Online Instructor’s Manualto accompany

Business Organizations for Paralegals

Kathleen Mercer Reed

Henry R. Cheeseman

John J. Schlageter, III

Prentice Hall

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ISBN-13: 978-0-13-510366-1ISBN-10: 0-13-510366-5

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CONTENTS

Chapter 1: Agency.......................................................................................................1

Chapter 2: Liability of Principals, Agents & Independent Contractors................9

Chapter 3: Entrepreneurship & Sole Proprietorships...........................................17

Chapter 4: General Partnerships.............................................................................21

Chapter 5: Limited Partnerships.............................................................................29

Chapter 6: Limited Liability Companies.................................................................37

Chapter 7: Corporate Formation and Financing...................................................46

Chapter 8: Franchises and Special Forms...............................................................57

Chapter 9: Corporate Governance and the Sarbanes-Oxley Act..........................65

Chapter 10: Corporate Acquisitions and Multinational Corporations................75

Chapter 11: Investor Protection and Online Securities Transactions..................85

Chapter 12: Employment, Worker Protection, and Immigration Laws..............97

Chapter 13: Equal Opportunity in Employment..................................................104

Chapter 14: International and World Trade Law................................................112

Chapter 1

Agency

Let every eye negotiate for itself, and trust no agent.

William Shakespeare

I. Teacher to Teacher Dialogue

Agency law is very important in a basic undergraduate law course in that it represents a synergy of two otherwise distinctive bodies of law: contracts and torts. Because these topics are a precondition to a good foundation to agency, we prefer to teach agency before having taught both contracts and torts. In addition, we have found it useful to remind students of the constant interplay that goes on between these two areas of law. For example, we may go through the creation of the agency relationship (which highlights contract elements), involve a third party (by way of tort), and decide whether any defenses may apply (possibilities from both the law of contracts and torts). Invariably, certain patterns of behavior can be identified which can be used to help students ask key questions about agency-based issues.

Qui facit per alium facit per se. He who acts through another, acts himself. This simple Latin phrase provides the keystone upon which the mutual obligations of agency law rest. Agency is defined by Section 1 of the Second Restatement of Agency as:

The fiduciary relation which results from the manifestation of consent by one person to another that the other shall act on his behalf and subject to his control, and consent by the other so to act.

Agency is a legally recognized relationship that allows an attribution of one person’s behavior to another. This carryover process is two-sided in that both benefit and burden inure to the parties involved in the agency relationship.

Under the basic doctrine of agency, the principal is allowed to reap the beneficial harvest of the agent’s actions made on his or her behalf. For example, assume an agent has agreed to be paid a set salary of $100 for selling certain kinds of goods. The principal gets to keep the net profits from that agent’s selling activities, be they $100 or $1,000,000. This net gain is what allows the use of agency theory to maximize one’s efficiency through the actions of others. Exponential growth of most any sort of enterprise is almost always directly tied to effective use of the talent of others through agency law. There are some limits on this ability to designate others to act on one’s behalf based on uniqueness of personal services or on public policy grounds that forbid use of agents, such as voting or serving a criminal sentence. As a practical matter, business as we know it today simply could not be conducted on any scale beyond sole proprietorship without extensive use of agency relationships.

II. Chapter Objectives

Define an agency.

Identify and define a principal-independent contractor relationship.

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Describe how express and implied agencies are created.

Define apparent agency.

Describe how an agency is terminated.

III. Key Question Checklist

How was the agency relationship created?

What definition best fits the agency relationship?

If there is not an agency, is there a principal/independent contractor relationship?

How will the agency be terminated?

IV. Text Materials

Section 1: Agency

Agency relationships are fiduciary relationships formed by mutual agreement between the principal and an agent. The principal employs the agent to act on his or her behalf.

Persons Who Can Initiate an Agency Relationship – Agents can be appointed by any person who has contractual capacity. The court may appoint a legal guardian to handle the affairs of anyone who lacks capacity. Agency contracts can only be created for lawful purposes.

Principal-Agent Relationship – The principal hires an employee and gives him/her the authority to act on the principal’s behalf. The authority is limited to any express agreement between the parties or implied by the circumstances surrounding the agency.

Employer-Employee Relationship – This relationship is created when an employer hires an employee to perform some service. To be an agent, the employee must be granted the authority to enter into contracts on behalf of the employer.

Principal-Independent Contractor Relationship – Outsiders may be employed to perform services and to enter into contracts on behalf of an employer.

Section 2: Formation of an Agency

An agency can arise as an express agency, an implied agency, an apparent agency, and an agency by ratification.

Express Agency – The most common form of agency is an express agency, where the agent contracts with the principal to act on the principal’s behalf. The contract may be oral or written, but is bound by the Statute of Frauds.

An exclusive agency contract binds the principal so that he may not employ any other agent. The exclusive agency terminates upon completion of the contracted services. Breach by the principal will allow the agent recovery of damages. Absent an exclusive agreement, the principal may employ multiple agents, and the services of all agents are terminated when anyone of the agents accomplish the stated purpose.

Power of Attorney - This express agency agreement gives an agent the power to sign legal documents. There are two types: general, which confers broad powers, and special, which limits the powers of the agent.

Implied Agency – This type of agency is implied by the actions of the parties, with the agent’s authority limited by the facts and circumstances of the situation. It may be conferred by industry standard, prior dealings, the agent’s position, or by the court.

Incidental Authority – If the express agency contract does not provide for all contingencies that arise, the agent may still have an implied authority to act under the theory of incidental agency.

Apparent Agency – Agency by estoppel arises when the principal creates the appearance of an agency that does not exist. The principal is estopped from denying the relationship and is bound by any contracts that the agent has entered into.

Agency by Ratification – This occurs when a person misrepresents himself as another’s agent and the purported principal ratifies the unauthorized act, binding the principal and relieving the agent of any liability for misrepresentation.

Section 3: Principal’s and Agent’s Duties

Principal’s Duty of Compensation – The principal owes a duty to compensate the agent for performance of services, either the amount stated in the contract or, if there was no agreement, whatever the customary fee paid in the industry is due.

Principal’s Duties of Reimbursement and Indemnification – The principal owes a duty to reimburse the agent for any authorized expenditures that were necessary to carry out his duties. The principal also owes a duty to indemnify the agent for any losses suffered because of the principal.

Principal’s Duty of Cooperation – The principal owes a duty to cooperate and assist the agent in performance of his duties.

Agent’s Duty of Performance – The agent must perform the lawful duties as stated in the contract and must meet the standards of reasonable skill, care, and diligence expected by one in his occupation.

Agent’s Duty of Notification – The agent must notify the principal of any information that would be important to the principal. Information learned by the agent is imputed upon the principal, whether or not the principal is actually informed.

Agent’s Duty of Accountability – An agent owes a duty to accurately account for all transactions that he undertakes on behalf of the principal, to maintain a separate account for the principal, and to use the principal’s property in an authorized manner.

Section 4: Termination of Agency

Termination by Acts of the Parties – The parties may terminate an agency relationship by either agreement or their actions.

The parties may end their relationship by mutual consent, relieving each other of any further rights and duties.

Agency agreements often are written for a specific time period, and the agency automatically lapses when the period passes.

The agency relationship will terminate upon the successful completion of the assigned duty.

An agency agreement may also specify that the relationship will terminate upon the occurrence of a specified event.

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Notification Required at the Termination of an Agency – Upon termination of an agency agreement, certain third parties must be given notification. Parties who dealt with the agent must be given direct notice. Either direct or constructive notice must be given to any parties that have knowledge of the agency relationship. There is no duty of notification to parties who have no knowledge of the agency. Failure to give appropriate notice of the termination to a third party will allow the agent to continue to bind the principal under the theory of apparent authority.

Irrevocable Agency – An agency coupled with an interest that is created for the agent’s benefit is irrevocable by the principal.

Termination by Operation of Law – Agency contracts may be terminated by operation of law by the death of either the principal or the agent, the insanity of either party, or bankruptcy of the principal. It is also terminated through impossibility by the loss or the destruction of the subject matter of the agency, the loss of a required qualification, or by a change in the laws. It is also terminated through changed circumstances or war.

Wrongful Termination of an Agency or Employment Contract – If the agency contract does not state a time for termination, the principal can terminate the contract through a revocation of authority, or the agent can through a renunciation of authority at any time. However, if either party ends the contract before the stated time, the nonbreaching party may sue for damages for the wrongful termination.

V. Answers to Business Law Cases

Creation of an Agency

Case Scenario Revisited. No, the unidentified patron was not an agent of the nightclub. The relation of principal and agent arises wherever one person—expressly or by implication—authorizes another to act for him. The court found no proof of agency by express agreement or by implication from the circumstances of the case. A review of the record persuaded the court that the unidentified person who caused Ginn’s injuries was merely an individual patron of the nightclub who was acting on his own. There was no evidence that the nightclub manager requested the patron to assist him in dealing with Ginn or that the manager ratified the patron’s actions. Because there was no agency, the nightclub is not liable for the actions of the patron who injured Ginn. The appellate court affirmed the trial court’s grant of a directed verdict in favor of defendant nightclub. Ginn v. Renaldo, Inc., 359 S.E.2d 390 (Ga.App. 1987).

Independent Contractor

1.1. No, Samuelson is not liable to Mercedes Connolly. The court held that African Adventures was an independent contractor and that Samuelson acted as a broker in selling Connolly the tour package. The court held that travel agents have no duty to advise tourists that a walking tour was part of the itinerary, to advise tourists of proper footwear, to know the walking conditions of the destination of the tour, or to provide tourists with a safe and secure tour. Connolly v. Samuelson, 671 F.Supp. 1312 (D.Kan. 1987).

Contract Liability

1.2 No, Universal Travel Agency, Inc. (Universal) is not liable to the football fans for their failure to receive tickets to Super Bowl XII. To avoid personal liability, it is the duty of an agent to disclose both the fact that he is acting in a representative capacity and the identity of his principal. An agent, by making a contract only on behalf of a competent disclosed principal, does not

thereby become liable for the principal’s nonperformance. The court held that Universal was the agent for a disclosed principal, Octagon Travel Center, Inc., and was not liable for Octagon’s nonperformance. The plaintiffs made a claim against Octagon, and each received only $75. Behlman v. Universal Travel Agency, Inc., 496 A.2d 962 (Conn.App. 1985).

Power of Attorney

1.3. Yes, King is liable to Bankerd for gifting the property to Mrs. Bankerd. A power of attorney creates a principal-agent relationship. Broadly defined, a power of attorney is a written document by which one party as principal appoints another as agent (attorney in fact) and confers upon the latter the authority to perform specified acts on behalf of the principal. The power of attorney delineates the extent of the agent’s authority and is strictly construed by the court.

The court held that the general power of attorney in this case which authorized the agent to sell and convey the property on such terms as the attorney in fact deems proper, did not, however, authorize the agent to make a gift of the property. This violated the agent’s duty of loyalty that he owed to the principal. The Appellate Court affirmed the trial court’s grant of summary judgment in favor of Bankerd that awarded $13,555 in damages against King. King v. Bankerd, 492 A.2d 608 (Md. 1988).

