1. BUSINESS ORGANIZATIONS Chapter 6

2. XYZ Enterprises Three “partners” Two (X and Y) contribute funds for startup The third agrees to contribute extra time in lieu of funds The business struggles; all investment cash disappears Partner Z doesn’t produce How should they split the income/debt? Will they be personally responsible for the company’s debt?

3. Chapter Issues Major forms of business organizations How businesses are created Factors that may influence a business’s choice of its type of organization Alternative business forms to apply to various circumstances See Exhibit 6.1 – Business Establishments in the U.S.

4. Sole Proprietorship A person doing business for himself/herself (sole proprietor) Usually the proprietor owns all of the business property Responsible for control of the business Responsible for management Responsible for liabilities/debts May hire agents – liable for them as well Capital must come from the owner’s own resources or is borrowed Profits from the business are taxed personally to the proprietor Record keeping formalities are at the owner’s discretion See Exhibit 6.1 See “Small is Not So Beautiful in Japan” Attitudes toward small business by both government and individuals are very different in Japan than in the U.S.

5. Partnerships Definition: An association of two or more persons to carry on business as co-owners for a profit Partners or General partners control the operations & profits Each of the partners has a fiduciary duty to the other partner(s) –Latta v. Kilbourn: One partner may not use partnership assets for own benefit Under state laws, a partnership may be sued as an entity Most states have adopted the Uniform Partnership Act (UPA) and Revised Uniform Partnership Act No need to enter into a formal agreement for a partnership to exist at law (can be verbal or inferred from conduct) However, agreements are preferable, esp. regarding finances, management and dissolution issues If the Partnership Agreement is silent, the UPA governs (default rules) If the agreement does not state otherwise, the profits of the partnership are divided equally See Brown v. Swett & Crawford of Texas, Inc.

6. THE PARTNERSHIP AGREEMENT Basics: name, place/date of formation; identification of applicable state law Finances: parties’ contributions; additional capital contributions; ownership; distribution of profits; priority rights (if any) in payments Management Dissolution: rights of partners to leave; death of a partner; valuation of partnership shares; limits on transferability of partnership shares; arbitration (mediation?) of disputes Note: partners owe a fiduciary duty to one another

7. Brown v. Swett & Crawford of Texas Brown was a wholesale insurance broker – middleman between retail insurance agents and insurance company. Worked closely with Galtney for a company where they shared commissions. Dallas company, IBS, asked Galtney to open a Houston office for it. Galtney wanted Brown to be with him, so the two were hired as Houston Team One for IBS. Shared a base salary on shared basis of 42:58 (Brown 42% and Galtney 58%) and they shared commissions similarly. Ratio adjusted annually based on performance. IBS fired Brown after a year – claimed mishandling of accounts. He was offered severance pay – rejected it. (Continued)

8. Brown v. Swett & Crawford of Texas, cont. Brown sued, saying wrongful expulsion from a partnership (Houston Team One) – a partnership comprised of IBS, Galtney, and himself. District court held for IBS and Galtney. Brown appealed. HELD: Summary judgment of trial court affirmed. There was no partnership in this case. Texas Revised Partnership Act (TRPA) says “sharing or having a right to share gross returns or revenues” does not indicate a partnership agreement. Supreme Court has held that “a community of profit, an interest in profits as profits, as distinguished from... compensation” is a necessary element of a partnership. Brown was entitled to base salary plus 42% of commissions of the IBS Houston office. Brown’s portion of gross commissions was compensation for services rendered, not partnership interest in overall profits of IBS. No partnership existed; IBS could fire him.

9. Termination of General Partnership Dissolution occurs when an event takes place to dissolve the partnership Change of the composition of the partners Withdrawal of a partner Bankruptcy of a partner concerning the business Death of a partner Winding up of the partnership involves completing any unfinished business If terminated, partnership must be reformed Common: Partnership purchases life insurance on partners –Proceeds used to buy back the interest of deceased partner from her estate

10. Limited Partnership Definition: 2 or more persons (partners) who have entered into an agreement to carry on a business venture for profit Must have a written agreement filed with the state –Called Certificate of Limited Partnership –Puts 3 rd parties on notice that limited partners assets not available to satisfy any claims against the limited partnership General partners (at least one) –Manage the business –Are personally liable to creditors –Have the duty to account to the limited partners Limited partners (at least one) are investors only –Do not manage the business –Are not liable for debts Limited partners become general partners at law if they participate in or manage the business (lose their limited liability) Most states use some form of the Uniform Limited Partnership Act (ULPA) or Revised Uniform Limited Partnership Act See Issue Spotter: “Brotherly Love?”: Who should be liable for injury?

