Chapter Sixteen | Corporations and Hybrid Forms Of Organization

Introduction

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.

Characteristics

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.

Bylaws

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

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.

Overview

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.

Outcome

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.

Overview

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.


Outcome

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.

Taxation

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.

Dissolution

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.

Taxation

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.

Termination

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.

Licensing

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

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?

Questions

  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 One | The Legal System

Sources of American Law

To a large part, the roots of our legal heritage can be traced to England, although the American legal system also has roots in Spanish and Dutch law. Once a British colony ruled by King George III through his appointed governors, the United States adopted the greatest share of our laws and legal traditions from the English. For all intents, English law began with the Norman invasion of England in 1066. William the Conqueror and his successors established the king’s court (Curia Regis) to help create a unified nation. Before the Norman Conquest, disputes were settled according to local tribal customs. The king’s court began to develop a common or uniform set of customs applica­ble to the whole population. This evolved into what became known as the common law, so named because it was intended to be common to the entire British kingdom.

As the number of courts and disputes increased, the more important rulings made each year were compiled into Year Books. Judges referred to these Year Books as a source of guidance in settling cases similar to those already decided. If a dispute was unique (called a case of first impression), judges had to create new law, but they attempted to base their decisions on previously established legal principles as much as possible. Today we still rely on this body of judge-made law developed over the centuries. It is called common law or case law in the United States.

The common law was carried to the colonies by the first English settlers and used by courts during the pre-Revolutionary War period. Common law continued to be applied after the Revolution and during the writing of the U.S. Constitution. It is still a valuable source of law, especially in tort, contract, and agency law. States have also codified some parts of the common law, such as the penal code in criminal law, the probate code in estate law, or the Uniform Commercial Code (UCC), which codifies much of the common law relating to the sale of goods.

The Doctrine of Stare Decisis

In cases governed by the common law, courts follow the doctrine of stare decisis. Stare decisis literally means, “to adhere to decided cases” and holds that similar cases should be decided in a similar manner and should yield a similar result. Precedent is the legal decision or holdings from a prior case that courts use to determine the outcome of a similar case or a similar question of law. If a court determines that the facts in the precedent case are not the same as those in the case before it and, therefore, should not control the ruling, the court may distinguish the current case from the precedent. Courts also can, but rarely do, overrule their prior decisions. Courts strive to avoid overruling earlier cases because it upsets the principle of stare decisis and the reliance people place on settled law in planning business and personal affairs.

Constitutional Law

The United States Constitution is the seminal legal document in this country. A state’s constitution holds similar importance within its borders. A constitution establishes the structure of government for the political unit (federal or state) by providing for the branches, subdivisions, and functions of government and by conferring and denying powers to each part. The U.S. Constitution created three branches of government: legislative, executive, and judicial. The Constitution provides each with unique powers that theoretically make each branch equal to the other two.  The doctrine of separation of powers provides a system of checks and balances so that one branch may not trammel over the rights and prerogatives of the others. Thus, the Constitution establishes a Congress to make laws, a president to enforce the laws, and a judiciary to interpret them. It also delegates to the states certain powers and casts a basic relationship between the states and the federal government. The relationship created is by definition a federal form of government. Each state possesses a limited amount of sovereignty, but the law of the federal government is supreme and applicable to all of the states.

The U.S. Constitution
Articles I to VII

Article I — Creates in the legislature [the Congress] the authority to enact laws. Article I defines the functions, powers, and role of Congress. Section 8 relates directly to matters affecting business in the United States: the power to lay and collect taxes; to regulate commerce with foreign nations and the states; to promulgate uniform bankruptcy laws; and to establish courts inferior to the U.S. Supreme Court. Section 9 also affects business affairs, states may not impose a tax on exports to a foreign country and they may not give preference to one state over another by regulating commerce.

Article II — The subject of this article is the executive power. The President has the duty to enforce all federal laws. It establishes the President’s term of office, the requirements to become President, and sets forth the presidential election process. It identifies the President as Commander in Chief of the Armed Forces, confers in the President the power to make treaties with the advice and consent of the Senate, and permits the President to make executive agreements with other nations without the advice and consent of the Senate. At the root of this power is the President’s authority to speak and act on behalf of the country in matters of foreign relations.