Apparent Agency

1.4. Bolus wins the lawsuit and may recover damages against United Penn Bank. A jury may find that an alleged agent had either actual or apparent authority to bind the principal. Here, Ziobro did not have actual authority to commit the bank to the loan because his loan limit was expressly set at $10,000. However, Ziobro had apparent authority to commit the bank to financing Bolus’s project. Apparent authority is authority that the principal has by words or conduct held the alleged agent out as having. Ziobro was employed as a loan officer of the bank, Bolus was referred to Ziobro when he contacted the bank about the possibility of financing the Bartonsville project, and the limit on Ziobro’s authority to make loans was not communicated to Bolus. Thus, the bank clothed Ziobro with apparent authority to commit the bank to financing Bolus’s project. The Appellate Court affirmed a jury verdict in favor of Bolus. Bolus v. United Penn Bank, 525 A.2d 1215 (Pa.Super. 1987).

Imputed Knowledge

1.5. Yes, Boulevard Investment Company (Boulevard) is liable to Iota Management Corporation (Iota) for breach of contract. The knowledge of an agent of corporate principal regarding matters within the agent’s scope of employment and authority is imputed to the principal. The court held that Cecil Lillibridge, who was Boulevard’s maintenance supervisor, had acquired knowledge of the condition of the pipes through his work at the hotel, clearly within the scope of his employment and authority. The court held that this knowledge was imputed to the corporate principal, Boulevard. The appellate court affirmed the trial court’s decision that permitted Iota to rescind the contract. Iota Management Corporation v. Boulevard Investment Company, 731 S.W.2d 399, 1987 Mo. App. Lexis 4027 (Mo. App.)

VI. Answers to Issues in Business Ethics Cases

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1.6. Yes, the agency agreement was terminated when the Hagues sent the termination letter to Hilgendorf on August 13, 1976. Since an agency is a consensual relationship, a principal has the power to terminate an agency, except those coupled with an interest, although the contract is for a period that has not yet expired. The agent’s authority to bind the principal ceases. Thus, the Hagues had the power to terminate the exclusive listing agreement with Hilgendorf.

However, absent some legal ground, the principal does not have the right to terminate an unexpired agency contract, and may subject himself to damages by doing so. The court held that the Hagues had no legal ground for terminating their agency agreement with Hilgendorf, and are therefore liable for wrongful termination of the agreement. Where the principal terminates an exclusive agency listing within the term, the agent may show that he would, but for the termination, have sold the property within the unexpired period at the listing price, and then recover his lost profits as ordinarily measured by the commission he would have earned. The appellate court affirmed the trial court’s award of the commission to Hilgendorf. Hilgendorf v. Hague, 293 N.W.2d 272 (Iowa 1980).

1.7. No, Anna Parana was not an agent of Elizabeth Krempasky in this case. Ms. Krempasky died at approximately 2:45 P.M. and the papers were not presented to the bank until after 3:00. Death of the principal ends the agency relationship. Anna Parana had no interest in the certificates of deposit at the time of the decedent's death. Parana acted unethically by trying to file the paperwork after the death of Krempasky. Estate of Krempasky, 501 A.2d 681, 1985 Pa.Super.Lexis 10545 (Pa. Super.)

VII. Terms

agency by ratification—An agency that occurs when (1) a person misrepresents him- or herself as another’s agent when in fact he or she is not and (2) the purported principal ratifies the unauthorized act.

agency—The principal-agent relationship: the fiduciary relationship “which results from the manifestation of consent by one person to another that the other shall act in his behalf and subject to his control, and consent by the other so to act.

agency law—The large body of common law that governs agency; a mixture of contract law and tort law.

agent—The party who agrees to act on behalf of another.

apparent agency—Agency that arises when a principal creates the appearance of an agency that in actuality does not exist.

employer-employee relationship—A relationship that results when an employer hires an employee to perform some form of physical service.

employment relationships—(1) Employer-employee, (2) principal-agent, and (3) principal-independent contractor.

exclusive agency contract—A contract a principal and agent enter into that says the principal cannot employ any agent other than the exclusive agent.

express agency—An agency that occurs when a principal and an agent expressly agree to enter into an agency agreement with each other.

implied agency—An agency that occurs when a principal and an agent do not expressly create an agency, but it is inferred from the conduct of the parties.

independent contractor—“A person who contracts with another to do something for him who is not controlled by the other nor subject to the other’s right to control with respect to his physical conduct in the performance of the undertaking.” [Restatement (Second) of Agency].

independent contractor—A person or business who is not an employee who is employed by a principal to perform a certain task on his behalf.

power of attorney—An express agency agreement that is often used to give an agent the power to sign legal documents on behalf of the principal.

principal-agent relationship—An employer hires an employee and gives that employee authority to act and enter into contracts on his or her behalf.

principal—The party who employs another person to act on his or her behalf.

termination by acts of the parties—An agency may be terminated by the following acts of the parties: (1) mutual agreement, (2) lapse of time, (3) purpose achieved, and (4) occurrence of a specified event.

termination by operation of law—An agency is terminated by operation of law, including: (1) death of the principal or agent, (2) insanity of the principal or agent, (3) bankruptcy of the principal, (4) impossibility of performance, (5) changed circumstances, and (6) war between the principal’s and agent’s countries.

wrongful termination—The termination of an agency contract in violation of the terms of the agency contract. The nonbreaching party may recover damages from the breaching party.

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Chapter 2

Liability of Principals, Agents & Independent Contractors

“The law, wherein, as in a magic mirror, we see reflected not only our lives, but the lives of all men that have been! When I think on this majestic theme, my eyes dazzle.”

Oliver Wendell Holmes Jr.

I. Teacher to Teacher Dialogue

The benefits of agency are not without counterbalancing detriment. The Latin maxim respondeat superior may be familiar to your students. In certain instances, a principal is liable to third parties for the acts of his or her agent. Just as the benefits of agency can be great, so can the burdens. One of the fastest growing areas of management specialization in today’s business environment is risk management. This area generally concerns business financial responsibility for exposures to specified contingencies or perils. Included in these perils are the acts of the agents for which the principal may be liable. The ironic aspect of all this is that the very same people who help a business grow can lead that same enterprise to financial ruin.

Every agency liability question having an involvement with third parties has three subquestions that must be answered in order to come to a final resolution of the issues at hand. They are:

1. What are the responsibilities of the principal and agent vis-à-vis each other?

2. What are the responsibilities of the agent vis-à-vis the third party?

3. What are the responsibilities of the principal vis-à-vis the third party?

Invariably a certain fact pattern emerges. First there is some sort of principal/agent relationship established. This relationship may be based on actual, implied, apparent, or ratified authority. In all events, once that authority line has been drawn, the question of the legal consequences to the principal and agent vis-à-vis each other must be answered. These consequences include their respective rights and duties to each other.

Once the first subquestion is resolved, the rights, duties, and obligations of the agent and principal, respectively, must then be examined vis-à-vis the third party. Often there will be some sort of wrongful and unauthorized act committed by the agent. That act will result in probable liability for both the agent and the principal to the third party who was harmed by the act. Think of the three subquestions as a loop that must be closed in order for the whole case to be resolved. The loop is similar to a legal description used to outline the surveyed ownership of real property. A proper legal description always closes at the point where it began. So must an agency issue. It starts with the establishment of the agency relationship. It goes through the rights and duties of third parties. It terminates back where it began, with a determination of the ultimate responsibilities of the principal and agent vis-à-vis each other.

II. Chapter Objectives

Describe the duty of loyalty owed by an agent to a principal.

Describe the principal’s and the agent’s liability of third-party contracts.

Identify and describe the principal’s liability for the tortious conduct of an agent.

Describe how an independent contractor status is created.

Describe the principal’s liability for torts of an independent contractor.

III. Key Question Checklist

What are the principal and agent’s duties to each other?

How did a relationship with a third party come about?

What are the principal and agent’s duties to the third party?

What is an independent contractor?

IV. Text Materials

Agency law controls the responsibilities and duties of principals, and agents, and defines their relationship and that of independent contractors.

Section 1: Agent’s Duty of Loyalty to the Principal

Agents owe both a duty of loyalty and a fiduciary duty to the principal. Agents will be liable to the principal for breaches of loyalty. The most common examples of this include undisclosed self-dealing, usurping opportunities that belongs to the principal, competing with the principal during the course of an agency, misusing confidential information about the principal’s affairs acquired during the course of the agency, and undisclosed dual agency. The agent can defend against these claims by making full disclosure to the principal before taking action (self-dealing, usurping, dual agency) or by using generally available information or knowledge (misuse of confidential information). An agent is free to compete with a principal after termination of the relationship if there is no enforceable covenant-not-to-compete.

Section 2: Contract Liability to Third Parties

Principals that authorize agents to enter into contracts with a third party will be liable on the contract. The agent may also be held liable under the contract, depending upon the type of agency.

Fully Disclosed Agency- This is the result of the third party knowing that the agent is acting as such for an identified principal. The agent has no liability under the contract unless they have guaranteed the performance of the principal.

Partially Disclosed Agency-This occurs when the agent discloses their agency status but not the identity of the principal to the third party. In this event, both the principal and the agent are liable on third party contracts, because the third party must rely on the agent’s reputation or credit when entering into the agreement. The agent is indemnified for any liability by the principal, and the third party can agree to relieve the agent of any liability under the contract.

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Undisclosed Agency- This is when the third party is unaware of both the existence of the agency or of the principal. Both the principal and the agent are liable on the contract. The agent becomes the principal to the contract, but they are indemnified by the principal, and can recover for any losses.

Agent Exceeding the Scope of Authority- When an agent enters into a contract on behalf of a principal, there is an implied warranty of authority. If the agent exceeds the scope of their authority, the principal will not be bound unless it is ratified. Instead, the agent remains liable.

Section 3: Tort Liability to Third Parties

Both principal and agent are liable for their own tortious conduct. The principal is liable for the tortious conduct of an agent who is acting within the scope of their authority. An agent is liable for tortious acts of a principal only if they aid or abet the conduct.

Negligence - Principals are liable for acts performed by agents acting within the scope of their authority under the common law doctrine of respondent superior, which is based on the legal theory of vicarious liability.

Frolic and Detour - Agents sometimes do things during the course of their employment that furthers their personal interests, such as running personal errands. This is referred to as frolic and detour. Agents are responsible for their own tortious act. Principals are usually relieved of liability unless the deviation is minor. Courts will review these on a case-by-case basis.

The “Coming and Going” Rule - Under the coming and going rule, principals are generally not held liable for injuries caused by agents or employees on their way to and from work, even if the principal supplies the transportation.

Dual-Purpose Mission - If an agent injures someone while on a dual-purpose mission, that is where they are asked by the employer to run an errand when they are on personal business, then most jurisdictions hold both the agent and the principal liable.

Intentional Torts – The principal is not liable for intentional torts of agents and employees that are committed outside the principal’s scope of business. However, they are held liable under the doctrine of vicarious liability for any intentional torts committed within the agent’s scope of employment. The courts apply either the motivation test to judge whether the agent’s motivation was to further the employer’s business or the work-related test to see if the agent committed the intentional tort within a work-related time or space, in order to determine if the principal is liable for any injuries caused by the agent’s intentional torts.

Misrepresentation – Principals are liable for both the intentional and innocent misrepresentations of their agents. Intentional misrepresentation occurs when the agent makes statements that he knows are false. Innocent misrepresentations occur when the agent negligently makes a misrepresentation to a third party. The third party may rescind the contract and recover any consideration paid or affirm the contract and recover damages.

