Business Associations Outline

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BUSINESS ASSOCIATIONS OUTLINE

PROFESSOR T. MAYNARD

Choice of Business Entity

  1. Introduction
  2. Overview of Principal Forms of Business Organization and Relevant Statutes
  3. What is a sole proprietorship?
  4. A business wholly owned by an individual.
  5. The business owner absorbs profits/losses on individual personal income tax.
  6. The owner of the business is personally liable on all business obligations because there is no legal separation between the owner and the business.
  7. What is a General Partnership?
  8. The General Partnership is the default form for businesses that are owned by more than one person.
  9. 2 or more co-owners engaged in a business for profit.
  10. Uniform Partnership Act (UPA)
  11. UPA §6: Definition of General Partnership:

1)A partnership is an association of 2 or more persons to carry on as co-owners a business for profit.

2)But any association formed under any other statute of this state, or any statute adopted by authority, other than the authority of this state, is not a partnership under this act, unless such association would have been a partnership in this state prior to the adoption of this act; but this act shall apply to limited partnerships except in so far as the statutes relating to such partnerships are inconsistent herewith.

  1. UPA §9: Veto Power

1)Each partner is a general agent for the other

2)One may carry on the business of the partnership for the other and legally bind the partnership.

3)One partner’s actions may legally bind the other partner(s) in matters relating to the business.

  1. UPA §15: Nature of the Partnership

1)All partners are liable jointly and severally for the debts and obligations of the partnership, including the wrongful acts or breach of trust by other partners.

  1. Revised UPA (RUPA)
  2. California
  3. UPA §15001
  4. RUPA §16100
  5. Characteristics of General Partnerships
  6. The definition of a partnership does NOT require a formal writing.

1)Default standard so handshake = inadvertent partnership.

2)Default standard for handshake deals that do not discuss the specific terms of the partnership.

3)The intent of the parties does not matter.

  1. If the partnership agreement is silent on a certain issue, the UPA is the default standard.

1)Example: If A and B only talk about the split of profits and not the split of losses, the UPA §18(a) becomes the default standard and losses will be allocated in the same proportion as profits.

  1. Under common law, partnerships were considered an aggregation of the individual partners and the partnership was NOT considered a separate entity from the individual owners; however, RUPA amended this and recognizes partnerships as a separate entity.
  2. Partners have individual rights against their other partners because each partner is jointly and severally liable for the debts of the business.
  1. Limited Liability Partnerships
  2. General partnership in all respects except that the statute provides that partners have no personal liability for firm obligations that exceed the assets of the general partnership.
  3. Partners in an LLP have full personal liability for claims arising from their own misconduct.
  1. What is a Limited Partnership?
  2. To form a limited partnership there must be 1 or more general partners and 1 or more limited partners.
  3. Uniform Limited Partnership Act (ULPA) §1

1)A limited partnership is a partnership formed by 2 or more persons under the provisions of §2, having as members one or more general partners and one or more limited partners. The limited partners as such shall not be bound by the obligations of the partnership.

  1. Revised ULPA §100
  2. California

1)ULPA §15501

2)RULPA §15611

  1. To form a limited partnership, the partners must sign and swear to the arrangement on a certified document.
  2. Cannot have an inadvertent limited partnership.
  3. The limited partner cannot exercise control of the operation of the partnership and retain the shield of limited liability.
  4. Once the limited partner exercises control of the partnership, he/she ceases to be a limited partner.
  5. ULPA §7

1)A limited partner shall not become liable as a general partner unless, in addition to the exercise of his rights and powers as a limited partner, he takes part in the control of the business.

  1. RULPA §303

1)Changed the ULPA §7 rule by adding: “if the limited partner participates in the control of the business, he [or she] is liable only to persons who transact business with the limited partnership reasonably believing, based upon the limited partner’s conduct, that the limited partner is a general partner.”

  1. CA RULPA §15632

1)“If a limited partner participates in the control of the business without being named as a general partner, that partner may be held liable as a general partner only to persons who transact business with the limited partnership with actual knowledge of that partner’s participation in control and with a reasonable belief, based upon the limited partner’s conduct, that the partner is a general partner at the time of the transaction.”