11. Termination of Limited Partnership Similar to the termination of a general partnership Death, insanity, withdrawal of a limited or general partner will terminate Bankruptcy of a general partner = termination Bankruptcy of a limited partner does not Organization must wind up the business Creditors are paid and profits are dispersed according to agreement

12. Corporations Legal “entities”/”persons” Can sue & be sued Corporation can be liable It has constitutional rights –Except the privilege against self-incrimination (only officers & employees have that right) MUST meet formal requirements according to state statutes Liable for agents’ actions and contracts Each state has its own corporation laws; federal government places very limited role Close corporation: Shares held by only one or small group of shareholders; stock not traded on a stock exchange Public corporation: Stock is traded on a stock exchange; is likely to have many shareholders See Ironite Products Co. v. Samuels

13. Ironite Products Co. v. Samuels 1972: Irwin Fox and Alvin Samuels established Ironite. Articles of incorporation set out guidelines for operation. Irwin and Alvin orally made decisions about company; shared equally. Later they formed Sweet Gas – ran under same rules. 1989: Invited their sons, Richard Fox and Mark Samuels, to join them – sons would eventually take control from Dads. 1990: Richard drafted new bylaws. Alvin made hand-written changes and all agreed to new bylaws. 1993: Irwin died and Richard took over his ½ of the company. Outsider invited to join Board of Directors for independent tie breaker vote. Fights began over who should be paid how much and who should control what. Richard and independent director voted to pay Richard more than Mark. (Continued)

14. Ironite Products Co. v. Samuels, cont. Mark sued Richard, Ironite, and Sweet Gas. Said original agreement of equal shares applied. Defendants said new bylaws would determine compensation, not old oral agreement. Trial court held that proceeds from operations would be shared equally by terms of the original agreement. Richard and companies appealed. HELD: Reversed. 1972 Oral Agreement contradicts terms of the bylaws. Oral agreement violated the parol evidence rule and evidence must be ignored. Written documents clearly state that compensation for the officers is at the discretion of the Board of Directors. Bylaws Article III, Section I clearly allows Board to manage affairs of the companies, absent proof of wrongdoing. No allegation that Board perpetrated fraud or made an irrational business judgment. Richard, Ironite and Sweet Gas win.

15. Creating A Corporation Articles of Incorporation and an application are sent to the appropriate state office The state issues a Certificate of Incorporation –See Exhibit.13.2 Incorporators hold a first organization meeting At the first meetingAt the first meeting – Elect a Board of Directors –Enact bylaws or rules that govern internal operations (bylaws cannot contradict the Articles of Incorporation) –Issue the corporation’s stock

16. Relationship of Parties of A Corporation Shareholders –Owners of the corporation; no day-to-day control of activities –Shareholder meetings need quorum (usually more than ½ total shares present –Most shareholders give proxy to 3 rd parties to represent them. –Shareholders elect Board of Directors –No legal relationship to creditors –See Storetrax.com v. Gurland Board of Directors –Have management power over large decisions –Can be removed from office by shareholders for cause (breach of duty/misconduct) –Have fiduciary duty of loyalty to the shareholders Managers –Appointed/hired by directors to manage day-to-day decisions –Have broad duties of care & loyalty to directors Employees –Workers

17. FLOW OF CORPORATE AUTHORITY

18. Business Judgment Rule Makes directors & managers immune from liability When problems result from honest mistakes in judgment If there was a reasonable basis for their decisions If they acted in good faith Directors’ fiduciary duty

19. “Your Honor, I’ll Turn Rocks Into Gold” Marinov forms Amrox Corporation. Claims to have a PhD in solid state physics from Russia AND medical degrees from Bulgaria, Sweden and Germany Tells investors that he can turn cheap corundum into rubies and sapphires Nothing is produced Investors sue that he breached his fiduciary duties; won at district court In appeals court Marinov said “he is developing a linear accelerator which he wishes to sell to the United Nations.” Held: Appeals court affirmed for the investors. This claim by Marinov of what he can do are “absolutely incredible.”