Section 4: Independent Contractor

Outsiders who are employed by principals to perform certain tasks are called independent contractors.

Factors for Determining Independent Contractor Status – The key point for determining whether or not someone is an independent contractor is the degree of control that the principal has. The factors that the court reviews is whether the worker is engaged in a distinct occupation

or an independently established business, the length of time the agent has been employed, and the amount of time that he works for the principal, who supplies the tools, equipment, and administrative and support staff used, the method of payment, degree of skill needed, and who controls the manner and means of accomplishing the tasks.

Liability for an Independent Contractor’s Contracts – Principals are bound by authorized contracts, but not those entered into without the express or implied authority.

Liability for an Independent Contractor’s Torts – The principal is not liable for the torts of their independent contractors, since they do not control the means by which their results are accomplished

Exceptions Where a Principal Is Liable for the Torts of an Independent Contractor – The principal will be held liable for the torts of an independent contractor in the case of inherently dangerous activities and when they are negligent in selecting the contractor.

V. Answers to Business Law Cases

Fiduciary Duty

2.1. The court held that there was substantial evidence that E.F. Hutton had either authorized or ratified the acts of its employee in a manner sufficient to justify the punitive damages award, including evidence that the firm's branch manager had learned of the excessive trading activities of the broker prior to the broker's departure from the firm, and had taken no remedial action. The manager had also failed to undertake an inspection of plaintiff's portfolio despite the clear need to do so. Pusateri v. E.F. Hutton & Co., Inc., 180 Cal.App.3d 247, 225 Cal.Rptr. 526, 1986 Cal.App. Lexis 1502 (Cal.App.)

2.2. The court, following precedence established in other cases, determined that, absent an express or implied agreement to the contrary, when an agent is employed for the performance of a particular task, the agency terminates on the completion of that task. After the termination of the agency, an agent owes a continuing duty not to use or disclose confidential information obtained during the course of the agency. The court held that any remaining fiduciary obligations which arose during the agency no longer exist, and an agent is free to take any actions that they might choose. Boettcher DTC Building Joint Venture v. Wilfred, 762 P.2d 788, 1988 Colo.App. Lexis. 323 (Colo.App)

Duty of Loyalty

2.3. Yes, Shields breached his fiduciary duty of loyalty to his principal, Production Finishing, by usurping a corporate business opportunity. Shields, as president and a member of the board of directors of Production Finishing, was an agent of the corporation. A corporate officer or director is an agent of the corporation and under a fiduciary duty not to divert a corporate business opportunity for his own personal gain. If an agent acquires any pecuniary advantage to himself from third parties by breaching his fiduciary duties, he is accountable to his employer for the profit made. The court held that Shields breached his fiduciary duty of loyalty and honesty to his principal by diverting the Ford contract to him. The Court of Appeals affirmed the trial court’s granting of summary judgment in favor of Production Finishing and remanded the case for a determination of damages. Production Finishing Corporation v. Shields, 405 N.W.2d 171 (Mich.App. 1987).

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Independent Contractor

2.4. The court held that although Butler had an engineer on site to inspect the work being completed by Sandidge, the engineer did not exercise any control over the construction company or any of its employees. The engineering company had been hired to lay the wire, and had complete control over the mode and method, and hence was an independent contractor. The Pugh family could not be granted a recovery against Butler Telephone. Pugh v. Butler Telephone Company, Inc., 512 So.2d 1317, 1987 Ala. Lexis 4468 (Ala.)

Personal Guaranty

2.5. Sebastian International, Inc., wins, and Peck is held personally liable on the lease guarantee. The general rule is that an agent who signs a contract in his agency capacity and discloses the identity of the principal is not personally liable on the contract. There is an exception to this rule where an agent expressly makes himself liable. Where a writing is signed by a person and contains apt words to bind him personally, the fact that to his signature is added such words as “President,” “Vice President,” and the like does not change the character of the person signing, but is considered merely descriptive of him. The mere fact that a person sustains an agency relation to another does not prevent him from becoming personally liable. The court held that Peck personally obligated himself to the guaranty contract, and that the mere fact that Peck was identified as a “Vice President” did not relieve him of personal liability. Sebastian International, Inc. v. Peck, 195 C.A.3rd 803, 240 C.R. 911 (Cal.App. 1987).

Contract Liability

2.6. Both Elvin Grinder personally and G. Elvin Grinder Construction, Inc., are liable to Bryans Road Building & Supply Co., Inc. This is a situation of an undisclosed principal. An agent who makes a contract in his own name without disclosing his agency and the identity of the principal is liable on the contract to the other party. The principal is liable because the contract was made for his benefit. The court held that a creditor who contracts with the agent for an undisclosed principal does not obtain alternative liability, but that he may proceed to judgment against both, and that he is limited to one satisfaction. The court held that Grinder was the agent for an undisclosed principal, and that Bryans is entitled to take judgment against Grinder personally in addition to its unsatisfied judgment against the corporation. Grinder v. Bryans Road Building & Supply Co., Inc., 432 A.2d 453 (Md.App. 1981).

Dual Agency

2.7. Washington Steel wins. Washington Steel and TW had adverse interests to each other because of TW’s planned hostile tender offer for the stock of Washington Steel. The court held that Chemical Bank owed a fiduciary duty of loyalty not to act adversely to the interests of its client, Washington Steel. By accepting TW as a client and agreeing to finance its hostile tender offer on Washington Steel, Chemical Bank became a dual agent. Chemical Bank did not disclose its dual agency status to Washington Steel, did not seek to obtain Washington Steel’s permission to act as a dual agent, and intentionally concealed its dual agency status from Washington Steel. The court held that Chemical Bank’s undisclosed dual agency status violated the fiduciary duty of loyalty it owed to Washington Steel. The court enjoined Chemical Bank from in any way financing or participating in the TW’s tender offer, and also temporarily enjoined TW for a period of 90 days from proceeding with its tender offer for Washington Steel. Washington Steel Corporation v. TW Corporation, 465 F.Supp. 1100 (W.D. Pa. 1979).

Tort Liability

2.8. Yes, Intrastate Radiotelephone, Inc., is liable to Largey for the injuries caused by its agent, Kranhold. Generally, a principal is responsible to third persons for the negligence of its agents, including acts committed by such agents while acting within the scope of their employment. Ordinarily, while an employee is going to or coming from his place of employment, he is outside the scope of his employment during that period. There is an exception to the “coming and going” rule—if it is an implied or express condition of the agent’s employment that he use his vehicle in attending to his duties, then the employer will be vicariously liable for any accidents incurred while the employee is driving to or from work. The court held that there was sufficient and substantial evidence for the jury to have inferred that Kranhold was acting within the scope of his employment when the accident in question occurred. Therefore, the exception to the coming and going rule applies in this case. The appellate court affirmed the judgment of the trial court that was entered in favor of Largey against Intrastate. Largey v. Intrastate Radiotelephone, Inc., 136 C.A.3d 660, 186 C.R. 520 (Cal.App. 1982).

Tort Liability

2.9. The court held that the employer, Higgenbotham-Bartlett Lumber Company, was not liable for the intentional tort of its employee, Jackson, which caused injuries to Green. The court applied the motivation test in examining the principal’s liability in this case. The established rule in Texas is that it is not ordinarily within the scope of an employee’s authority to commit an assault on a third person. Such an assault is usually an expression of personal animosity and is not for the purpose of carrying on the employer’s business. The court held that when Jackson assaulted and battered Green, he was not acting in the furtherance of his employer’s business, but that the fracas was the outgrowth of a long-simmering personal dispute arising out of the asserted debt owed by Jackson to Green, and the incident was not connected with Jackson’s employment. The Appellate Court affirmed the trial court’s grant of summary judgment in favor of the employer, Higgenbotham-Bartlett Lumber Company.

If the more modern work-related test were applied to the facts of this case, the employer would have been found liable for Jackson’s actions. Under this test, if an agent commits an intentional tort on a third person within a work-related time or space, the principal is liable for the injuries suffered by the injured third person. Under this test, the motivation of the employee in committing the tort is immaterial. In this case, the assault and battery took place at the employer’s place of business and during ordinary working hours. The victim, Ted Green, was a customer at the lumberyard at the time of the incident. Thus, if the work-related test were applied to this case, the employer, Higgenbotham-Bartlett Lumber Company, would have been held liable for the intentional tort of its agent, Jackson. Green v. Jackson, 674 S.W.2d 395 (Tex.App. 1984).

VI. Answers to Issues in Business Ethics Cases

2.10. King can enforce the contract. An agent acting for a partially disclosed principal becomes, unless otherwise agreed, a party to the contract and is personally liable on it. Since he is liable on the contract he may enforce the contract even though the principal was only partially disclosed. Venezio v. Bianchi, 508 N.Y.S.2d 349 (N.Y. App. 1986).

2.11. Nabisco is liable for the intentional assault and battery of Lange by its employee Lynch. The Minnesota rule is that where it is shown that “the employee’s acts were motivated by a desire to further the employer’s business,” then liability will be imposed. However, in developing a test

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for application of the rule the court stated, “the focus should be on the basis of the assault rather than the motivation of the employee.” Applying this test, the court held, as a matter of law, that the employer is liable where an assault or battery has its origin in an argument concerning the work being done by the employee. Lynch was found to have been originally motivated to become argumentative in the furtherance of his employer’s business. The court held an employer is liable for an assault by his employee when the source of the attack is related to the duties of the employer and the assault occurs within work related limits of time and place. Lange v. National Biscuit Company, 211 N.W. 2d 783 (Minn 1983).

VII. Terms

“coming and going” rule—A rule that says a principal is generally not liable for injuries caused by its agents and employees while they are on their way to or from work.

dual-purpose mission—An errand or other act that a principal requests of an agent while the agent is on his or her own personal business.

duty of accountability—A duty that an agent owes to maintain an accurate accounting of all transactions undertaken on the principal’s behalf.

duty of notification—An agent’s duty to notify the principal of information he or she learns from a third party or other source that is important to the principal.

duty of performance—An agent’s duty to a principal that includes (1) performing the lawful duties expressed in the contract and (2) meeting the standards of reasonable care, skill, and diligence implicit in all contracts.

duty to compensate—A duty that a principal owes to pay an agreed-upon amount to the agent either upon the completion of the agency or at some other mutually agreeable time.

duty to cooperate—A duty that a principal owes to cooperate with and assist the agent in the performance of the agent’s duties and the accomplishment of the agency.

duty to indemnify—A duty that a principal owes to protect the agent for losses the agent suffered during the agency because of the principal’s misconduct.

duty to reimburse—A duty that a principal owes to repay money to the agent if the agent spent his or her own money during the agency on the principal’s behalf.

frolic and detour—When an agent does something during the course of his employment to further his own interests rather than the principal’s.

implied warranty of authority—An agent who enters into a contract on behalf of another party impliedly warrants that he or she has the authority to do so.

imputed knowledge—Information that is learned by the agent that is attributed to the principal.

independent contractor—“A person who contracts with another to do something for him who is not controlled by the other nor subject to the other’s right to control with respect to his physical conduct in the performance of the undertaking” [Restatement (Second) of Agency].

innocent misrepresentation—Occurs when an agent makes an untrue statement that he or she honestly and reasonably believes to be true.

intentional misrepresentation—Occurs when an agent makes an untrue statement that he or she knows is not true.

intentional tort—Occurs when a person has intentionally committed a wrong against (1) another person or his or her character, or (2) another person’s property.

motivation test—A test to determine the liability of the principal; if the agent’s motivation in committing the intentional tort is to promote the principal’s business, then the principal is liable for any injury caused by the tort.

ratification—When a principal accepts an agent’s unauthorized contract.

respondeat superior—A rule that says an employer is liable for the tortious conduct of its employees or agents while they are acting within the scope of his or her authority.

work-related test—A test to determine the liability of a principal; if an agent commits an intentional tort within a work-related time or space, the principal is liable for any injury caused by the agent’s intentional tort.

