Business Organizations

1. Business Organizations Chapter 12 Meiners, Ringleb & Edwards The Legal Environment of Business, 12th Edition

2. 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 12.1

3. Sole Proprietorships • A person doing business for him/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

4. 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 • Equal control unless agreed differently • Under most state laws, a partnership may be sued as an entity. • Most states have adopted the Uniform Partnership Act (UPA) and Revised Uniform Partnership Act (RUPA).

5. Partnerships • No requiredto enter into a formal agreement for a partnership to exist at law • However, agreements are preferable, especially regarding finances, management and dissolution issues • If the Partnership Agreement is silent, the UPA governs (“default rules”). • Each of the partners has a fiduciary duty to other partner(s) • Latta v. Kilbourn: One partner may not use partnership assets for own benefit • If the agreement does not state otherwise, the profits of the partnership are divided equally.

6. CaseZhou v. Bickley • Bickley worked at a Yamaha shop. Frequently ate lunch at a Chinese restaurant where Zhou and Zhang (Chinese immigrants) worked. Bickley told Zhou and Zhang that the Yamaha shop was going out of business. Suggested they help him open a new motorcycle repair shop. • Three of them signed two-year lease on building for the shop. Zhou and Zhang paid security deposit & 1st month’s rent. They helped pay for inventory; helped get the shop ready. Gave Bickley more money when he asked for it. • Soon after Zhou and Zhang asked for keys to building; Bickley refused. Asked to see receipts and invoices; he refused. Asked to work at the shop; he refused. Demanded a written agreement; he refused. Attorney sent a demand letter on behalf of Zhou and Zhang; he ignored it. • Suit was filed. Demanded return of funds expended. • Bickley counterclaimed for breach of contract by his partners. • Trial court held: No partnership, only “a vague agreement to open a motorcycle repair shop.” • Bickley operated as a sole proprietor who borrowed money that he owed to Zhou and Zhang. Bickley appealed. (Continued)

7. CaseZhou v. Bickley • Mere fact parties called themselves partners and refer to business as a partnership, doesn’t make them partners or a partnership. • Zhou, Zhang and Bickley contributing money for expenses and signed a lease, is no binding contract, much less a partnership. A reasonable person could conclude that Zhou and Zhang simply intended to enter into a partnership agreement in the future. • Bickley denied Zhou and Zhang access to building; denied them access to financial records; refused to let them participate in the operations of business. Such actions not consistent with a partnership. • Affirmed: Parties did not intend to do things that would constitute a partnership. • Intent to do things which constitute a partnership determines if parties are partners.

8. Termination of the 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

9. 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 writtenagreement that is filed with the state. CalledCertificate of Limited Partnership.Puts 3rd parties on notice that limited partners assets not available to satisfy claims against the LP • 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 beyond their contributions • Limited partners BECOMEgeneral partners at law IFthey participate in ormanage the business (lose their limited liability). • Most states use some form of the Uniform Limited Partnership Act (ULPA)orRevised Uniform Limited Partnership Act (RULPA).

10. CaseEagles Landing Development, L.L.C. v. Eagles Landing Apartments, L.P. • Eagles landing Development LLC (Eagles) contracted to build apartments for Eagles Landing Apartments, LP (ELA) for $1.4 million. • ELA’s general partner was Bluff City. Two limited partners, PNC, (a limited partnership) & Columbia (a corporation). • Eagles completed work but still was owed $931,000. Agreement stated that Bluff City’s contribution wouldn’t exceed net cash flow from rental of apartment. • Cash flow was not good; no money there. All cash invested in ELA by partners was gone. • Eagles sued for contribution by PNC and Columbia. • Trial Court Held: ELA owed the $931,000. • ELA appealed. (Continued)

11. CaseEagles Landing Development, L.L.C. v. Eagles Landing Apartments, L.P. • Columbia and PNC argue that if full developer’s fee is due under the Development Agreement, they were not parties to it. They were only limited partners • Contend they can’t be charged for any liability of partnership under Development Agreement. Court agreed. • Unlike general partners, a Limited Partnership (LLP) protects partners registered as limited liability partnerships. Partner in a registered LLP is not liable. As partners in an LLP, neither Columbia nor PNC can be held liable for partnership debts. • Trial court appeared to disregard PNC and Columbia’s status as LLPs. • HELD: Affirm trial court’s judgment and amount of $ owed. • Reverse assessment of judgment to PNC and Columbia • Remand to trial court for purpose of entering judgment against only the partnership, ELA.

12. Terminating a 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

13. Corporations • Legal “entities”/”persons” • Can sue & be sued • It has liability • It has constitutional rights • Except the privilege against self-incrimination (only officers & employees have that right) • MUST meet formal requirements according to state statutes • States issue corporate charter. • Liable for agents’ actions and contracts • Each state has its own corporation laws; federal government places very limited role

14. Creating a Corporation • Articles of Incorporation and an application are sent to the appropriate state office • Name & Address of corporation • Name and Address of registered agent • Purpose of business • Class(es) of stock and par value • Names & Addresses of incorporators • The state issues a Certificate of Incorporation • Incorporators hold a first organization meeting • At the first meeting • Elect a Board of Directors • Enactbylaws or rules that govern internal operations (bylaws cannot contradict the Articles of Incorporation) • Issue the corporation’s stock

15. Relationship of the Parties • Important Separation • Of ownership (the shareholders) • AND of control (management & board of directors) • 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 their proxyto 3rd parties to represent them. • Shareholders elect Board of Directors • No legal relationship to creditors • Board of Directors • Have management power over large decisions • Can be removed from office by shareholders for cause (breach of duty/misconduct) • Havefiduciary duty of loyalty to the shareholders • Managers • Appointed/hired by directors to manage day-to-day decisions • Have broad duties of care & loyaltyto directors • Employees: Workers

16. Business Judgment Rule • Makes directors & managers immune from liability • WHEN problems result from honest mistakes in judgment • IF there is a reasonable basis for their decisions • IF they act in good faith

17. CaseStoretrax.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. • He 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. Storetraxappealed. (Continued)

18. CaseStoretrax.com, Inc. v. Gurland • 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”. • HELD: Gurland receives severance pay.