20. Storetrax.com, Inc. v. Gurland Gurland founded Storetrax.com – internet-based commercial real estate listing service in Maryland in 1998. Incorporated as a Delaware corporation in 1999. Agreed for a group of investors to buy majority share. Became president and member of the Board of Directors. Employment contract said that he had a year’s worth of pay in case he was fired. Two years later, he was removed as president, but stayed on the Board for another year. Requested severance pay, but was denied it. He sued. Board claimed he was not due severance pay because his job duties, title and salary changed. Also, as Board member, they claimed he breached a fiduciary duty by suing the company. Lower court held for Gurland. Storetrax appealed. (Continued)

21. Storetrax.com, Inc. v. Gurland, cont. HELD: Affirmed. There is a fiduciary duty of directors to the corporation. However, situations arise where a corporate director may proceed with an individual interest that may conflict with those of the corporation on whose Board he sits. When conflicts of interest arise, courts look closely if director’s dealings are in “good faith and fair dealing”. If conflict arises, director can find a “safe harbor” by disclosing to the corporation the conflict and important facts to the remaining shareholders or directors. Gurland had a conflict as an aggrieved former employer and his duty as director of the corporation. Gurland’s seeking $150,000 severance pay was not in corporation’s best interest, however Gurland notified Storetrax sufficiently of imminence of lawsuit. Gurland’s notification gives him the protections of “safe harbor”. Gurland receives severance pay.

22. Termination of the Corporation (Dissolution) Voluntary –Approval of the shareholders and the Board of Directors –Articles of Dissolution are filed with the state Involuntary –The state dissolves it –Sometimes due to fraud in the establishment of corporation or bankruptcy of the corporation “Wind up” business to pay creditors and disburse profits to shareholders Refer to “Mad at Each Other?...” (lawsuit dismissed; disagreement was “nothing more than a business dispute”)

23. Professional Corporations (PCs) Created by state laws Owners of PC can only be professionals involved in the firm itself (i.e. MD’s whose practices are tied together Created to have limited liability for its members Example: Doctors join to reduce liability risk for malpractice of a member- doctor (but not in Wash.) Stock usually cannot be sold to outside investors Has special tax treatment with IRS See Test Yourself, p. 380

24. Limited Liability Companies (LLC) LLC is treated like a corporation for liability purposes but like a partnership for federal tax purposes. State laws have procedures to create LLC’s –Filing a document: Certificate of Formation –State issues a Certificate to operate as an LLC Usually is formed by two or more members (not req’d) Members have membership interests Limited liability of owners – the same as a corporation Members enter into an Operating Agreement –Similar to bylaws of a corporation An LLC does NOT have perpetual life Death, resignation, retirement, expulsion of member terminate LLC But, if remaining members give consent, LLC can continue (should be set out in Articles of Organization) Termination: There is a period of winding up, followed by payment of creditors and distribution of profits. See “Offshore Businesses”: Reasons to have are tax-related, anonymity, professional services available, solid legal systems, low cost of doing business

25. LLCs Offer limited liability, as do corporations Avoid double taxation (of corporation on its earnings, then on shareholders’ receipts) Taxed like a partnership: passes income through to the members of the LLC

26. In re 1545 Ocean Avenue, LLC 1545 Ocean Avenue LLC formed to develop real estate Owned 50-50 by two companies (Ocean Suffolk & Crown Royal); each company had membership certificate in 1545 Operating agreement had no dissolution provisions Two managers appointed to operate 1545 –Crown Royal appointed King –Ocean Suffolk appointed Van Houten King and Van Houten argued; King announced Crown Royal would pull out King sued for work to stop and the LLC too be dissolved Trial court granted King’s requests Ocean Suffolk and Van Houten appealed. continued

27. In re 1545 Ocean Avenue, LLC, cont. LLCL 702 (New York LLC Law) states that court must examine the LLC’s operating agreement Unilateral action of a single manager was permitted in Article 4.1 of 1545 LLC Operating Agreement Lets each manager act autonomously to bind LLC in furtherance of business of the LLC Operating agreement was silent about manager conflicts 1545 can only dissolved if cannot further purpose of LLC HELD: Lower Court ruling reversed and proceeding dismissed. Dissolution is not granted.