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Chapter 3Entrepreneurship & Sole Proprietorships

One of the most fruitful sources of ruin to men of the world is the reckless or want of principle of partners, and it is one of the perils to which every man exposes himself who enters into partnership with another.

Malins, V.C. Mackay v. Dougkas

I. Teacher to Teacher Dialogue

Entrepreneurship is the basis for almost every new business start today. Thousands of entrepreneurs open their doors each month. Unfortunately, most are doomed to failure. This chapter picks up where agency left off in that it introduces students to the law of business entity choices. These choices will be developed in this and subsequent chapters through a set of concepts starting with sole proprietorship, working up through the various permutations of partnerships, and culminating with that most elaborate of all business organizations, the corporation. In order to ensure the success of any organization, the proper business entity must be carefully selected, allowing for appropriate control, flexibility, management organization, and taxation benefits.

One of the key roles of attorneys engaged in the practice of modern business law is advising their clients on the selection of the best venue for doing business. What seems like a relatively limited number of options is, in fact, quite extensive. The choices run the gamut from the simplest lemonade stand setup for a youngster to a multinational publicly traded corporation and everything in between.

With each choice comes a list of pros and cons in the eyes of the law. For example, if a person seeks maximum privacy in his or her financial affairs along with the least possible accountability to others, a private form of sole proprietorship may be best. Compare this with the businessperson who wants to leverage the maximum utilization of other people’s money while limiting her personal financial exposure. That person may find the corporate form best suited for her needs.

Business entity law literally has something for everyone. The real issue is first finding out what options are legally available, and then choosing the best fit. That fit should be tailored by sound advice from a number of quarters including law, accounting, finance, and business management strategy. It is this constant interdependent equation that makes the practice of business law so difficult yet so interesting.

Sole proprietorship is still the most widely used form of business entity even though it may not be the most important in sheer economic terms. With the advent of the information highway and more emphasis on entrepreneurial niche marketing of goods and services, this form of business may enjoy a renaissance in the twenty first century. The law of sole proprietorship is, in fact, derived from a combination of property, contract, agency, and tort law doctrines. The practice of law for sole proprietorships is akin to the medical family doctor. Every sort of business issue ranging from taxes to zoning may confront this businessperson. Yet in spite of the

high risk and sometimes-marginal rewards, few sole proprietors would willingly give up their personal control over their fate.

II. Chapter Objectives

Define a sole proprietorship.

Explain how a sole proprietorship is formed and terminated.

Describe the liability of a sole proprietorship.

Describe the liability of a sole proprietor.

Explain how a sole proprietorship is taxed.

III. Key Question Checklist

What are your objectives in doing business, and what business entity choice best meets those objectives?

What are the advantages and disadvantages of doing business as a sole proprietor?

How is a sole proprietorship formed and terminated?

Describe the liability of a sole proprietor.

How is a sole proprietor taxed?

IV. Text Materials

Section 1: Entrepreneurship

An entrepreneur is a person who forms and operates a business, alone or with others.

Entrepreneurial Forms of Conducting Business – The major forms for conducting business and professions include the sole proprietorship, general partnership, limited partnership, limited liability partnership, limited liability company, and the corporation.

Section 2: Sole Proprietorship-advantages and disadvantages

The sole proprietorship is the simplest form of business. As the name indicates, the owner is the business. It is easy to form and does not cost a lot. The owner has the right to make all management decisions. He owns all of the business, receives all of the profit, and carries the tax liability on his personal income tax. The sole proprietorship can be easily transferred or terminated at any time. The disadvantages include access to capital, which is generally limited to personal funds and loans, and the owner is personally liable for all contracts and torts committed by himself or his employees in the course of business.

Creation and Termination of a Sole Proprietorship – There are no formalities and no government approvals required, although you might need to purchase a business license from the municipality where the business is located. Similarly, there are no formalities and no government approvals required to terminate the sole proprietorship. However, you may need to cancel a license, permit, application or contract.

Personal Liability of Sole Proprietors – The owner has unlimited personal liability.

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Taxation of Sole Proprietorships-The proprietorship business does not pay any income tax separate from the individual proprietor. The sole proprietor must report profit and loss from the business on his or her own personal tax form. The sole proprietor is responsible for paying income tax on all business profits.

V. Answers to Business Law Cases

Insurance Issues

3.1. Yes, the trial court was correct. The appellate court found the injured party was not the named insured under the commercial general liability policy; she was not the sole proprietor named and the sole proprietor did not notify the insurance company of the change in business structure, as the policy required. It also found the injured party did not show she was covered by operation of law. Koehlke v. Clay Street Inn, Inc., No. 2002-A-0108, 2003 Ohio LEXIS 4819 (Ct. App. Sept. 30, 2003)

Fictitious and Trade Names

3.2 Yes, she waived the right due to her failure to comply with Fla. Stat. ch. 865.09 and was therefore not entitled to defend under the statute’s express provisions. The court held that although her failure to comply with the statute would not have had any effect on the outcome, orderly procedure required compliance with the statute. The court reversed the summary judgment and held that the lower court should have granted relief sought by Chaikin, until Skolnick complied with the statute. Chikin v. Skolnick 201 So. 2d 588 (Fla. Dist. Ct. App. 1967)

3.3 No, he was not correct. The court found that where a trial court failed to acquire jurisdiction of a party by service of process or by the party’s appearance, a judgment rendered against such party was void. The court determined that the district court had acquired proper jurisdiction over the construction company, which was “but two names for one person.” Therefore, the court found, M. J. Gill’s contention was without merit. National Surety Co. v. Oklahoma Presbyterian College for Girls, 132 P. 652 (Okla. 1913)

Legal separation

3.4 No, the court affirmed that the stock sale was not a transfer between employers. The facts indicated that Glidden continued to exist and operate as a separate corporate entity and continued to pay its employees’ salaries after the stock sale. Therefore he was not entitled to a reduced tax rate for Pennsylvania unemployment compensation. Glidden Co. v. Department of Labor and Indus., 700 A.2d 55 (Pa. Commw. Ct. 1997)

3.5 No, a sole proprietorship under Illinois law has no legal existence apart from the individual and could not have been separately sued. Therefore the court dismissed the sole proprietorship. Cashco Oil Co. v. Moses, 605 F. Supp. 70 (N.D. Ill, 1985)

V. Terms

entrepreneurship- A position where one can be educated by a person who has formed and operates a new business either by him- or herself or with others.

ENTREPRENEUR-A PERSON WHO FORMS AND OPERATES A NEW BUSINESS EITHER BY HIMSELF OR HERSELF OR WITH OTHERS.

sole proprietorship-A form of business in which the owner is actually the business; the business is not a separate legal entity.

sole proprietor-An owner, one who runs a business.

trade Name-A name used in trade to designate a particular business.

doing business as (d.b.a.)-The act of engaging in business activities, specifically the carrying out of a series of similar acts for the purpose of realizing a pecuniary benefit, or otherwise accomplishing a goal, or doing a single act with the intention of starting a series of such acts.

fictitious business name statement (certificate of trade name)-A statement that most states require businesses operating under a trade name to file.

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Chapter 4 General Partnerships

One of the most fruitful sources of ruin to men of the world is the reckless or want of principle of partners, and it is one of the perils to which every man exposes himself who enters into partnership with another.

Malins, V.C. Mackay v. Dougkas

I. Teacher to Teacher Dialogue

The operation of a partnership is one of the oldest recognized methods of cooperative business conduct. Many of its antecedents go back to the age of chivalry where the duties of loyalty were paramount. “All for one and one for all” was more than just a rallying cry before battle. The phrase connoted an expectation that made your acts the acts of your colleague and vice versa. A legal oneness came to be recognized between partners and the third parties with whom they dealt. Subsequent evolution of partnership law has carried forth this unity.

Modern contract law, tort law, and agency law all reflect this commonality when it comes to partnerships. Partners are expected to be responsible for each other’s acts in the eyes of the law. These responsibilities may not always seem fair to the layperson. Partnerships are a binding marriage, and require all the formality of a divorce to terminate, even if they lacked any formality at the start.

Given our nation’s divorce rate of nearly seventy percent, many social reformers have argued for making marriage a more difficult institution to enter into. Perhaps the same argument can be raised vis-à-vis partnership. Given the long and sometimes tortuous entanglements that people find themselves in, maybe they should think long and hard (and get the best legal advice they can) before getting in bed with someone legally by way of partnership. As Suetonius said in the first century A.D., “Make haste slowly.” Remember, both partners have a lot of latitude in contracting rights and duties between themselves, but less so vis-à-vis third parties under the Uniform Partnership Act.

II. Chapter Objectives

Define a general partnership and describe how general partnerships are formed.

Explain the contract and tort liability of partners.

Describe how a partnership is dissolved and terminated.

III. Key Question Checklist

What are your objectives in doing business, and what business entity choice best meets those objectives?

What are the advantages and disadvantages of doing business as a general partnership?

What are the rights and duties of general partners?

How can a partnership be dissolved by acts of the partners?

How can a partnership be dissolved by operation of law?

How can a partnership be dissolved by judicial decree?

VI. Text Materials

Section 3: General Partnership

General (ordinary) partnerships have been recognized since ancient times. It is a voluntary association of two or more persons for the purpose of carrying on a business for profit.

Uniform Partnership Act (UPA) – The UPA codifies partnership law, basing the rules on the entity theory of partnership, and has been adopted in whole or in part by 48 states.

General Partnership Name - Ordinary partnerships can operate under the name of any one or more of the partners or under a fictitious name, if a proper filing has been made with the appropriate governmental body.

Formation of a General Partnership – To be a partnership, a business must be a voluntary association of at least two persons that are carrying on a business as co-owners for profit. The formation requires little or no formality. The courts will consider receipt of a share of the business profits and losses as prima facie evidence of a partnership, as opposed to right to management.

The General Partnership Agreement – The agreement may be oral, written, or implied by the conduct of the partners. The Statute of Frauds will require a written partnership agreement if the partnership is to exist for over a year or deal with real estate.

Section 4: Rights and Duties of General Partners

Right to Participate in Management – Absent to an agreement to the contrary, all partners have equal rights to participate in management.

General Partner’s Rights to Share in Profits – Unless there is a agreement stating otherwise, all partners have a right to an equal share in the profits and losses. If the agreement explains the share of profits, but is silent as to the losses, the losses are shared in the same percentage. If the agreement details the share of losses but not profits, the profits are shared evenly.

