Business Associations Outline PDF

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Reed Horowitz Business Associations Outline – Dibadj – Fall 2019 I. GENERAL BA THEMES/POLICY CONCERNS: a. How to evaluate and critique law of business enterprise i. INCREASING SOCIAL WELFARE 1. “EFFICIENY” ii. SHAREHOLDER WELFARE iii. Effects on third parties b. Comparing courts/lawyers to economists/social scientists i. Focus on fairness, morals, etc. II. The Law of Agency a. INTRO b. AGENCY FORMATION, TERMINATION, & PRINCIPAL’S LIABILITY i. Formation – Principal hires agent in order to expand the scope of their activity. ii. Termination – Either party can terminate agency relationship. (Although there may have a breach of contract claim if you have a contractual duty). iii. Liability – Authority 1. Actual Authority: What reasonable person in agent’s position would infer from principal’s conduct. (Can be express or implied) a. Express: Principal expressly gives authority b. Implied: A regular relationship between agent and principal but the principal basically tells the court there is no authority when there actually is. 2. Apparent Authority: What a reasonable 3rd party would infer from principal’s conduct 3. Inherent Authority: What a reasonable 3rd party would infer from Agent’s conduct 4. a. Imposed by courts – typically not conferred by principal b. Not included in restatement of agency

5. 6. Ancillary Forms of Authority: a. Waiver – principal waives his rights, waives any defenses. b. Estoppel – third party has changed their position based on the facts (a representation of the principal or agent) and it

would be unfair not to compensate them. Similar to inherent authority. 7. LIABILITY IN TORT – Generally, the more control p has over A will determine tort liability. a. Respondeat Superior i. Principal typically liable if A is an employee but not when they are a general contractor. ii. Ability of Principal to Control agent’s action as proxy to differentiate between employee and general contractor. 1. Humble Oil v. Martin – master-servant relationship exists when two parties agree that one party will work on behalf of another party, and be subject to P’s control for how the job will be performed 2. Hoover v. Sun Oil – basically same rule but they found the agent to be more of a contractor who did not have to completely comply with gas company’s rules. b. Actual Authority i. Does not really apply since a principal would rarely if ever give consent to commit a tort. ii. But can be analyzed in respondeat superior type of way – was it an employee or a contractor. c. Apparent Authority i. P liable in tort when agent acts on P’s behalf with apparent authority to do so. ii. Corporation can be liable for a CEO’s misstatements d. Inherent Authority – analogize to respondeat superior. iv. Jenson Farms v. Cargill 1. An agency relationship exists between a creditor and debtor when the creditor intervenes in the business affairs of the debtor. No need for a formal agreement/written contract. 2. Facts – creditor had sufficient control of the debtor and created an agency relationship. v. White v. Thomas 1. There must be authority (through agency) in order to enter into a contract on someone else’s behalf. 2. Woman enters into contract for tract of land that her boss had never given her authority to do and for amounts that he did not give her authority to use. c. AGENT’S DUTIES i. Fiduciary Duties – Fuzzy standards, not bright line rules. 1. Loyalty (or Obedience) – to advance the purposes of the beneficiary, not invidual’s benefit.

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2. Care – to act as a reasonable person would 3. Good Faith* - not much caselaw. Unlikely to be found unless extremely wrong behavior is going on. 4. Candor* - duty of disclosure. Limited caselaw. ii. CASES: 1. Tarnowski a. Jukebox contract deal where p’s agent misrepresented profitability of a jukebox route. Agent had a “secret commission.” b. Takeaway – making money behind a principal’s back is a breach of duty. There was a duty to make accurate representations to the principal. 2. Gleeson a. Trustee of an estate of farmland leases land to himself, he uses land productively but still is breaches duty of loyalty to the trust. – Court basically says you can either be a tenant or a trustee, not both. b. PROHIBITION AGAINST SELF-DEALING PARTNERSHIP/JOINT OWNERSHIP a. Intro to Partnership i. MAIN GOAL: 1. Include pass-through taxation 2. Limit liability of owners. ii. Allows partners to pool cash iii. Partnership as an entity rather than an aggregate iv. GENERAL PARTNERSHIP: 1. Pass Through Taxation (Business goes untaxed but partners individually get taxed). 2. Liability for Partners b. FORMATION i. General Partnerships can be inferred without formal agreement. 1. Vohland v. Sweet, receipt of profits as prima facie evidence of partnership. 2. Working under commission (rather than share of profits) is typically evidence against informal partnerships. a. Think entertainment industry – actors want a percentage of the sales rather than a share of profits after taxes. c. AGENCY CONFLICTS AMONG CO-OWNERS i. Meinhard v. Salmon 1. Both parties were vaguely in business together (20 year real estate project/plan), plaintiff sued because defendant basically conducted a new business deal behind his back while there were still a few months left in their deal. 2. Cardozo basically infers an agency relationship and the DUTY OF LOYALTY. – basically forced people to go into business together. 3. *Not as heavily enforced today but this case is cited a lot.