  1. What is a Limited Liability Company (LLC)?
  2. Uniform Limited Liability Company Act (ULLCA)
  3. California
  4. LLC §17000
  5. Hybrid of partnerships and corporations.
  6. Newly created in the 1990s.
  7. Corporations
  8. Revised Model Business Corporation Act (RMBCA or MBCA)
  9. California Corporations Code
  10. There are formalities if you want to form a corporation
  11. Must file Articles of Incorporation with the Secretary of State.
  12. Hierarchy in Corporations
  13. Shareholders

1)The shareholders elect the Board of Directors

  1. Board of Directors

1)The directors appoint the Officers

2)The directors manage the “big picture” decisions of the business, not the day-to-day functions.

  1. Officers

1)The officers manage the day-to-day business affairs of the corporation.

  1. Federal Securities Laws – Administered by the SEC
  2. Securities Act of 1933
  3. SEC Rules under the 1933 Act
  4. Securities act of 1934
  5. SEC Rules under the 1934 Act
  6. State Securities Laws – Blue Sky Statutes
  7. Uniform Securities Act
  8. California – Corporate Securities Law of 1968 §25000
  9. Administered by the Department of Corporations (DOC)
  10. Rules promulgated by the DOC
  1. Overview of Basic Agency Principles
  2. Klein and Coffee “Business Organization and Finance” (Handout)
  3. Agency Relationship: Agent and Principal
  4. Fiduciary Relationship that arises from the manifestation of mutual consent between the principal and the agent that the agent shall act on principal’s behalf and subject to principal’s control.
  5. Fiduciary Relationship: default rule  If no agreement to the contrary, there is a fiduciary relationship between principal and agent. Principal owes Agent a duty to pay and Agent owes Principal a duty of loyalty.
  6. Agency Relationship includes implied terms

1)Duty of care

2)Duty of loyalty

3)Fiduciary responsibility

  1. 2 elements to a principal agent relationship

1)Hierarchal: Principal has the right to control the Agent

2)Consensual: Agent and Principal must both agree to the relationship. Principal can only control the Agent who consents to the control.

  1. No writing is required, mere consent by conduct is sufficient.
  2. Example: AB Furniture Store (a partnership) hires C to deliver furniture and drive truck.

1)AB Furniture Store = Employer = Principal

2)C = Employee = Agent

3)C is an employee of the furniture store and is under the control of the business and under the supervision of AB Furniture Store.

  1. Example: What happens if C is hired to be night manager? C is hired o B can go home at nights. Is there a difference between hiring C to drive a truck vs. hiring C to manage?

1)Still principal-agent relationship.

2)C now has more decisions more directly impacting the profitability of the business.

3)C needs to be given enough incentives to act in A and B’s best interest.

4)C has to be more trustworthy.

  1. Scope of Agent’s Authority: Actual Authority and Apparent Authority
  2. General Rule: An agent can bind the Principal if the Agent has Actual or Apparent Authority to Transact.
  3. Actual Authority: Defined boundaries in the scope of the duty

1)Look to the writing

(a)Partnership agreements, or

(b)Executive Committees

(c)Board of Directors Resolution

(d)Bylaws

2)Implied Authority is authority inherent in the position.

  1. Apparent Authority: Exists if it is reasonable for the third party to conclude that A has the authority to bind the entity.

1)Factual Inquiry asking how Principal holds Agent Out.

2)Cannot contract this away.

3)This is based on the perception of the 3rd party.

4)UPA §16 Partnership by Estoppel

  1. Example: What if C, the night manager, who has been explicitly told NOT to make any purchases on behalf of the Furniture Store is working one night when a vendor of Cuckoo Clocks comes to solicit business. Despite the lack of actual authority, C enters into an agreement with the vendor to purchase 10 cuckoo clocks. Is the store bound to the agreement?

1)C has no actual authority

2)Does C have apparent authority?

(a)Factual Inquiry: did the vendor have a reasonable belief that C could bind the store?

(b)What was C wearing?

(c)Did C look like the manager?

(d)Did the vendor believe that C had the authority?

(e)Was the vendor on notice that C had no such authority?

  1. Doctrine of Respondeat Superior
  2. Example: What happens if while C is driving a truck C hits a pedestrian, V?

1)Respondeat Superior: AB Furniture Store may be liable to V based on the principle that the accident occurred while C was in the course and scope of employment.

2)If V wants to sue, he can sue C, AB Furniture Store, and A and B individually if the partnership does not have enough assets.

3)If AB Furniture Store is incorporated, the corporation is the only entity that can be sued as long as the Corporate Veil of limited liability is in place.