Right to Compensation and Reimbursement – Unless the agreement states otherwise, no partner is entitled to remuneration because they are supposed to devote their full time and energy to the partnership. However, they can be reimbursed for business expenses incurred in the service of the partnership.

Right to Return of Loans and Capital – Partners who make loans to the partnership become creditors subordinated to the claims of all creditors, and are due both principal and interest.

When the partnership terminates, their capital investment will be returned, if there are funds remaining after all creditors are satisfied.

Right to Information – Each partner has the right to information about the partnership, including financial records and taxes.

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Duty of Loyalty – Partners have a fiduciary duty to each other. This duty includes the duty not to self-deal, usurp partnership opportunities, compete with the partnership, to make secret profits, breach the confidentiality of the partnership, and misuse partnership property. If any partner breaches this duty, they will be forced to disgorge any profits that were made and be liable for any damages caused by the breach.

Duty of Care – Partners must use the reasonable skill and care that would expected of someone in their position, but are not liable for honest business errors.

Duty to Inform – Partners have a duty to inform co-partners of any information that they have, since the knowledge is imputed on the others.

Duty of Obedience – Partners must adhere to the rules of the partnership, or they will be liable for any damages caused by the breach.

Right to an Accounting – Partners cannot sue the partnership, but, instead, can bring an action for an accounting, wherein the court will review the partnership to determine and award each partner their share.

Section 5: Liabilities of General Partners

Tort Liability – The partnership is liable for any acts caused by a partner, employee, or agent within the ordinary course of business. Each partner is jointly and severally liable for torts and breaches of trust. A third party may sue one or more of the partners and recover a judgment against them. A release of one partner does not release the others. The partner sued or recovered against may seek indemnification from the other partners.

Contract Liability – Partners are jointly liable for contracts. A party must name all partners in a lawsuit in order to collect against any of the partners or the partnership. Releasing a single partner releases all. If a partner is made to pay more than their share, they may seek indemnification from the other partners.

Liability of Incoming Partners – A new partner is only liable for antecedent debts to the amount of their capital contribution, but will be personally liable for all debts incurred after they become a partner.

Section 6: Dissolution of a General Partnership

A partnership for a term is for a fixed term or until a particular event occurs, while a partnership at will is for an unspecified period. With the former, the partnership automatically dissolves at the time proscribed or upon the occurrence of the event. A partnership at will can be dissolved at any time.

Unless it is agreed that the partnership will continue, the windingup of the partnership follows the dissolution.

Notice of Dissolution – Notice of dissolution must be given to certain parties, or the partners will be deemed to have apparent authority to continue to bind the partnership. Third parties who dealt with the partnership must be given actual notice of the dissolution. Third parties who did not deal with the partnership but had knowledge of it must be given either actual or constructive notice. Third parties who had neither dealt with the partnership nor had knowledge of it are owed no notice.

Distribution of Assets – Partnerships assets should be liquidated, and payment made first to creditors and then creditor-partners. If assets remain, the capital contribution of each partner should be returned, and any remaining monies should be distributed as profits.

Wrongful Dissolution – Although a partner has the power to withdraw at any time, he may not have the right, and will be held liable for any damages the wrongful dissolution caused.

Continuation of a General Partnership after Dissolution – The remaining partners may enter into a continuation agreement, dissolving the old partnership and creating a new one.

Liability of Outgoing Partners – Outgoing partners are personally liable for any debts in existence at the time of dissolution of the partnership, but not for any new debts.

Right of Survivorship – The surviving partners receive the partnership property from a deceased partner through the right of survivorship. His heirs or beneficiary receives only the value of the deceased partner’s share.

V. Answers to Business Law Cases

General Partnership

Case Scenario Revisited. Yes, a partnership was created between Smithson and the four defendants—White, Devrow, Ennis, and Morgan. The Uniform Partnership Act defines a partnership as an association of two or more persons to carry on as coowners of a business for profit. It is not necessary that a partnership be designated as such to be created. The court held that the preponderance of the evidence showed the existence of a joint venture among Smithson and the four defendants to develop the property on Boyd Mill Pike; that they would share in the profits equally; and that Smithson would not be required to put any money into the venture. The court entered judgment for Smithson against the four defendants for $36,800, which was one-fifth of the $184,000 profit made on the sale of the property.

Note: Morgan had previously agreed to indemnify the other three partners from any claims by Smithson; the court enforced this agreement against Morgan on a counterclaim by the other partners. Smithson v. White, 1988 W.L. 42645 (Tenn.App. 1988).

General Partnership

4.1. No, Elliot is not liable for the debt owed by Trans Texas to Cox. A partnership is defined as a voluntary association of two or more persons carrying on a business as coowners for profit. The court held that Elliot was not a partner in Trans Texas because he did not own an interest in the firm and did not voluntarily associate himself with the firm. The court held that a person cannot be made a partner in a business solely because another person states that he is such a partner. The court held that Elliot did not create a partnership. The court dismissed Cox’s lawsuit against Elliot. Cox Enterprises, Inc. v. Filip and Elliot, 538 S.W.2d 836 (Tex.App. 1976).

Tort Liability

4.2. The appellate court held that until the assets had been distributed, and the partnership finally terminated, the partners owed a fiduciary duty to each other. Fial breached this duty by distributing the assets without an accounting. The trial court had determined that there was a constructive trust created on behalf of Steeby, and that he was owed half of the profits as an equitable remedy. The appeals court upheld this decision, as well. Steeby v. Fial, 765 P.2d 1081, 1988 Colo.App. Lexis 409 (Colo. App.)

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Fiduciary Duty

4.3. Yes, the partnership, Husted and Husted, is liable to the estate for the conversion by Edgar Husted of the estate’s funds. Under the Uniform Partnership Act, a partner is jointly and severally liable for the tortious conduct of another partner committed within the ordinary course of partnership business. The court held that Edgar Husted was acting within his apparent au-thority when he took the estate’s check and misappropriated it. The partnership is liable for this tortious act, as are the partners of the partnership. The court awarded compensatory and punitive damages to the estate. Husted v. McCloud, 436 N.E.2d 341 (Ind.App. 1982).

Tort Liability

4.4. No, the law firm and the other partners are not liable for McGrath’s tortious conduct in shooting Hayes. The court noted that a master is responsible for the servant’s acts under the doctrine of respondeat superior when the servant acts within the scope of his employment and in the furtherance of the master’s business. Where a servant steps aside from the master’s business in order to affect some purpose of his own, the master is not liable. The court found no evidence to indicate, either directly or by inference that McGrath was acting in the scope of his employment when he shot Hayes. There was no evidence that McGrath transacted law firm business or engaged in any promotional activities on behalf of the law firm, and its other partners were not liable for McGrath’s tortious conduct. Hayes v. Torbenson, Thatcher, McGrath, Treadwell & Schoonmaker, 749 P.2d 178 (Wash.App. 1988).

Notice of Dissolution

4.5. Leonard Sumter Sr. is liable for the debt owed Thermal Supply by Michael. Under partnership law, if a partnership is dissolved, actual notice of the dissolution must be given to third parties who actually dealt with the partnership. The court found that Leonard and Michael had failed to notify Thermal of the dissolution of their partnership, and that Thermal did not receive notice of this fact from any other source. The court further held that the passage of one year between purchases at Thermal was not unusual in the plumbing trade because plumbers often use several sources of supplies. The court held that a creditor is not obligated to investigate or ask if a partnership is still in operation. Instead, the burden is on the partners to notify creditors with whom they have dealt that their partnership has been dissolved. The court held that Sumters’s failure to give such a notice to Thermal made Leonard liable for Michael’s debts to Thermal. Thermal Supply of Louisiana, Inc. v. Sumter, 452 So.2d 312 (La.App. 1984).

Liability of General Partners

4.6. The partnership assets are subject to the claims of the unpaid suppliers. Under limited partnership law, a partnership is bound by a general partner’s wrongful acts, and the general partners are jointly and severally liable for everything chargeable to the partnership. The court held that Somers and Robertson had charged McGowan and his company, Advance, with the responsibility of developing Vermont Place, and effectively made McGowan and Advance their agents. The partnership agreement provided that the purpose of the partnership was to acquire real estate and construct duplexes for lease or sale. In furtherance of this purpose, the partners agreed that McGowan and Advance would supervise the construction of the duplexes.

When McGowan acquired labor and materials and then failed to pay for them, he was acting within his authority as a partner and agent of the partnership and thereby bound the other two general partners. McGowan and Advance are liable for their acts. In addition, the court held that Somers and Robertson, as general partners of the limited partnership, were jointly and severally liable for the partnership debts owed to the unpaid suppliers. Because of their limited liability, none of the limited partners are liable for the debts of the partnership. National Lumber Company v. Advance Development Corporation, 732 S.W.2d 840 (Ark. 1987).

IV. Answers to Issues in Business Ethics Cases

4.7. There was a breach of duty and the court should appoint a receiver. After six years of management, the windingup partners had failed to liquidate the partnership. Although time alone would not necessarily establish mismanagement when combined with evidence that Moe Hankin, one of the windingup partners, desired to buy certain partnership property at a premium, it seems reasonable to find a breach of fiduciary duty on behalf of that partner and to appoint a receiver so as to expedite the liquidation. The trial findings and decision were upheld; the superior court decision was reversed. Hankin v. Hankin, 493 A.2d 675 (Pa. 1985).

4.8. Gilroy wins. The court held that Conway had breached his fiduciary duty that he owed to his copartner, Gilroy, by misappropriating partnership assets and failing to pay or account for income from the partnership. Partnership law provides that partners owe a fiduciary duty to one another, and provides that as such they owe each other a duty of loyalty. This duty is implied by law and cannot be waived.

The court held that Conway had breached this duty by taking for himself benefits of the partnership and failed to pay the income there from to the partnership; had misappropriated partnership accounts and assets; withdrew capital of the partnership for personal use; failed to pay capital and income due Gilroy; and took possession of, and used as his own, partnership property, including inventory, equipment, customer lists, contract rights and expectancies, and accounts.

The court characterized this case as a “classic study of greed” and found that Conway had literally destroyed the partnership by knowingly and willfully converting partnership assets in violation of his fiduciary duty. The court awarded Gilroy $53,779—his one-half interest in the partnership—plus attorney’s fees. Gilroy v. Conway, 391 N.W.2d 419 (Mich.App. 1986).

VII. Terms

action for an accounting—A formal judicial proceeding in which the court is authorized to (1) review the partnership and the partners’ transactions and (2) award each partner his or her share of the partnership assets.

certificate of partnership—A document that a partnership must file with the appropriate state government agency in some states to acknowledge that the partnership exists.

charging order—A document that the court issues against the debtor-partner’s partnership interest in order to satisfy a debt.

Dissolution—“The change in the relation of the partners caused by any partner ceasing to be associated in the carrying on of the business” [UPA § 29].

distribution of assets—Upon the windingup of a dissolved partnership, the assets of the partnership are distributed in the following order [UPA § 40(b)].