4. *There is no clear indication of the type of relationship they had from Cardozo so you can explicitly apply this to General Partners. (Doesn’t indicate if it is GP, trust, or venture. d. LIMITED LIABILITY SUCCESSORS OF GENERAL PARTNERSHIP i. Limited Partnership (LP) 1. Limited Liability 2. Uniform Limited Partnership Act abandons control test and moves toward “status based” liability. a. Passive v. Active partners for liability purposes. b. Overtime this distinction changed and states give limited liability through the form of LLC and LLP 3. *LP does not provide anything that cannot be satisfied through LLC or LLP ii. Limited Liability Partnership (LLP) – designed to protect against the torts of colleagues. 1. Typically for professionals, i.e. doctors, lawyers, accountants. 2. Limited to tort liability – most states do not provide protections against contract creditors 3. Some states require minimum capital or insurance. 4. *think of as step between LP and LLC iii. Limited Liability Company (LLC) 1. PASS THROUGH TAXATION 2. LIMITED LIABILITY a. Protection against creditors and torts b. No need for minimum capital or insurance c. Probably best option for private entitites. 3. Disadvantages: a. Cannot go public without being subject to entity level taxation. b. Rules of professional responsibility prevent certain entities from forming LLCs (like law firms, etc. ) iv. CURRENT ISSUES REGARDING PARTNERSHIPS: 1. Delaware pushing for more LLCs 2. LLC and LLPs expanding due to failures of LPs and GPs, not corporations. 3. Delaware emphasizes contracting over fiduciary duties a. Pappas v. Tzolis (NY 2011) i. Rule: Members of a LLC may explicitly restrict or eliminate fiduciary duties owed by the terms of the operating agreement. ii. Both parties formed an LLC, D tries to buy out membership interest, forcing other party to sell. P contracts away D’s fiduciary duty and D has control of LLC. D secretly works on transaction with third party and sells to same third party. P sues for breach of duty.

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The CORPORATE FORM a. INTRO – MAJOR GOAL = Limited Liability + Pass Through Taxation i. Artificial legal personality with indefinite life with (1) limited liability for investors (2) free transferability of shares (3) Centralized management ii. Tension between insiders & outsiders, as well as “Controlling” and “noncontrolling” shareholders iii. Close Corporation – typically incorporated for tax and liability purposes (not to raise funding). iv. Controlled Corp: Shareholder controls the corporate machinery. (appointing majority of board, access to confidential material, relative shareholdings). b. CREATION OF A FICTION LEGAL ENTITY i. CORPS enjoy virtually all of the Bill of Rights, except privilege against self-incrimination. Is it a real entity, association or concession? ii. Theories: 1. Real Entity – they have rights 2. Associational – See Citizens United – Corps are associations of people. 3. Artificial Entity – created and controlled by government, not popular. iii. Creation 1. Statute – DE Corp Law 2. Articles a. Charter i. Name & Purpose, Incorporators & Board, Address, Capital Structure ii. Filed with state government iii. Modification requires shareholder vote 3. By-Laws – operating rules a. No filing requirement – not publicly available b. Standard rules for corp. c. Modification is dependent on the by-laws c. LIMITED LIABILITY i. Veil of LL for shareholders – they cannot lose more than they invest. 1. Default -> Shareholder can become guarantor by contract. ii. Advantages: 1. Encourages investors to pool capital a. Creditors cannot seek personal assets b. Decreases need to monitor management and other shareholders c. Allows investor to diversify among investments 2. Simple Valuation – cost of capital doesn’t change every time shares are transferred. iii. Disadvantages – lack of creditor protection 1. Creditors must contract ex ante to protect themselves 2. Hard on tort victims/involuntary creditors.