  1. Risks and Control: Incentives and Monitoring
  2. The amount of discretion given to an agent can be lowered by increasing the level of specificity.

1)However, there is a cost to increasing the level of specificity.Transaction Costs

(a)Can increase specificity by making an employment manual.

(b)Apparent Authority can be eliminated by putting 3rd parties on notice of the agent’s actual authority.

  1. The Principal may seek to create an incentive to the Agent to align their interests.

1)May create profit incentives for the Agent.

2)Ownership interest short of partnership.

3)The problem with this is that by giving the Agent these interests in the store, A and B’s business interests will be diluted.

  1. However, the Separation of Ownership from Control gives rise to agency costs.

1)The principal must retain a right to information to monitor investment from being squandered.

2)However, the principal must then also retain the Right to intervene/Veto Power.

(a)What good is the right to information if there is no right to intervene.

  1. Importance of Fiduciary Duty Law
  2. Fiduciary Duty arises in every agency relationship.
  3. The scope of the fiduciary duty depends on the legal relationship.
  4. Look at the expectations of the parties.

1)If less than a breach of fiduciary duty, then business ethics issue.

  1. Klein and Coffee specialization of economic functions maximize the organization of a company by separating ownership and management although agency costs arise as a result of unanticipated contingencies when ownership is separated from control.
  2. Trust is part of every agency relationship and fiduciary duty law creates implicit duties and is used as a gap filler for the responsibilities each person/entity in the relationship owes to the other.
  1. Choice of Business Entity
  2. The General Partnership
  3. Formation and the Need for a Written Agreement
  4. The formation of a partnership does not require a written instrument.
  5. However, an agreement in writing provides the parties with a substantial number of benefits.
  6. Sharing of Profits and Losses
  7. A partnership agreement can provide for any method of sharing profits and losses.
  8. Where the agreement fails to provide for a particular division of profits and losses, the UPA Controls.

1)UPA §18(a)

“A partner is to share in profits equally and in losses according to his share in the profits.”

  1. Partners are jointly and severally liable for the debts of the partnership.
  1. Inadvertent Partnerships
  2. A partnership may be implied from the conduct of the parties.
  3. Martin v. Peyton (154): lenders investing in a near-bankrupt partnership were granted profit sharing and some management rights until they were repaid. When the partnership defaulted on debts, a creditor sued the lenders, contending their rights made them partners and personally liable for partnership debts.

1)Just receiving profits is prima facie evidence of a partnership unless it is a loan [UPA §7(4)(d)].

(a)In this case the profits were to be paid with a cap and floor and do not continue indefinitely.

(b)There is a limited interest in the total business.

(c)No open-endedness

(d)Length of the relationship is limited to the date from which the loan must be paid.

2)There is an option to purchase and interest in the partnership suggesting that the creditors are not partners.

(a)Preserves the intent of the agreement which specifically states that this is NOT a partnership.

(b)***Suggests that intent is no irrelevant, but the courts will look beyond it***

  1. Negative Rights of Control v. Affirmative Rights of Control  ????Does one type make the partnership more likely????
  2. Negative Rights

1)Protecting your interest?  Less likely that it will be a partnership.

  1. Affirmative Rights
  1. Management of Partnership Business – UPA §9, 15, 18
  2. UPA §18 states that each partner has the right in management and the conduct of the business and if the partners cannot agree with each other, the business will do nothing because both parties have the right to exercise control and exercise his/her veto power.
  3. Duties of Partners to Each Other
  4. Fiduciary Duty is an implied term of agency.
  5. 2 elements of Fiduciary Duty

1)Duty of Care: to promote the interest of the employer

2)Duty of Loyalty: to put the company’s interest above the individual’s interest and not enrich him/herself at the cost of the company.

  1. Meinhard v. Salmon (80): Salmon and Meinhard are joint venturers. They enter into a 20 year lease. 4 months before the lease is over Salmon is offered a profitable lease which he accepts under his wholly owned subsidiary, Salmon Corp.
  2. Meinhard sues Salmon for breach of fiduciary duty.

1)Duty of loyalty case.

  1. Salmon had a duty of full and adequate disclosure of all the facts to Meinhard.

1)Salmon can enter into an agreement with Gerry but he must inform Meinhard of the opportunity.