Article III — Article III establishes the judicial branch of the government. Article III authorizes the establishment of the U.S. Supreme Court and other federal courts. It confers the power to interpret laws and adjudicate certain disputes to the courts. Article III also provides for trials by jury for crimes and contains a definition of treason. The power of the courts was affirmed in the precedent case of Marbury v. Madison.

Article IV — Concerns the relationships between the states. Each state is bound to recognize the public acts and proceedings of the other states through the “full faith and credit” clause. The power to extradite a criminal from one state to another is also found here.

Article V — Lays out the means by which the U.S. Constitution may be amended.

Article VI — Confers supremacy of the U.S. Constitution, federal laws, and treaties over all other laws. All officials – federal and state – are sworn under oath to uphold the U.S. Constitution.

Article VII — Includes original acceptance of the U.S. Constitution by the states.

Constitutional Amendments

The Bill of Rights is the collective name of the first ten amendments to the U.S. Constitution. The Bill of Rights contains the freedoms of speech, press, religion, and assembly; the requirement that law enforcement authorities must possess a warrant in order to perform a search and seizure; provisions for protection from self-incrimination; the establishment of a grand jury for capital offenses; requirements for just compensation in eminent domain cases; a prohibition against double jeopardy; and, important provisions for “due process of law.”

The Fourteenth Amendment — While each amendment to the U.S. Constitution is intrinsically and equally important, the Fourteenth Amendment may be considered the “first among equals” in that it makes most of the fundamental guarantees of the Bill of Rights applicable to the states.

Supremacy of the U.S. Constitution

Since the 1930s and the presidency of Franklin D. Roosevelt, the U.S. Constitution has been interpreted to allow the federal government to become involved in the conduct of many areas of our daily lives. The regulation of some activities may also be relegated or delegated to the states. In this situation, any federal law that conflicts with a state law on the same subject matter takes precedence over and preempts the state law, unless, of course the federal action is ruled unconstitutional. Should Congress determine that federal law takes priority, its decision generally will be accepted. If Congress is silent on the matter, a court of competent jurisdiction would apply the following analysis to the federal law to determine whether it takes precedence over a state enactment:

  • Does the U.S. Constitution permit the federal government to regulate the area of law in which this particular law resides? If yes, the federal law will likely prevail.
  • Does the federal law violate a right guaranteed by the U.S. Constitution, for example, the right to a speedy trial? If yes, the federal law is preempted by the U.S. Constitution.
  • If not, does a state law address the same subject mater? If so, is there an inconsistency between the two laws? If one exists, the federal law prevails.

If both the federal and state laws are not contradictory, and Congress has not specifically preempted state action, the state law is said to be concurrent with federal law and may be applied.

State Constitutions

Powers not delegated to the federal government are retained by the states unless prohibited in the states’ own constitutions. Therefore, laws on the same subject matter can differ from one state to another in many ways. Businesses need to be aware of these distinctions, including differences between federal and state authority. Conflicting perceptions may appear with respect to the point at which federal power ends and so-called “state rights” begin.

Statutory Law

Statutes are written laws enacted by Congress or a state legislature for the purpose of declaring, ordering, or prohibiting something. Counties, cities, and towns may enact laws, as well. These “local laws” are generally called ordinances. Neither statutes nor ordinances can violate the U.S. Constitution or the applicable state constitution.

State statutory law varies throughout the country, partly because of cultural and geographical differences, and partly because of diverging needs. For example, eight western states enacted marital property statutes, called community property laws, originally derived from the Spanish legal system that originated in Mexico. Louisiana has laws that originated under the Napoleonic Code, because the French initially settled that area and brought with them their system of law. New York has adopted aspects of Dutch property law as it relates to condominium and co-op ownership.

Throughout the text, you will encounter various state and federal statutes. As you read these statutes, you will begin to understand the difficulty in interpreting and applying them. A large portion of the work that modern courts do consists of interpreting what the legislators meant when they passed a law and applying that understanding or meaning to the current circumstances. In this task, a court may be guided by consulting the legislative history of any law, in order to ascertain the intention of the writers of any statute.

Equity

Equity is that body of law that carries out justice when the law itself fails to provide a fair or adequate remedy or no remedy at all. Equity originated in medieval England. During this period, the existing common law rules were highly technical and rigid. The remedies available in the common law courts were scarce. As a result, a prevailing party might not be able to obtain adequate relief in many courts. To rectify this problem, the chancellor, the king’s highest-ranking advisor, heard cases that could not be settled satisfactorily. The Court of Chancery, an offshoot of the Curia Regis, was the court of the king’s chancellor. The most famous chancellor in British history was perhaps Sir Thomas More.