28. Business &Taxation Corporate profits are taxed at corporate tax rate. Dividends are taxed at each individual shareholder’s tax rate. In effect this is “double taxation” of the same profits. The Supreme Court has held: There is no “double taxation” under the law, since “two separate entities” (corporations and shareholders) are taxed only once each. Partnership pays no income taxes –Income passes to parties who pay tax on their share of income Limited Liability Company –Treated like a corporation for liability purposes –Treated like a partnership for federal tax purposes

29. Factors That Influence the Choice of a Business Organization Limited liability Control Capital considerations Taxation Transferability of ownership interests Method of creation Entity as a distinct status separate from its owner Each owner must make his/her own choice See Issue Spotter: “Keeping Things in Order” See Exhibit 13.3

30. Limited Liability (Protecting Personal Financial Risks) Allows person to invest in business without placing all wealth at risk. Allows investors to be passive toward internal management. Sole proprietors have unlimited personal liability for debts of business, including torts. Liability of limited partner is limited to capital contributed to LP. Shareholders of corporation and members of limited liability companies risk only their capital investment if corporation fails – generally not personally liable for the business debts or torts.

31. Piercing The Corporate Veil Owner treats corporation as an “alter ego” –Co-mingling funds –No separate records –Loans money without loan papers –No reimbursement for expenses Result: Shareholders are personally liable for all corporate liability – torts, contracts, debts See KC Roofing Center v. On Top Roofing, Inc.

32. K.C. Roofing Center v. On Top Roofing, Inc. Nugents owned a series of roofing companies 1977: Russell Nugent Roofing Inc. was incorporated Russell and wife only shareholders, directors & officers 1985: Corporation name changed to On Top Roofing 1987: On Top Roofing ceased doing business 1987: Nugents did business through new corporation RNR, Inc. 1988: RNR ceased to exist 1988: Replaced by RLN Construction, Inc. 1989: RLN Construction was replaced by Russell Nugent, Inc. Business was run out of Nugent’s home In 1986 Nugents paid themselves salaries over $100,000 each Charged corporation $99,290 in rent for space in their home K.C. Roofing was owed $45,000 for roofing supplies sold to On Top Roofing, which no longer existed. (Continued)

33. K.C. Roofing Center v. On Top Roofing, Inc., cont. K.C. asked court to pierce the corporate veil and hold Nugents personally liable. District held for K.C. Nugents Appealed. HELD: Affirmed. Nugents must pay K.C. When corporation is used for an “improper purpose... to perpetuate injustice” and “avoid its legal obligations”, corporate veil is pieced. Here: –1. Nugents had control of all aspects of business –2. Control was used to commit fraud or wrong or other positive legal duty, including an “unjust act” –3. Breach of duty caused unjust loss or injury to plaintiff Nugents were avoiding debts to plaintiffs. Refused On Top’s obligations to creditors. It is unfair, unjust, and inequitable to allow Nugent to hide behind corporate shield and avoid legal obligations to plaintiffs.

34. Transferability of Ownership Interests Refers to ability of business owner to sell or pass interest to others Nontraded Entities –In sole proprietorship, selling the business ends the proprietorship. Price is FMV to be determined. –If a partner sells or assigns interest in the partnership, the partnership continues, but the new person doesn’t automatically become a partner. New person is just entitled to receive the share of profits the partner would have received, but can’t participate in management of partnership or right to its business information. –Sale of close corporation is like a sole proprietorship sale as price of shares is not determined on a stock exchange Must determine the market value of the close corporation and its shares. May need specialists to determine value. Publicly Traded Corporations –Public corporation stock may be traded on stock exchange. –Price is known and therefore no specialists need to be hired to determine market value.

35. Duration Duration refers to ability to continue to operate in event of death, retirement or incapacity of owner of business Limited Life: –Sole proprietorship terminates with death or incapacity of proprietor. –At common law partnerships and LLC’s are dissolved by death, retirement or incapacity of a partner, but are not necessarily terminated. (Can reform) Perpetual Existence: –Unless, articles of incorporation provide for period of duration, corporation has perpetual existence. –Death or retirement of shareholder(s) does not bring termination of the corporation. –(In fact, usually does not have any impact on operations of the business.) –Close corporation or LLC with few members – death of a shareholder may impact the business.