19. Terminating the Corporation • Voluntary • Approval of the shareholders and the Board of Directors • Articles of Dissolution are filed with the state • Involuntary • The state dissolves it • Bankruptcy • “Wind up” business to pay creditors and disburse profits to shareholders

20. Close Corporation vs.S Corporation Close Corporation • 20 states allow • Distinguished from a “closely held corporation” (See Ch. 18) • Limited # of shareholders – 30-50 • Shares not sold openly • Shareholders must have agreement that governs affairs • Not subject to formal rules regarding shareholder and director meetings (unlike regular corporations) S Corporation • Regular C corporation can elect with IRS to be classified as S Corporation • Have only one class of stock • No more than 100 shareholders • Only natural persons (U.S. citizens or legal residents) can be shareholders – not another corporation or partnership • Primarily for tax considerations • Profits/losses allocated to shareholders who pay income taxes • Very popular in smaller businesses

21. Professional Corporations • 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 • Stock usually not sold to outside investors • Has special tax treatment with IRS

22. Benefit Corporation • New Class of Corporation • Voluntarily meets high standards of purpose, accountability and transparency. • Characteristics • (1) Corporate purpose to create a material positive impact on society and environment • (2) Required to consider impacts of their decisions on shareholders, workers, community & environment • (3) Required to make available to public annual benefit report assessing their overall social and environmental performance against a 3rd party standard • This entity gives its leadership greater leeway in making decisions that may not comport with traditional standard of maximizing financial interest of the firm.

23. Limited Liability Companies • 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: Articles of Organization • State issues a Certificate to operate as an LLC • Usually is formed by two or more members • Members have a membership interest • 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 terminates LLC • 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.

24. CaseIn re 1545 Ocean Avenue, LLC • 1545 Ocean Avenue LLC formed for real estate project • 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)

25. CaseIn re 1545 Ocean Avenue, LLC • 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 to act autonomously to bind LLC in furtherance of business of the LLC • Operating agreement was silent re: manger conflicts • 1545 can only dissolved if cannot further purpose of LLC • HELD: Lower Court ruling reversed; proceeding dismissed. • Dissolution is not granted.

26. Key Organizational Features • 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

27. Limited Liability • Allows a person to invest in a business without placing their personal wealth at risk. • Allows investors to be passive toward internal management. • Sole proprietors and general partners have unlimited personal liability for debts of business, including torts. • Liability of limited partner is limited to capital contributed to limited partnership. • 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.

28. Limited Liability • Piercing the corporate veil • Affects limited liability organizations • Prove corporation is a sham • Owners actually intend to operate the business as a proprietorship or partnership • Can involve fraud, undercapitalization or failure to follow corporate formalities • Result: Owners are personally liable for all corporate liability – torts, contracts, debts • See KC Roofing Center v. On Top Roofing, Inc.

29. CaseK.C. Roofing Center v. On Top Roofing, Inc. • Nugents owned a series of roofing companies. Russell and wife only shareholders, directors & officers • 1977: Russell Nugent Roofing Inc. was incorporated; 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: 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)

30. CaseK.C. Roofing Center v. On Top Roofing, Inc. • 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. • This is unfair, unjust and inequitable to allow Nugent to hide behind corporate shield and avoid legal obligations to plaintiffs.

31. Refers to ability of an owner in a business to sell or pass interest to others Nontraded Entities In sole proprietorship, selling the business ends the existing 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 P-ship information without permission of other partners Transferability of Ownership Interests

32. Duration • Duration: Refers to ability to continue to operate in event of death, retirement or incapacity of owner of business • 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) • 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.)

33. Franchises • Three types: • Product distributorships (i.e. Ford Dealership) • Trademark/trade-name licensing (i.e. Coca-Cola) • 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 12.4

34. Franchises • Some states have laws to regulate franchises as well – for example, California. • Many states have business opportunity disclosure filing requirements. • Most states use the Uniform Franchise Offering Circular (UROC) as basis of reporting. • State agencies have authority to investigate franchise fraud and other bad business practices. • Some franchisees given extra protection by state laws: • Example: auto dealers and gas stations – often have extra rights over other franchises • Laws are still developing • 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 ,Inc.: FTC alleged that 3 entities violated Section 5 in selling home-based Internet business opportunity by misrepresenting purchases will earn substantial income. • When violations occur, the result is usually that promoted activity is closed down.

35. Franchises • The franchise agreementsets forth rights and obligations of the parties, i.e. territorial rights, fees and royalties, termination, etc. • 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

36. CaseDunkin’ Donuts Franchised Restaurants v. Sanlip • Three individuals owned Sanlip, Inc, which was 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’ also 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)

37. CaseDunkin’ Donuts Franchised Restaurants v. Sanlip • Sanlip submitted proposed sale agreement. Dunkin’ refused to accept the buyer. Asked court to order Sanlip to return shops to Dunkin’. • Sanlip counterclaimed: Dunkin’ had rejected a reasonable proposal from buyer to take over shop. • HELD: Summary Judgment in favor of Dunkin’ Donuts. Defendants must pay attorneys’ fees & costs. • Dunkin’ may not “unreasonably” reject proposed sale agreement. • Dunkin’ analysis: If store will lose money. If so, 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 provide Dunkin’ may terminate lease if franchise agreement for shop is terminated for any reason.