”/”Sale of the Farm”; Count III, “Declaratory Judgment – Injunctive Relief”/”Removal of Cecile as a General Partner”; and Count IV, “Judicial Dissolution [of Pickwick Farm LP],” as an “alternative to the relief sought in Counts I and II.”

Currently before the Court is plaintiffs’ pre-discovery Motion for Summary Judgment. In support of the Motion, plaintiffs submitted a Memorandum (collectively, “Motion”), and five exhibits. Defendant filed an opposition to the Motion and appended the Affidavit of Ms. Pickford as well as a copy of the LP Agreement. Plaintiffs Bartlett and Barse filed a Reply, along with a Supplemental Affidavit of Christy Pickford Bartlett.


Plaintiffs rely, inter alia, on Section 10-802 of the Corporations and Associations Article (“Corps.”) of the Md. Code ***. *** In plaintiffs’ view, dissolution is appropriate because of the deadlock as to whether to sell the Farm. Similarly, they argue *** that removal of Ms. Pickford as a partner is an appropriate remedy under Corps. § 9A-601(5), which states, inter alia, that “expulsion” of a partner by judicial determination may be appropriate “[o]n application by the partnership or another partner,” if the partner to be expelled “engaged in conduct relating to the partnership business which makes it not reasonably practicable to carry on the business in partnership with the partner.”

In her Opposition, Ms. Pickford contends, among other things, that summary judgment is inappropriate, because she has not had an opportunity to complete discovery. According to Ms. Pickford, when plaintiffs filed the Motion, “the parties served, but had not yet responded to, written discovery and the parties had not yet taken any depositions.” Therefore, she maintains that the record is incomplete, and insists that a “full record” must be developed.

Based on the record before the Court, it does not seem that the Court can yet make a determination as to whether dissolution of the partnership or expulsion of Ms. Pickford is appropriate. In particular, it remains unclear if it is no longer “reasonably practicable to carry on the business in conformity with the partnership agreement” as required by Corps. §10-802. The LP Agreement describes the purpose of the partnership as “managing, operating, developing, and otherwise dealing with the [Farm] for the production of profit.” *** And, according to Ms. Pickford, the parties “vigorously dispute[ ]” whether the Farm is able to produce a profit. ***

Summary judgment is ordinarily inappropriate “where the parties have not had an opportunity for reasonable discovery.” *** The Fourth Circuit has explained that “[s]ummary judgment before discovery forces the non-moving party into a fencing match without a sword or mask.” *** However, “the party opposing summary judgment ‘cannot complain that summary judgment was granted without discovery unless that party had made an attempt to oppose the motion on the grounds that more time was needed for discovery.'” ***


The Motion has been fully briefed and no hearing is necessary to resolve it. *** For the reasons that follow, I will deny the Motion as premature.


Taxation of Limited Partnerships

The same tax rules apply to limited partnerships as to general partnerships: both are pass-through entities — profits and losses pass through to the individual partners. Limited partnerships will file informational returns with the federal and state governments, and the individual partners report the income and losses on their individual income tax returns and pay their proportional share of taxes, based on the partnership agreement.

Termination of Limited Partnerships

Termination of a limited partnership can happen upon the following: the occurrence of an event in the LP agreement; the consent of all general partners and of limited partners owning a majority of the rights to receive distributions as limited partners at the time the consent is to be effective; the dissociation of a person as a general partner; administrative dissolution (the signing and filing of a declaration of dissolution by the Secretary of State); or judicial dissolution (obtaining a court decree upon the application of a partner).

Dissolution of the limited partnership does not occur if a limited partner dies or assigns his or her interest to another. Bankruptcy of a limited partner will not dissolve the partnership unless it results in the firm itself becoming bankrupt. The death, mental incompetence, illegality, expulsion, or bankruptcy of a general partner does not cause the dissolution of the partnership if the business has one or more general partners or there is a unanimous vote to carry on the business. If a general partner retires or dissociates, dissolution does not automatically occur. The partnership agreement usually provides for such eventuality and, if not, the law provides for the remaining general partners to continue with the business.

Upon termination of the limited partnership, the partners go through the process of winding up and liquidation of all the assets. The RULPA provides that money from the sale of the assets be disbursed as follow: creditors (including partners, but not with respect to distributions), partners and former partners for distributions owed to them, and for return of capital contributions; and the balance divided according to the partnership agreement. Thereafter, the general partner must file a certificate of termination with the Secretary of State.


Ethical Considerations

Liability for Debts
In a sole proprietorship, the proprietor is liable for all debts of that “business.” What are the ethical implications in the law requiring a sole proprietor to continue to be liable for debt when a member of a limited liability company can simply “walk away” from a similar obligation? Does this make sense?

Joint and Several Liability
In applying the rule of “joint and several liability,” a partner who owns just a small percentage of a partnership may nonetheless be requited to shoulder the entire amount a a partnership debt. Is that “fair” to that individual partner? How might this be alleviated?



  1. Identify the factors that a business owner must take into consideration when determining what type of business organization to choose.
  2. What is the purpose of a sole proprietorship?
  3. Explain some advantages / disadvantages of this form of business entity.
  4. Explain the concept of “respondeat superior.”
  5. What is an independent contractor?
  6. Is the proprietorship an entity for legal purposes?
  7. Describe how a partnership is created.
  8. Discuss the rights and duties of partners in relation to the partnership and to other partners.
  9. What impact does the transfer of a partner’s interest have on the partnership?
  10. Explain how a partnership may be dissolved.
  11. Differentiate between a general partnership and a limited partnership.
  12. Explain the taxation of a general partnership and a limited partnership.
  13. How is a limited partnership created?
  14. How can a limited partner engage in the “management and control” of a firm?