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duty of care—The obligation partners owe to use the same level of care and skill that a reasonable person in the same position would use in the same circumstances. A breach of the duty of care is negligence.

duty of loyalty—A duty that a partner owes not to act adversely to the interests of the partnership.

duty of obedience—A duty that partners must adhere to the provisions of the partnership agreement and the decisions of the partnership.

duty to inform—A duty a partner owes to inform his or her co-partners of all information he or she possesses that is relevant to the affairs of the partnership.

entity theory—A theory that holds that partnerships are separate legal entities that can hold title to personal and real property, transact business in the partnership name, sue in the partnership name, and the like.

entrepreneur—A person who forms and operates a new business either by him- or herself or with others

express partnership—General partnership created by words, either verbal or written.

general partnership—An association of two or more persons to carry on as co-owners of a business for profit [UPA § 6(1)].

implied partnership—General partnership implied from the conduct of the parties.

indemnification—Right of a partner to be reimbursed for expenditures incurred on behalf of the partnership.

joint and several liability—Partners are jointly and severally liable for tort liability of the partnership. This means that the plaintiff can sue one or more of the partners separately. If successful, the plaintiff can recover the entire amount of the judgment from any or all of the defendant-partners.

joint liability—Partners are jointly liable for contracts and debts of the partnership. This means that a plaintiff must name the partnership and all of the partners as defendants in a lawsuit.

judicial decree of dissolution—Order of the court that dissolves a partnership. An application or petition must be filed by a partner or an assignee of a partnership interest with the appropriate state court; the court will issue a judicial decree of dissolution if warranted by the circumstances.

management—Unless otherwise agreed, each partner has a right to participate in the management of the partnership and has an equal vote on partnership matters.

partner’s interest—A partner’s share of profits and surplus of the partnership.

partnership agreement—A written partnership agreement that the partners sign. Also called articles of partnership.

partnership at will—A partnership with no fixed duration.

partnership capital—Money and property contributed by partners for the permanent use of the partnership.

partnership for a term—A partnership with a fixed duration.

partnership property—Property that is originally brought into the partnership on account of the partnership and property that is subsequently acquired by purchase or otherwise on account of the partnership or with partnership funds.

sole proprietorship—A form of business where the owner is actually the business; the business is not a separate legal entity.

Uniform Partnership Act (UPA)—Model act that codifies partnership law. Most states have adopted the UPA in whole or in part.

windingup—Process of liquidating the partnership’s assets and distributing the proceeds to satisfy claims against the partnership.

wrongful dissolution—When a partner withdraws from a partnership without having the right to do so at that time.

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Chapter 5Limited Partnerships

There are a great many of us who will adhere to that ancient principle that we preferred to be governed by the power of laws, and not by the power of men.

Woodrow Wilson

I. Teacher to Teacher Dialogue

Limited liability’s first real incursion into the law of business found its way in the early partnerships in commendam of the civil law tradition of France. The English-based common law later embraced these elements on its way to the evolution of corporate law. We use these historical tie-ins to remind my students that the law of business entities is not some newly minted brain child of some whiz-kid law review editor, but rather the product of a long and sometimes tortuous evolutionary process. This process is premised on a trial and error learning curve that goes back many centuries and crosses many cultures. Limited partnerships remain, in many ways, the best of both worlds. They can provide the flexibility of partnership while affording limited liability exposure to investors. But as with all deals that seem too good to be true, there is no free lunch. The rules of the legal road must be strictly complied with and failure to do so leads to severe consequences.

Compare the first three issues in partnership (creation, operation, and dissolution) with the rules of limited partnership. The law of limited partnership enjoys a rather unique niche in our system of jurisprudence in that its origins are French rather than English. Under the original partnerships in commendam as used in France, a partner could enter into a contract with another person or partnership. Under that contract, the partner would be supplied with a certain amount of goods or services in exchange for a share of the profits of the partnership. If there were a loss, the investor would be liable for no more than his investment.

Investment is the key to the original notion of limited partnership. The idea was to create a middle ground between pure partnership and an entity with a totally autonomous existence. In the Middle Ages when limited partnerships were first used, the corporate form of business was simply not in existence, as we know it today. In many ways, history shows us that limited partnerships were the precursors of more modern methods of capital fund raising used in corporation law.

Today’s modern laws of limited partnerships are found in two key statutes: the original 1916 Uniform Limited Partnership Act and its heir apparent, the Revised Uniform Limited Partnership Act first promulgated in 1976. Even though there are substantial differences between the two versions, they remain the same with regard to several key provisions:

1. Both call for statutory creation (as opposed to just contract creation) of limited partnerships, including the use of a certificate of limited partnership.

2. Both call for two key classes of partners to be in place: at least one general partner with unlimited traditional partner’s liability and a class of limited partners who normally can be held liable only to the extent of their capital contribution.

3. Both statutes generally limit the amount of activity a limited partner may engage in regarding the business as a price of having limited liability protections.

4. Both use the general partnership principles of the Uniform Partnership Act as a fallback position if their respective statutory requirements are not complied with.

In both scenarios, the basic intent of the statutory scheme is the same as was found in the early French versions of partnerships in commendam. That intent was to raise capital investment contributions while providing the investors some assurance of immunity from claims. In spite of many more regulatory compliance rules, it is still easier to float a limited partnership than to go public into the corporate world. In addition, limited partnerships generally provide more opportunities for a small investor (remember these are relative terms) to acquire higher percentages of equity growth than in stocks.

One other undeniably important factor in this equation has been the Internal Revenue Code. Up until 1986, the tax code strongly favored the use of limited partnerships as a means to tax shelter income through what came to be known as PILs (passive investment losses). With the advent of the Tax Reform Act of 1986 and its attendant passive income rule requirements, the most sought after tax shelters are now called PIGs (passive income gainers) because they are needed to offset losses. In spite of the complex rules, most commentators feel that the reforms were needed. Economic reality, not tax supported fictional losses, should be the underlying motive of any good investment, be it partnership, corporate, or any other form of business.

There are three basic sets of issues of the law of limited partnerships: formation, the rights and duties of partners vis-à-vis each other, and rights and duties of partners relative to third parties.

II. Chapter Objectives

Define a limited partnership.

Describe the process for forming a limited partnership.

Distinguish between limited and general partners.

Identify and describe the liability of general and limited partners.

Describe the process of dissolution and winding-up of a limited partnership.

III. Key Question Checklist

Was the limited partnership properly formed?

What are the rights and duties of the partners?

Do third parties have priority rights as creditors?

IV. Text Materials

Section 1: Limited Partnership

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Limited or special partnerships have two types of partners, general and limited. The general partners invest capital, manage the business, and have unlimited personal liability for all partnership debts, while limited partners invest capital but have no management participation, and are liable only to the extent of their capital contribution. A limited partnership must have at least one general partner and one limited partner, which may be the same person.

Natural persons, limited partnerships, trusts, estates, partnerships, associations, and corporations may be general or limited partners.

The Revised Uniform Limited Partnership Act – This created a uniform set of laws covering the formation, operation, and dissolution of limited partnerships.

Section 2: Formation of a Limited Partnership

Certificate of Limited Partnership – Two or more persons must execute the certificate of limited partnership which should include the name, general character of the business, address of the principal place of business, latest date for dissolution, and the identity and contact information for the agent. The name and address of each partner, as well as their capital contribution must be included.

The certificate is filed with the secretary of state for the appropriate state.

Amendments to the Certificate of Limited Partnership – Amendments designed to keep the certificate current must be filed within 30 days of the occurrence of any changes.

Name of the Limited Partnership – The name may not include the surname of a limited partner unless it is also the name of a general partner or if the name was used before the admission of the limited partner. It must also contain the words “limited partnership.”

Capital Contributions – Capital contributions may include cash, property, services, or a promissory note. All capital contributions from both general and limited partners are at risk.

Defective Formation – Defects in the filing of or actual certificate may be corrected through filing an amendment or by withdrawing from participation and filing a certificate of withdrawal.

A limited partner who is mistakenly identified as a general partner remains liable for all transactions incurred until the amendment or the withdrawal is filed.

Limited Partnership Agreement – The limited partnership agreement or articles of limited partnership establishes the rights and duties of the partners, as well as the terms for operation and dissolution. It should also establish the voting rights of the partners.

Share of Profits and Losses – Absent a stated allocation in the limited partnership agreement, profits and losses are allocated based on the percentage of capital contribution.

Rights to Information – Every limited partner has the right to obtain full information on the financial affairs of the limited partnership.

Admission of New Partners – New limited partners can only be added by the unanimous written consent of all partners, unless the agreement states otherwise.

Foreign Limited Partnership – A limited partnership is considered to be domestic in the state in which it is organized and foreign in all other states. Foreign limited partnerships must file a certificate of registration in these other states.

Section 3: Liability of General and Limited Partners

General partners have unlimited personal liability for all debts and obligations of the limited partnership, while limited partners are only liable up to the amount of their capital contribution.

Participation in Management – The general partners have the right to manage the limited partnerships, while the limited partners have given up their rights.

Permissible Activities of Limited Partners – Limited partners may be an agent, employee, or contractor of either the limited partnership or of a general partner, as well as an advisor or consultant. They may act as a surety, and vote on a number of partnership matters including the dissolution and windingup, the sale or transfer of substantially all of the assets, the incurrence of indebtedness, and the removal of a general partner.

Liability of Personal Guarantee – If a limited partner serves as a surety for a loan to the limited partnership, he will be held personally liable for that loan, beyond the limits of his capital contribution.

Section 4: Limited Liability Partnership (LLP)

LLPs do not have general partners who are personally liable for all debts and obligations. Instead, all partners have limited liability. LLPs are taxed as partnerships.

Articles of Partnership – LLPs are formal creatures of statute, and require the filing of articles of partnership with the secretary of state. The LLP is considered domestic in the state in which it makes the filing, and foreign in any other state that it wants to conduct business.

Liability Insurance Required – Most states require LLPs to carry high values of liability insurance to cover negligence and misconduct in exchange for the limited liability.

Section 5: Dissolution of a Limited Partnership

Causes of Dissolution – A limited partnership can be dissolved by reaching the end of its defined life, the written consent of all members, the withdrawal of a general partner, and by entry of a degree of judicial dissolution, which occurs when a general partner shows a court that it is not reasonably practical to carry on the business in conformity of the limited partnership agreement.

WindingUp – Upon dissolution, any partner may petition the court to wind up the affairs of a limited partnership.

Distribution of Assets – The proceeds of assets are distributed first to creditors, including partners who are creditors. The remaining funds are then distributed to partners with respect first to unpaid dividends, capital contributions, and, finally, the remainder of the proceeds is distributed.

V. Answers to Business Law Cases

Liability of General Partners

5.1. The partnership assets are subject to the claims of the unpaid suppliers. Under limited partnership law, a partnership is bound by a general partner’s wrongful acts, and the general partners are jointly and severally liable for everything chargeable to the partnership. The court held that Somers and Robertson had charged McGowan and his company, Advance, with the responsibility of developing Vermont Place, and effectively made McGowan and Advance their

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agents. The partnership agreement provided that the purpose of the partnership was to acquire real estate and construct duplexes for lease or sale. In furtherance of this purpose, the partners agreed that McGowan and Advance would supervise the construction of the duplexes.

When McGowan acquired labor and materials and then failed to pay for them, he was acting within his authority as a partner and agent of the partnership and thereby bound the other two general partners. McGowan and Advance are liable for their acts. In addition, the court held that Somers and Robertson, as general partners of the limited partnership, were jointly and severally liable for the partnership debts owed to the unpaid suppliers. Because of their limited liability, none of the limited partners are liable for the debts of the partnership. National Lumber Company v. Advance Development Corporation, 732 S.W.2d 840 (Ark. 1987).