36. I’m the Real Owner” Shreepriya Gopalan filed suit in federal court in San Diego against Microsoft, Google, Apple, McDonald’s Starbucks, Coca-Cola & 50 other corporations Claimed he was actual owner of the companies. Said what was not understood is that he used the Chinese system, I Ching, to invent the companies when he was 15 or 16 years old. “These companies were I Chinged in through a metaphysical layer created and owned by me,” he claimed. Despite lack of formal documentation of company creation, Gopalan asked the court to confirm his rightful ownership.

37. Franchises Three types: – 1) product distributorships (i.e. Ford Dealership) – 2) trademark/trade-name licensing (i.e. Coca- Cola) – 3) business format franchising (i.e. McDonald’s) Franchisor grants a right to sell goods or services to a franchisee in return for payment of a franchise fee Uniform product or services and the use of a trademark help the franchisee establish quickly in the market See Exhibit 6.4: Franchise agreement

38. Franchises –Federal & state laws protect investors –FTC Franchise Rule: Franchisor is required to give an offering circular (disclosure statement) to potential franchisees –FTC v. Wealth Systems: FTC alleged that 3 entities violated Section 5 in selling home-based Internet business opportunity by misrepresenting purchases will earn substantial income. –Also failed to give purchasers a complete disclosure document and failed to provide purchasers with earnings claims documents and did not comply with Franchise Rule’s general media claims requirements. –When violations occur, the result is usually that promoted activity is closed down. –Some states have laws to regulate franchises as well – for example, California, Illinois, New York and Washington –Some franchisees given extra protection by state laws: auto dealers and gas stations – often have extra rights over other franchises, i.e. McDonald’s See International Perspective: “The Difficulty of Starting a Business” (countries differ re: procedures, time, costs of doing business) See Issue Spotter: “The Road to Riches?”

39. Franchises The franchise agreement sets forth rights and obligations of the parties, i.e. territorial rights, fees and royalties, termination, etc. (See Exhibit 6.4) Termination Through explicit events that bring about franchise’s termination Fixed expiration time Franchisor’s right to termination re: occurrence of events – Inspection problems or violations of franchisee Bankruptcy of franchisor See Issue Spotter: “The Road to Riches?” See Test Yourself, p. 235 See “Offering Franchise on the Internet”  Concern about Internet scams  FTC has ruled franchises can be marketed through the Internet as long as franchisor satisfies disclosure requirement of the Franchise Rule

40. Dunkin’ Donuts Franchised Restaurants, LLC v. Sanlip, Inc. Three individuals owned Sanlip, a Dunkin’ Donuts franchisee. Operated two donut shops in Norcross Georgia Dunkin’ said defendants breached franchise agreements Failed to remodel their shops Failed to participate in mandatory system-wide programs Failed to attend required training Failed to prepare immigration forms for new employees Dunkin’ said defendants transferred significant part of franchise w/o Dunkin’s knowledge in violation of franchise agreement. Sanlip did not dispute claims. Protested that Dunkin’ was not allowing owners reasonable chance to sell franchise. Dunkin’ entered into settlement agreement. Allowed Sanlip time to try to find buyer. (Continued)

41. Dunkin’ Donuts Franchised Restaurants, LLC v. Sanlip, Inc., cont. Sanlip submitted proposed sale agreement. Dunkin’ refused to accept the buyer. Asked court to order Sanlip to return shops to Dunkin’. Sanlip counterclaimed: Dunkin’ rejected reasonable proposal. HELD: Summary Judgment for Dunkin’ plus attorneys’ fees & costs. Dunkin’ may not “unreasonably” reject proposed sale agreement. Dunkin’ analysis: –If store will lose money Dunkin’ rejects proposed sale agreement. –Also looks at financial condition of the buyer if it decides store may break even. This is firmly-established policy by Dunkin’ and reasonable. Dunkin’ has right to terminate the agreement. Lease agreements provides Dunkin’ may terminate lease if franchise agreement for shop is terminated for any reason.

42. Your take-away from today’s class