d. TRANSFERABLE SHARES i. Managers can continue to run corporation even as share ownership changes. ii. Follows directly from limited liability. – otherwise firm’s credit rating would constantly change. iii. Listing on capital markets 1. Access to capital 2. Threat of possible takeover (Negative) iv. Default Provision – Restricted by Contract 1. Shareholder agreement to limit ability to buy or sell shares in a close corporation. e. CENTRALIZED MANAGEMENT – Shareholder -> Board -> Management i. CHALLENGE: How to ensure managers will advance interests of investors without unduly impinging on managers’ ability to run firm. 1. Assist shareholders to act collectively. 2. Force officers to act in the interest of shareholders. ii. Board of Directors – Act as intermediaries between shareholders and management. 1. Appoint, compensate, remove officers 2. Declare and pay dividends 3. Monitor and approve management decisions 4. Make major business decisions 5. Initiate and approve extraordinary corporate transactions. iii. Formation: 1. Shareholders Elect 2. Board governs officers iv. ***IMPORTANCE OF FORMAL PROCEDURES**** 1. Boards can only act at formal constituted meetings (Some states allow informal meetings with unanimous consent). 2. Delegation to committees and sub-commitees. 3. Use of outside experts – i.e. attorneys, bankers, accountants. v. Trends of professional board members with specific skills. f. Alternative View: i. Critique – tightly knit social networks amongst board of directors makes strong pressure to acquiesce to each other’s demands. ii. Management (Nominates Board) -> Board (dictates policies to shareholders) -> Shareholders (Just provide capital) g. CASES: i. Fogel v. US Energy Systems 1. Board tries to fire a CEO during an informal meeting. CEO fires board formally and hires new board to secure his job. 2. Takeaway – importance of formalities for board members ii. Automatic Self Cleansing Filter Syndicate v. Cunninghame 1. Controlling shareholder (owns about 55% of shares) and wants to sell assets of the firm. Company’s directors object to this –

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shareholders can only overrule directors with a ¾ majority extraordinary resolution (By-Laws). Court rules with directors. 2. Takeaway: The board is not an agent of the majority shareholders, it is an agent of all shareholders. a. Just because 55% say sell doesn’t mean you should ignore the 45% that says don’t sell. iii. Jennings 1. Vp/Treasurers and Financial consultant consult with Jennings, a consultant about a sale leaseback transaction saying that Jennings needs board approval to receive commission. The VP told egmore that the board had agreed to a deal but then several days rejected the deal – Jennings sues for commission. 2. Rule: Apparent authority is required for an agent to act on behalf of the principal – VP was not principal. a. Prior Dealings -> Apparent Authority requires a measure of (1) similarity to the act for which the principal is sought to handle and (2) a degree of repetitiveness 3. Takeaway – court says this isn’t a typical transaction that occurs regularly. PROTECTION OF CREDITORS – same protections for contract and involuntary creditors. a. MANY WAYS TO DEFRAUD CREDITORS i. COMMON METHODS: 1. Forging/Falsifying accounting documents 2. Shifting Assets 3. Taking on more debt 4. Changing business strategy 5. Engaging in conflicted transactions where board members are also creditors ii. Creditors best defense is ex ante contracting – commercial law is best line of defense. iii. Public policy favors entrepreneurship over the protection of creditors. b. MANDATORY DISCLOSURE i. Corporate Law does not require the disclosure of financial documents. ii. There are credit reports but these do not show the full details of a corporation’s debt. iii. *Different than Securities law where there are disclosure requirements c. CAPITAL REGULATION i. Accounting Documents 1. Balance Sheet, Income Statement ii. NO MINIMUM CAPITAL REQUIREMENTS 1. Some jurisdictions have small capital requirements but none are large enough to be meaningful. 2. *Certain requirements on banks – but this is unique to finance. iii. Distribution Constraints – This is no longer meaningful but there are restraints on paying dividends.

d. STANDARD-BASED DUTIES i. Director Liability – directors typically have a duty towards shareholders rather than creditors… they make decisions that are more beneficial to shareholders than creditors (Except in bankruptcy) 1. Insolvency a. Some case law says there is a duty to creditors – but prioritizing obligations can be very difficult. b. See Credit Lyonnais (1991) ii. Fraudulent Conveyance Law 1. 2 Methods for attacking a transfer a. Actual Fraud – smoking gun-- present or future creditors can void transfers made with actual intent to hinder, delay, defraud any creditor. b. Constructive Fraud – not necessarily actionable i. Indirect ii. Motive & Opportunity 2. Challenge to leverage buyouts and spinoffs as fraudulent transfers a. Courts have not really agreed. e. SUING SHAREHODLERS i. Equitable Subordination – Bankruptcy Procedure 1. Unlikely to occur in a major corporation – unlikely to have such a dominant shareholder 2. SITUATION – shareholder (likely controlling) sees bankruptcy coming and recharacterizes their interest in the company as debt, basically cooking the books to become a creditor rather than a shareholder. a. The court can use equitable subordination to push that creditor’s interest down to zero so that their recovery is about the same had they not tried to do anything sketchy. b. Evidence: Undercapitalization, withdrawal of equity. 3. Costello v. Fazio a. Dominant shareholder/investor recharacterizes their equity as debt (leaves a bit in for appearance reasons). b. Court says the firm is grossly undercapitalized and the shareholder only recharacterized their equity because they saw the failure of the business on the horizon and wanted to take advantage of bankruptcy. – subdorination. ii. VEIL PIERCING ON BEHALF OF INVOLUNTARY CREDITORS 1. UNITY OF INTEREST IN OWNERSHIP a. Shareholder/Entity are one in the same b. Evidence: i. Commingling of funds (shareholder using personal bank account for expenses or company funds to pay for personal expenses, undercapitalization). ii. Lack of Corporate Formalities (No annual meetings, board never meets, BA fees are not paid)