The American colonies adopted the principles of equity along with the common law. Eventually, law and equity became merged, so that today, the majority of states have eliminated separate equity (chancery) and law courts. The same court handles both types of claims. Further, courts may award both monetary damages (“a remedy in law”) and an equitable remedy in specific cases.

Actions at law and suits in equity resolve issues using different procedures. In actions at law, disputes are generally resolved by the application of statutes and previously decided cases. Suits in equity are decided by principles of fairness and equity.

Examples of equitable principles include the doctrines of laches and the “Clean Hands” doctrine. Laches is the product of the maxim that “equity aids the vigilant and not those that slumber on their rights.” This means that if one neglects or omits to do what one should do in a timely fashion it is presumed that he has abandoned his right or claim. The “Clean Hands” doctrine means that the court will not provide an equitable remedy to one who has violated conscience or good faith or other equitable principles. Simply stated, it means that “he who seeks equity must do equity.”

Equitable decisions are called decrees. Unlike legal relief, which involves awards of money or something else of value, equity decrees order a party to do or refrain from doing something. For example, the remedy may come in the form of an injunction—either temporary or permanent—prohibiting one party from doing an act or commanding a party to perform an act. Another type of equitable relief is that of specific performance, where the losing party is ordered to perform the contractual promise he or she made. It is imposed when monetary damages are inadequate. For example, Ross offers to buy Joan’s building for his motorcycle shop and Joan accepts. Joan later changes her mind and decides to keep the property. Since real estate is considered to be unique, and there is no other piece of property or building exactly like Joan’s, a court may order specific performance on the contract. Joan would be compelled to go through with the sale.

Additional equitable remedies include rescission (canceling a contract, thereby putting the parties to the contract in the same position they were in before the contract was formed), restitution (returning property or money to a party), and reformation (where the court of equity will rewrite all or part of a contract to reflect the parties’ actual intentions).

Administrative Law

Congress or a state legislature will oftentimes enact a statute using general language leaving it up to the appropriate administrative agency to create more detailed rules.  Federal and state regulatory agencies (for example, the Environmental Protection Agency and the Federal Trade Commission) promulgate their own “rules and regulations” to implement the statutes enacted by the legislatures.  These regulations generally have the same impact as a statute, and therefore are often termed administrative laws.    

Administrative Agencies

As the United States became industrialized in the latter half of the 19th century, the need arose to create divisions of government that could handle the ever-complex situations that evolved. Congress and state legislatures began to establish administrative agencies. The duties that Congress could not perform in regulating certain activities because of the lack of time and specialized knowledge were delegated to these agencies.

To date, Congress and the executive branch have created over 100 administrative agencies to make, interpret, and enforce laws. These agencies provide a forum where complex issues and disputes can be adjudicated with efficiency, expertise, and fairness. Administrative agencies are authorities in their particular areas of law. Their expertise is critical given the complexities of the law and the complexities of the areas of business the laws seek to regulate.

Administrative agencies exist at every level of the government and they derive their power from the particular branch of the government that created them. For example, Congress creates federal agencies, state legislatures create state agencies, and city councils create their cities’ administrative agencies. An example of a federal agency is the Securities and Exchange Commission (SEC), which is authorized to enforce the federal securities laws that apply to issuers and persons who trade in securities. The New Jersey Department of Environmental Protection is an example of a state agency. It regulates air and water quality, wetlands, solid and hazardous waste management, parks and forestry, fish and wildlife. An example of local agency is the Business Integrity Commission of New York City. This agency regulates the trade waste industry, shipboard gambling industry, Fulton Fish Market distribution area and other seafood distribution areas, and public wholesale markets.

Legislative supervision over agencies may be minimal; however, administrative agencies are subject to the Administrative Procedure Act (APA) which requires agencies to follow uniform procedures in making rules and establishes basic notice and hearing requirements, which are collectively known as “due process” rights.

While the vast majority of administrative actions are processed informally, certain administrative agencies have been assigned quasi-judicial authority to adjudicate cases through an administrative proceeding. These proceedings are not identical to court trials; however, the agency must comply with the Due Process Clause of the U.S. Constitution. In other words, the individual or business must be given adequate notice and a meaningful opportunity to be heard, and fair trial procedures must be utilized in making administrative determinations. Administrative actions may also be challenged by claiming that an agency has acted ultra vires, that is, beyond the scope of their own power and authority.