  1. The breach of duty in this case came from the failure to disclose.
  2. Cardozo’s point is that Salmon does not have to share the opportunity Meinhard, but Salmon is obligated to notify Meinhard of the opportunity.
  3. Meinhard gets the benefit of hindsight because if Salmon had made a loss, Salmon would not be able to go after Meinhard to share in the losses.

1)Cardozo is creating incentives for partners to disclose.

  1. Dissenting Opinion

1)The dissent says that fiduciary duty law is a gap filler when the agreement is silent, but the gap is filled at the time of the agreement.

2)The contract is the end all and be all.

  1. Cardozo does not ignore the agreement, but looks to the duty of loyalty which he states was breached by Salmon when he failed to disclose that he had entered into an agreement with Gerry.
  2. Salmon could have terminated the partnership and entered into the agreement, but Salmon did so when the partnership was still in effect and when it was continuing.
  1. Dissolution of General Partnership – UPA §29, 31
  2. UPA §29 Dissolution Defined
  3. The dissolution of a partnership is the change in the relation of the partners caused by any partner ceasing to be associated in the carrying on as distinguished from the winding up of the business.
  4. UPA §30 Partnership Not Terminated by Dissolution
  5. On dissolution the partnership is not terminated, but continues until the winding up of partnership affairs is completed.
  6. UPA §31 Causes of Dissolution
  7. Dissolution is caused:

1)Without violation of the agreement between the partners,

(a)By the termination of the definite term or particular undertaking specified in the agreement,

(b)By the express will of any partner when no definite term or particular undertaking is specified,

(c)By the express will of all the partners who have not assigned their interests or suffered them to be charged for their separate debts, either before or after the the termination of any specified term or particular undertaking,

(d)By the expulsion of any partner from the business bona fide in accordance with such power conferred by the agreement between the partners;

2)In contravention of the agreement between the partners, where the circumstances do not permit a dissolution under any other provision of this section, by the express will of any partner at any time;

3)By any event which makes it unlawful for the business of the partnership to be carried on or for the members to carry it on in partnership

4)By the death of any partner

5)By the bankruptcy of any partner or the partnership

6) By decree of the court under section 32.

  1. Law Firm Partnerships
  2. Limited Liability Partnerships (LLPs)
  1. Fundamental Considerations in Choice of Entity Decisions
  2. Limited Liability
  3. One of 2 dominant considerations in choosing form of organization
  4. Incorporation offers the corporate shield of liability.
  5. There are other ways to protect individual investors from individual liability aside from incorporation
  6. An investor can contract to shift the loss
  7. An investor could be a limited partner in a limited partnership
  8. An investor could buy insurance
  9. Informality, Flexibility and Cost of Operation and Formation
  10. Flexibility and Cost of Operation
  11. When there are gaps in the agreement, for partnerships, the statute is the gap filler.
  12. To become a member of a partnership, all the members have to assent to the new member.
  13. To obtain a partnership interest, the partner does not need to make a capital investment.

1)Can obtain an interest by contributing money or labor, etc.

  1. Partnership rules are completely open-ended, which is not true of corporations.

1)Partnership agreements may alter the default rule and allow for greater flexibility within the partnership, especially if it is a large firm.

2)Example: Gibson, Dunn and Crutcher probably does not require the unanimous consent of the partners to make a business decision.

  1. The partnership may be organized hierarchically allowing for specialization by the partners.
  1. Formation
  2. A corporation is harder to form than a general partnership
  3. Cannot inadvertently form a corporation while a general partnership may be inadvertently created.
  4. The formalities of forming a corporation are expensive and time consuming.
  5. A partnership does not need to qualify if it wants to form another partnership in another state.
  1. Continuity of Life
  2. 2 Issues in Continuity
  3. Legal Continuity
  4. Business Continuity
  5. Partnership
  6. The death of a partner terminates and dissolves the partnership unless the agreement provides otherwise.
  7. The business may continue, but the death of the partner has terminated the partnership and the partnership may liquidate the business, form a new partnership between the dead partner’s heirs and the live partner, or the live partner can buy out the dead partner’s heirs’ interest in the business.
  8. Survivorship Clause: the default rule for partnerships is that they terminate/dissolve with the death of a partner. The default may be contracted away with a survivorship clause stating the entity survives the death of the partners.
  9. Corporation
  10. The death of a shareholder has no legal effect on the legal continuity of the corporation.

1)The corporation is a legally separate entity and survives the death of its shareholders.