2. INJUSTICE – FRAUD – INEQUITY a. Case-by-case analysis of doing something that society frowns upon. b. ** Usually both parts of test need to be satisfied unless injustice is so extreme to justify piercing the veil. 3. Public Policy Question a. Good for businesses bad for tort victims b. Rewards companies who can afford sophisticated lawyers but not smaller companies – follow formalities, pay fees, don’t commingle funds. c. Good for plaintiff lawyers who can make money on just attempting to pierce the veil. 4. Cases a. Pepper Source – basically articulates the test above and says that plaintiff needs to articulate fraud/injustice on remand. b. Kinney/Polan – articulates a third prong for cases where creditors do not assume the risk (Involuntary tort creditors) but does not apply in this case. – courts are reluctant to invoke a third prong. c. Walkovsky v. Carlton (NY 1966) – taxi tort victim case i. Defendant followed formalities ii. Injustice – yes this was unjust but the defendant followed state law, it would be bad public policy to say that a defendant committed fraud while following state law. 5. Takeaway a. Piercing the veil is difficult because prong 1 is often not satisfied. iii. Adjunct Doctrines - **Not so important** 1. Enterprise Liability – Principal’s liability under agency law. a. Largely unsuccessful 2. Substantive Consolidation – “Horizontal Veil Piercing” a. Equitable remedy in bankruptcy i. Consolidates assets among corporate subsidiaries for benefits of creditors. ii. Concern: Federal law preempting the common law veil piercing tests. 3. Successor Liability – “Temporal Veil Piercing” a. New firm assumes liabilities of prior firm (or product line) b. Transactional Clarity v. Creditors Rights iv. Unfairness to Tort Victims 1. IDEAS FOR REFORM – largely unsuccessful a. Ex Post, pro-rata liability for shareholders b. Direct Regulation c. Mandatory Insurance

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d. Giving priority to involuntary tort creditors in bankruptcy GOVERNANCE – SHAREHOLDER VOTING a. INTRO i. Shareholders vote on: (1) election/removal of directors (2) Fundamental Changes (3) Shareholder resolutions ii. VENUES: 1. Annual Meetings 2. Special Meetings 3. Consent Solicitations b. ELECTING AND REMOVING DIRECTORS i. Every Corporation must have: (1) a board – even if one person (2) 1 Class of Voting Stock with 1 Share/1 Vote default ii. Directors must be elected annually iii. Variations: 1. Staggered (or Classified Boards) – 40% of large companies a. Only a fraction of the board is up for election each year i. Prevents hostile takeovers – or at least delays them ii. Research shows staggered boards have lower returns 2. Cumulative Voting – 10% of large companies a. Each shareholder gets to vote # of shares owned X # of directors to be elected. b. Positive for MINORITY SHAREHOLDERS – allows them to cast their votes for one or more candidates efficiently. iv. REMOVAL: 1. Common Law Requirement: “For Cause” 2. “For Cause” v. “Without Cause” highly relevant today for executive compensation for removal – employment law 3. Shareholders & Courts can remove 4. Some statutes permit shareholders to give the board power to remove individual members. c. SHAREHOLDER MEETINGS AND ALTERNATIVES i. Annual Meeting – vote for board, resolutions, shareholder proposals. 1. *typically non-events unless your Berkshire Hathaway ii. Special meetings – anything that cannot wait until the annual meeting 1. Typically only way to take any action between annual meetings 2. Can be called by only the board (or someone else in the charter) iii. Consent Solicitations – 1. Written consent agreements to act a certain way. 2. Only used for small companies with distance between board members. iv. Proxy Voting d. PROXY VOTING & ITS COSTS i. Sending out ballots (usually paper) for voting – Incumbent v. Insurgent Boards. ii. Allows shareholders to vote without attending annual meeting.

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iii. Extremely Expensive 1. Froessel Rule: Win or lose, the incumbent board can be reimbursed from corporate treasury; however, insurgents only get reimbursed if they win. See Rosenfeld v. Fairchild Engine (1955) iv. Alternatives: 1. Super Froessel Rule – award both sides – not in practice 2. SEC eProxy Rules – 14a-16 – for public companies a. Company sends notice – shareholders request paper or email. b. OPTIONAL RULE – this rule is favorable to insurgent boards and its optionality is beneficial to incum...