Administrative law judges (ALJs) preside over administrative proceedings. There is no jury. Counsel may represent the administrative agency and the respondent and may call witnesses and introduce evidence. Upon hearing the case, the ALJ will render a decision in the form of an order that will state “the findings of fact and the conclusions of law” upon which the decision is based. The order becomes final if it is not appealed. If either party is dissatisfied with the decision, it may seek an appeal that consists of a review by the agency or perhaps by a court. In some cases, a successful appeal will result in a completely new or “de novo” hearing on the merits of the case. In other cases, the scope of appellate review is limited. A court will defer to the findings of the ALJ and only decide whether those findings could reasonably have been reached on sufficient or substantial credible evidence present in the record.

Treaties

According to the U.S. Constitution, a treaty is made by the President with the head of a foreign country. It must be ratified by two-thirds of the Senate. It then becomes “the supreme law of the land.” A conflict of law between a treaty and a state or federal law causes that law to become invalid.

Basis of Commercial Law

The area of law pertaining to commercial dealings is called commercial or business law. It includes aspects of contract law, sales, corporations, agency, partnerships, and other subjects included in this text.

Uniform Laws

Since each state is a sovereign, with a different set of laws, the differences created issues for commerce between the states. Beginning in the late 18th century, a group of legal scholars formed the National Conference of Commissioners on Uniform State Laws (NCCUSL) and began meeting to draft uniform statutes. State legislatures were encouraged to adopt the uniform law. In addition to the NCCUSL the American Law Institute [ALI], founded in 1923, has also developed a number of comprehensive codes of law. Each state may adopt all or part (or none, for that matter) of a uniform law. Therefore, the law on any particular subject is not “uniform” throughout the country.    

Examples of uniform laws include the Model Business Corporation Act, the Uniform Gifts to Minors Act, the Uniform Arbitration Act, and the Uniform Federal Lien Registration Act. A number of other uniform laws have been written as well. Students of business law become familiar with the Uniform Commercial Code or “UCC,” one of the most important legal codes.

The Uniform Commercial Code

The UCC is a unified body of statutes governing nearly all commercial transactions. Nevertheless, the interpretations of the UCC are found in case law, or the reported decisions of the courts. By providing uniformity and stability among the states, the UCC encourages the advancement of business and assures businesspeople that their legal contracts will be carried out and enforced by the courts.

The UCC did not result in drastic changes in the basic principles of commercial law. There are, however, important differences from the common law. While the common law was guided, to a large extent, by the principle of caveat emptor or “let the buyer beware,” the UCC envisions a different role of a merchant in commercial transactions. Merchants are held to a very high standard of performance and must act to act in good faith within the commercial sphere.  UCC § 2-103 defines good faith as “honesty in fact” and the “observance of reasonable commercial standards of fair dealing in the trade.” This is a far cry from caveat emptor!

The UCC defines and explains important and sometimes commonly misunderstood legal and business terms, thus assisting parties in the drafting of contracts and aiding courts in their interpretation and enforcement. For example, courts may rule that certain contracts or terms within a contract are unconscionable and therefore unenforceable. The case law governing contracts in one state has persuasive value in courts of other states because adoption of the UCC results in “uniformity.”

All fifty states have adopted the UCC, as well as, the District of Columbia, the Virgin Islands, and Guam. Louisiana was the last state to adopt the UCC. Why do you think Louisiana was so late in adopting the UCC?

Classification of Law

Laws may be classified into three different groupings. They are: (1) criminal law and civil law; (2) substantive law and procedural law; and (3) public law and private law.

Criminal and Civil Law

Philosophically, a crime may be considered a wrong committed against society. Federal and state prosecutors who bring the case against the defendant, or the person committing the wrongdoing, represent society. The respective criminal law applies in these cases. In certain instances, a city or municipality may initiate a criminal action, such as charging a person with theft, assault, public disorderliness, or some other criminal offense. The formal charge is made in the name of the state in which the alleged violation took place. In some cases, “persons” may include corporations and other types of business entities. Crimes are punishable by imprisonment and/or fines, and in some cases, the making of restitution to the victim of a crime.