Liability of Limited Partners

5.2. No, the limited partners of USANL are not individually liable for the alleged breach of contract by the limited partnership. Partnership law stipulates that only general partners are individually liable for the debts of a limited partnership. Limited partners are not individually liable unless they take part in the management of the partnership or personally guarantee the performance of the partnership. The court held that in this case the limited partners did not take part in the management or control of the limited partnership, nor had they personally guaranteed the performance of the lease with the NRPA. Only the limited partnership and its general partners may be held liable to the NRPA. Note, however, that the limited partners may lose their capital contribution that they have made to the limited partnership. National Railroad Passenger Association v. Union Station Associates of New London, 643 F.Supp. 192 (D.D.C. 1986).

Liability of Partners

5.3. No, the recently added limited partners are not individually liable for the debts of the limited partnership that were allegedly owed to Sloate and Bear Stearns. Generally, partnership law provides that if there is a substantial defect in the formation of a limited partnership, the partnership is a general partnership and the purported limited partners are individually liable as general partners. However, there is an exception to this rule. This exception provides that if a person who has contributed capital to a business conducted by a partnership erroneously believing that he has become a limited partner in a limited partnership, he is not bound by the obligations of the partnership if, upon ascertaining the mistake, he promptly renounces his interest in the profits of the business.

Although Brookwood was defectively formed as a limited partnership because it had failed to amend its certificate of limited partnership to reflect the addition of the new limited partners, the court held that these partners were not individually liable because (1) they erroneously believed that they were limited partners in a limited partnership and (2) upon receipt of the arbitration notice from Sloate and Bear Stearns they immediately renounced their interest in the profits of the Brookwood. Therefore, the court held that the newly added partners were not individually liable on the debts allegedly owed by Brookwood to Sloate and Bear Stearns. 8 Brookwood Fund v. Bear Stearns & Co., Inc., 539 N.Y.S.2d 411 (N.Y.A.D.2d Dept. 1989).

Liability of Partners

5.4. Molander can only recover against the assets of the limited partnership and its corporate general and limited partners. He cannot recover against Calvin Raugust personally. Under limited partnership law, a limited partnership is liable on its own contracts; in addition, the

general partner is individually liable for the debts and obligations of a limited partnership. Limited partners may be held liable for the obligations of the limited partnership if the limited partnership has been defectively formed. Otherwise, limited partners’ liability is limited to their capital contribution to the limited partnership.

The court held that the limited partnership had been defectively formed because the parties had not even executed the limited partnership agreement and a certificate of limited partnership had not been filed with the state as required by law. Thus, because of this defect the limited partners also became liable on Molander’s contract. Thus, Molander can recover against the assets of the partnership, the assets of the corporate general partner, and the assets of the corporate limited partners. However, because all of these entities are corporations, Molander can only recover against the shareholders of these entities. That is, Molander cannot recover against Calvin Raugust, the shareholder of the corporate general partner, individually. If the assets of these defendant corporate entities are insufficient to pay Molander’s claim, he cannot recover against Raugust’s personal assets. In reaching this conclusion, the court stated:

Few people are aware of the organizational intricacies of businesses with which they are dealing and unless there is an agreement to be personally liable, absent fraud or a similar basis, personal liability cannot be imposed just because a person seeks a corporate entity. A professional architect doing business in a complex financial world cannot escape the legal consequences of failure to protect himself by professing ignorances as to corporate and partnership liability. Subjective expectations or postdisaster wishful thinking is not a substitute for legal advice and appropriate contract language.

The Court of Appeals overturned the trial court’s $447,011 judgment against Calvin Raugust. Note: If Molander wanted to make Calvin Raugust personally liable for the architectural services, he should have required Raugust to sign a personal guarantee of the performance of the contract. Molander v. Raugust-Mathwig, Inc., 722 P.2d 103 (Wash.App. 1986).

Limited Partnership

5.5. Yes, the limited partnership may recover on the fire insurance policy, but any partner proven to have participated in or authorized the arson cannot recover their proportionate share of the insurance proceeds. The court addressed the extent to which the “arson defense” applies in this case. The court held that the wrongful act of one partner, even though the general partner, is not to be attributed to the other partners unless those acts are in the ordinary course of partnership business or are undertaken with the express or implied authority of the other partners.

The court found that Reich’s alleged acts were not part of the partnership’s business or done with the authority of the other partners. The court held that the innocent limited partners cannot be barred from recovering their proportionate share of the partnership’s $1.7 million-plus claim against Charter Oak. If Charter Oak can demonstrate that any of the limited partners expressly or impliedly authorized Reich’s alleged conduct, however, such partners may be barred from recovery as well. Reich will, of course, be barred from any recovery if Charter Oak can demonstrate by a preponderance of the evidence that he set the fire or procured its setting. Courts of the Phoenix v. Charter Oak Fire Insurance Company, 560 F.Supp. 858 (N.D.Ill. 1983).

Removal of a General Partner

5.6. Yes, the Aztec Petroleum Corporation (Aztec) may be removed as the general partner of the limited partnership. It is true, as Aztec alleges, that the Limited Partnership Act provides that a

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general partner may not be removed except by the unanimous vote of all of the partners. However, the act also provides that where the limited partnership agreement sets forth the rights and duties of the partners, the agreement, rather than the act, controls.

The court held that the partnership agreement permitted 70 percent of the limited partnership units to amend the agreement, which they did, to provide that 70 percent of these units could remove the general partner and replace it with a substitute general partner, again which they did. The court held that the provisions of the limited partnership agreement controlled in this case, and that Aztec had been properly removed as the general partner and replaced by the MHM Company. Aztec Petroleum Corporation v. MHM Company, 703 S.W.2d 290 (Tex.App. 1986).

Limited Partner’s Interest

5.7. Yes, Chrysler Credit may obtain a charging order against Peterson’s four limited partnership units in Cedar Riverside Properties. The court held that it is a proper remedy for a judgment creditor to obtain a charging order against the debtor’s interests in limited partnerships. The charging order entitles the judgment creditor to receive the profits and other distributions due on the partnership interests. The court issued a charging order in favor of Chrysler Credit against Peterson’s limited partnership units in Cedar Riverside Properties.

Note: In this case, Peterson had transferred his interests in the four limited partnership units to his wife and attorney after he was notified of Chrysler Credit’s petition for a charging order but before the court’s hearing on the matter. Chrysler Credit asserted that these transfers could be avoided under Minnesota’s fraudulent transfer act. The court issued the charging order to Chrysler Credit, stating that the charging order attached to whatever limited partnership interests Peterson is later determined to have in Cedar Riverside Properties. Chrysler Credit Corporation v. Peterson, 342 N.W.2d 170 (Minn.App. 1984).

VI. Answers to Issues in Business Ethics Cases

5.8. Yes, the limited partners of Cosmopolitan are individually liable on the contract between the partnership and Dwinell’s Central Neon. Partnership law provides that if a limited partnership “substantially complies” with the legal requirements for organizing a limited partnership, the limited partners are not individually liable for the debts of the partnership, and are only liable up to the extent of their capital contribution to the limited partnership. However, if substantial compliance is not met, the partnership is a general partnership, and the purported limited partners are individually liable as general partners.

The court held that Cosmopolitan had not substantially complied with the legal requirements for the organization of a limited partnership at the time it had entered into the contract with Dwinell’s. This was because the certificate of limited partnership had not been filed with the state until several months after the contract was signed. Obviously, the purpose of the filing requirement is to acquaint third persons, such as Dwinell’s, of the existence of the limited partnership and the limited liability of the limited partners. In this case, no filing was made at the time Dwinell’s entered into the contract, so it had no way of apprising itself of the asserted limited liability. Further, the contract only identified Cosmopolitan as a “partnership,” not as a limited partnership. The court held that there was a defective formation of Cosmopolitan as a limited partnership, and that it was a general partnership at the time the contract was signed with Dwinell’s. Therefore, the court held the purported limited partners individually liable as general partners on the debt due Dwinell’s. Dwinell’s Central Neon v. Cosmopolitan Chinook Hotel, 587 P.2d 191 (Wash.App. 1978).

5.9. Cox violated the law and ethical principles when he used the assets of the limited partnership to further his own interests. The court appointed a receiver to ensure no further illegal or unethical behavior. The court dissolved the partnership because Cox acted only for himself, not the other partners, and he paid for various inappropriate expenses out of partnership funds. Cox v. F&S, 489 So.2f 516 (AL 1986).

VII. Terms

certificate of amendment—A document that keeps the certificate of limited partnership current.

certificate of limited partnership—A document that two or more persons must execute and sign that makes the limited partnership legal and binding.

certificate of registration—A document permitting a foreign limited partnership to transact business in a foreign state.

decree of judicial dissolution—A decree of dissolution that is granted to a partner whenever it is not reasonably practical to carry on the business in conformity with the limited partnership agreement.

defective formation—Occurs when (1) a certificate of limited partnership is not properly filed, (2) there are defects in a certificate that is filed, or (3) some other statutory requirement for the creation of a limited partnership is not met.

domestic limited partnership—A limited partnership in the state in which it was formed.

foreign limited partnership—A limited partnership in all other states than the one in which it was formed.

limited liability partnership (LLP)—A special form of partnership where all partners are limited partners and there are no general partners.

limited partnership agreement—A document that sets forth the rights and duties of the general and limited partners; the terms and conditions regarding the operation, termination, and dissolution of the partnership; and so on.

limited partnership—A type of partnership that has two types of partners: (1) general partners and (2) limited partners.

revised uniform limited partnership act (RULPA)—A 1976 revision of the ULPA that provides a more modern comprehensive law for the formation, operation, and dissolution of limited partnerships.

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Chapter 6Limited Liability Companies

Justice is the end of government. It is the end of civil society. It ever has been, and ever will be pursued, until it be obtained, or until liberty be lost in the pursuit.

James Madison

I. Teacher to Teacher Dialogue

The advent of limited liability companies in our system of jurisprudence reflects a synthesis of both something new and something old. As illustrated by the international materials in this book, various forms of limited liability companies have been used in other parts of the world for many years. For example, Germany is considered to be the latest country to add this form of doing business, and its enabling statute is “only” a century old.

What is it, then, that kept U.S. jurisprudence from adopting this form of business for so many years? In a word: taxes. More specifically, the specter of double taxation on corporations held back the dam on the implementation of limited liability companies. Traditional interpretations of state laws allowing for limited liability focused on corporate laws. As such, the possibility for legitimate tax structure avoidance was severely limited to the rules and regulations covering “Sub-S” corporations. Subchapter S was first added to the Internal Revenue Code in 1958 and has undergone numerous revisions and updates since. The essence of these provisions has been to allow a corporation to avoid double taxation only under very limited constraints outlined in Internal Revenue Code § 1361, et al.

With increasing pressures to attract more overseas capital and investment into the United States, a number of states decided to create new forms of business entities. They would not only be familiar to overseas investors who were already comfortable with the limited liability company, but also gain the Internal Revenue Service imprimatur for being taxed like a partnership and still provide limited liability to all participants in the entity. Wyoming was the first to venture forth in heralding the modern era of LLC laws in the U.S.