In general terms, civil law is applied when an injured party, or a plaintiff, brings an action against another party, a defendant, because the defendant did not meet or breached a legal duty owed to the plaintiff. Anyone may be a party to a civil suit—individuals, business entities, and government entities. If the defendant loses a civil case, the plaintiff is usually awarded some form of damages (money, property) or some form of equitable relief.

At times, the same behavior may violate both criminal and civil laws. For example, a car thief may be charged for violating a criminal statute and may also be sued in a civil court by the owner of the car for money damages.

Substantive and Procedural Law

Laws that prescribe the rights and obligations of people in their everyday lives are called substantive laws. A statute that makes theft illegal is a substantive law.

Procedural laws establish the means and rules by which substantive laws are applied. For example, in federal civil suits all individuals involved (judge, defendant, jury, plaintiff, etc.) act in compliance with the rules set down in the Federal Rules of Civil Procedure. By way of example, one such rule sets forth time limits for the filing of law suits in federal courts.

Public and Private Law

Public law is law enacted by an authorized government body. Examples include the U.S. Constitution, state constitutions, federal aviation laws, state laws of incorporation, municipal parking ordinances, and zoning laws.

Private law develops from a relationship between parties and creates a framework of rules to establish rights and obligations of the parties. For example, an employment contract creates a legal relationship between the employer and employee. The terms of the contract are a type of private law to be obeyed by the parties. The requirements for executing the contract and the means for enforcing the contract are a matter of public law; however, the terms for performance are private law created by the parties to the employment contract.

Primary and Secondary Sources of Law

Primary sources of law, or binding authority, are those sources of law a court must follow when deciding cases. Primary sources include, constitutions, statutes, regulations, and case law. Secondary sources of law, or persuasive authority, include case law from other jurisdictions, legal dictionaries, law review articles, and treatises.  Secondary sources of law are not binding on the court but may help guide the court in deciding a case.

Schools of Jurisprudential Thought

The Natural Law School

The natural law school is one of the oldest legal philosophies, at least dating back the days of Aristotle.  He noted the natural law applies to all humankind.  There is a higher and universal law transcending all creation, and the human law, or civil law, aspires to embody these general, universal principles.  Every human being has an inclination to discern good from bad, right from wrong.  The notion of “natural rights” comes from the natural law.

The Positivist School

The adherents to the legal positivist school do not believe natural rights come from a higher form of law.  Instead, laws are created by societies.  Whether there are good laws or bad laws does not matter.  Under their philosophy, all laws must be obeyed until they are changed.

The Historical School

Followers of the historical school look to history, tradition, or customs.  They look to what legal doctrines have withstood the passage of time—what works and what does not work.  Adherents to the historical school will look to past cases for guidance and follow those decisions.

Legal Realism

Legal realists will look outside the statutory framework, as they believe the law cannot always be applied with total uniformity.  Judges are permitted to bring in their own psychological, economic, and political predispositions into their decisions.  They believe that law is not a scientific enterprise in which deductive reasoning can be applied consistently to reach an outcome in every case.  Instead, judges must resolve cases by balancing the interests of the parties with that of society.

 

Questions

    1. How did the common law develop?
    2. What is a “case of first impression”?
    3. Explain the principle of “stare decisis.”
    4. Why is the U.S. Constitution so important in this country?
    5. What are the various rights protected in the Bill of Rights?
    6. Explain the federal powers conferred in Articles I, II, and III. What is the doctrine of separation of powers?
    7. Differentiate between courts of equity and law. Why are each needed?
    8. What is preemption and when is a state law preempted by a federal law?
    9. What role do administrative agencies play in government? Name a federal agency and a state agency.
    10. What is the difference between a state constitution and the federal constitution?
    11. How would a secondary source of law guide a court?
    12. Explain what a treaty is and when the courts have to follow it.
    13. What is the difference between statutory law and constitutional law?
    14. What is the difference between public and private law? Give examples.
    15. Give an example of substantive law. How does the procedural law compliment the substantive law?
    16. Who brings the charges against the accused in a criminal matter?
    17. Why are uniform laws important? What is the UCC?
    18. What is the definition of “good faith” under the UCC?
    19. What is the difference between civil law and criminal law?
    20. What are the differences between the various schools of jurisprudential thought? Which is more convincing?

Copyright © 2017 Hunter | Shannon | Amoroso | O’Sullivan-Gavin