In 1977, Wyoming passed its LLC law, and in 1978, the IRS issued its Revenue Ruling (Rev.Rul.88-76, 1988-2 C.B.360), which accorded partnership tax treatment to the Wyoming LLC This was the first of many rulings on similar statutes adopted by virtually all states. The IRS subsequently adopted the “check-the-box” listed in this chapter, and the rest is history.

Because of all the possible permutations that have evolved since this opening foray into limited liability company laws, the demand for a uniform statute was not unexpected. This chapter focuses on the main element of the Uniform Limited Liability Company Act as promulgated by the National Conference of Commissioners on Uniform State Laws. This act, in effect, seeks to “marry” the best elements of agency, partnership, and corporate law into a format that allows for uniformity and predictability on these issues throughout the U.S. As with any major turn in the process of legal evolution, we are witnessing a work in progress. The final product is far from complete, but it surely has come a long way in a generation.

As we have seen in earlier chapters, business entity choices are strategic decisions based on a number of factors. These elements include choosing the best options for potential capital investment and financing growth, protection from personal liability, and tax planning. No one entity format is ideal for all objectives. However, recent trends have led to the use of the limited liability company format as the best vehicle for providing the “best of both worlds—the single-layered conduit taxation of proprietorships, and partnerships with the limited personal liability accorded to shareholders of a corporation.”

The actual advent of limited liability companies does not start with U.S. legal history. Many countries have allowed for the formation of limited liability companies for many years. For example, many countries in Latin America provide for entities called “limitadas.” Similar developments have taken place in England and Western Europe, with examples such as the English “stock company” format tracing its history back to 1555. Traditionally, the limited liability company format was not used in the U.S. until the late 1970s.

II. Course Objectives

Define limited liability company (LLC).

Describe the process of organizing an LLC.

Explain the differences between an S corporation and an LLC.

Describe the limited liability shield provided by an LLC.

Describe how an LLC can be taxed as a partnership.

Define foreign limited liability company.

Describe the contents of an LLC’s operating agreement.

Compare a member-managed LLC to a manager-managed LLC.

Determine when members and managers owe fiduciary duties of loyalty and care to the LLC.

Explain the equivalent forms of business to the LLC that are used in foreign countries.

III. Key Question Checklist

Was the limited liability company properly formed?

How is a limited liability company organized?

How is a limited liability company operated?

What are the fiduciary duties of loyalty and care owed to an LLC?

How is an LLC dissolved and wound up?

IV. Text Materials

An LLC is an unincorporated business entity that combines the more favorable aspects of partnerships and corporations.

Most states now permit professionals to operate as LLPs, with limited liability.

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Section 1: Limited Liability Company (LLC)

LLCs are creatures of statute, and are allowed to operate as separate legal entities from their members.

The Uniform Limited Liability Company Act – ULLCA was created to provide a uniform code for LLCs.

Taxation of LLCs – The IRS has held that LLCs will be taxed as partnerships, unless they elect to be taxed as a corporation.

Powers of an LLC – An LLC is treated as a person in order to be able to carry out its business affairs.

Section 2: Member’s Limited Liability

The owners of an LLC are called members and have personal liability limited to their capital contribution.

Case 39.1: Page v. Roscoe, LLC.

Facts: Dale C. Bone was a member of Roscoe, LLC, a limited liability company organized in North Carolina. Roscoe purchased two acres of land near Apex, NC, to construct and operate a propane gas bulk storage and distributing facility. That use was permitted under Apex’s zoning regulations. Local residents sued Roscoe, claiming the facility would be a nuisance. The residents lost, and dropped the lawsuit. Bone sued to recover the attorney’s fees he spent to defend the lawsuit.

Issue: Were the sanctions warranted against the plaintiffs for naming an individual member of a limited liability company in the lawsuit they brought against the LLC?

Decision: No.

Reason: Bone, as a member of the LLC, was not liable as a matter of law for the acts of the LLC and was therefore improperly named as a defendant in the lawsuit.

Liability of an LLC – The LLC is liable for losses and injuries caused by its members, managers, employees, or agents.

Liability of Managers – The managers of an LLC have no personal liability for the LLC that they manage.

Case 39.2: Creative Resource Management, Inc. v. Soskin

Facts: Nashville Pro Hockey LLC was a limited liability company in Tennessee that owned and operated the Nashville Nighthawks. Nashville Pro Hockey contracted with Creative Resource Management to provide employee leasing services to Nashville Pro Hockey. The contract was signed by Barry Soskin, president. Nashville Pro Hockey failed, owing CRM about $30,000. CRM sued Nashville Pro Hockey and Barry Soskin. Soskin defended, alleging that his signature on the contract was in his representative capacity only and not in his individual capacity as a guarantor. The trial court agreed.

Issue: Did Soskin’s signature on the contract constitute a personal guarantee for the payment of the debt of Nashville Pro Hockey, LLC, to CRM?

Decision: Yes.

Reason: Soskin was a guarantor and was liable to repay the money owed to CRM by Nashville Pro Hockey, LLC.

Liability of the Tortfeasors – Persons who intentionally or negligently cause injury or worse are still responsible for their actions, even if a member, manager, employee, or agent of an LLC.

Section 3: Formation of an LLC

An LLC is organized in one state, but may operate in any number of them. They are designated by either the words “limited liability company,” “limited company,” or the abbreviations LLC, L.L.C., LC, or L.C.

Articles of Organization – The articles of organization contain the name and address of the LLC, the initial agent for service, and of each organizer. It should also state whether it is for a specified term of existence. Finally, it should include whether it is member-managed or manager-managed, and the liability of any member for the debts and liabilities of the LLC. The articles are filed with the secretary of state.

Duration – An LLC is considered to be at-will unless there is a designated term.

Capital Contributions – Members’ capital contribution can be in any form, including money, services, contracts, and both tangible and intangible property. Inability and incapacity do not excuse a member’s obligation to contribute capital.

Certificate of Interest – These certificates act the same as a stock certificate for an LLC.

Operating Agreement – These agreements regulate the company affairs and its conduct.

Conversion of an Existing Business to an LLC – In order for an existing business to take advantage of the tax benefits of an LLC, it must create an agreement of conversion that is approved by all parties and file an article of organization with the secretary of state.

Dividing an LLCs Profits and Losses – Unless otherwise agreed to, all members share equally in both the profits and losses.

Distributional Interest – This is a member’s ownership interest in an LLC. It is personal property and is freely transferable. The transfer entitles the transferee to receive distributions from the LLC, but not membership, unless the operating agreement provides for this, or the other members unanimously agree.

Section 4: Management of an LLC

LLCs are either member-managed or manager-managed. Managers may be members or nonmembers.

Member-Managed LLC – In a member-managed LLC, each member has equal management rights.

Manager-Managed LLC – In manager-managed LLCs, each manager has equal management rights, but members that are not designated as managers have no management rights. Nonmembers may be managers.

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Compensation and Reimbursement – Nonmanager members of an LLC are not entitled to remuneration for services, but managers are paid compensation.

Agency Authority to Bind an LLC to Contracts – In member-managed LLCs, all members have the authority to bind the LLC. In a manager-managed LLC, only managers can bind the LLC.

Duty of Loyalty Owed to an LLC – Members of member-managed LLCs and managers in manager-managed LLCs owe the fiduciary duty of loyalty to the LLC.

Limited Duty of Care Owed to an LLC – Members of member-managed LLCs and managers in manager-managed LLCs owe the fiduciary duty of care to the LLC not to engage in known violations of the law, intentional conduct, reckless conduct, or grossly negligent conduct. This does not include ordinary negligence.

No Fiduciary Duty Owed by a Nonmanager Member – Members that are not managers in manager-managed LLCs owe no duty of loyalty or care to the LLC.

Section 5: Dissolution of an LLC

Members have the power to withdraw from both at-will and term LLCs unless otherwise permitted by the operating agreement. Disassociation of a member from a term LLC before the end of the term is wrongful. Any member that wrongfully disassociates is liable for damages caused by his action. The disassociation terminates the member‘s right to participate in management or to conduct LLC business, and terminates the member’s duties of loyalty and care.

Payment of Distributional Interest – If a member terminates without causing a wrongful disassociation, the LLC must purchase the member’s distributional interest. If there is a wrongful disassociation of a term LLC, the LLC does not need to pay the distributional interest until the end of the term, and may offset any damages against the payment.

Notice of Disassociation – A disassociated member can continue to bind the LLC for two years under the doctrine of apparent authority, unless the third party knows of or was given notice of the disassociation. The LLC can give constructive notice by filing a statement of disassociation with the secretary of state.

Continuation of an LLC – Members of an LLC can unanimously vote prior to the expiration date for an additional term and file an amendment with the secretary of state or can continue as an at-will LLC by a simple majority vote.

WindingUp the LLC’s Business – The assets of the LLC are to be distributed first to the creditors, then any remaining funds are distributed to the members in equal shares.

An article of termination is filed with the secretary of state after the assets are distributed.

V. Answers to Critical Thinking Cases

In this section, Professor Cheeseman has developed 12 critical thinking case scenarios.   Unlike the typical critical thinking cases in other chapters, these cases are all fictional.  They cover various issues dealing with limited liability companies.   All would make great teaching tools for this chapter. 

Many of these fictional cases are based on real cases.  The following points may be raised by students in discussing these cases.

Liability of Members

 6.1. This is a question of the liability of an LLC for its agents.  Since Francie was within the ordinary course of business when she went to the Comdex show, her negligent act of running over Harold would make the LLC liable for damages for his injuries.  However, the individual members would not be held liable, and have limited exposure up to the amount of their capital contributions to the LLC. Francie  would remain liable under the tort theory of negligence.

 

Liability of Members

 6.2. Again, this is a liability question.  Although Mellon Bank can recover from the LLC, the members would be protected, unless Mellon can prove their gross negligence by failing to hold the members’ meetings, keep books, etc.  Managers in a manager-managed and members in a member-managed LLC owe a fiduciary duty of care, but we are not told if they are either of these.  If they are not, then they have only a limited duty of care, and would not be personally liable. 

 

Personal Guarantee

 6.3. In this situation, the LLC will be primarily liable, followed by Darla to the limit of the $100 million guarantee.  Amy, Kelly and Molly have no additional liability beyond that of their capital investment.

 

Member-Managed LLC

 6.4. In this case, the LLC is liable to Tilly for her damages.  If the court determines that John was grossly negligent, then he will be liable for the monetary recovery granted Tilly, and must reimburse Big Apple.  However, if the court determines that he was guilty of only ordinarary negligence, then he does not owe a reimbursement to the LLC.

 

Manager-Managed LLC

 6.5.  Managers in a manager-managed LLC have the authority to bind the LLC, but members do not, absent being granted this authority in the articles or bylaws.  Amanda’s lease on Rodeo Drive will be binding, Grace’s is not.

 

Division of Profits

 6.6.  Since there is no agreement controlling the distribution of profits and losses, under the ULLCA, they will be divided evenly among the members, regardless of the amount of the capital contribution.

 

Distributional Interest

 6.7.  The distributional interest that a member has in an LLC may be freely transferred, but this does not entitle the transferee to any membership rights.  It merely means that they will receive only the distributions that the member would have been entitled to, when it is distributed.  He/she does not become a member and cannot vote.  River Bank may receive the monies when

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distributed for Emma’s share of Blue Note, but does not receive any membership rights, which are retained by Emma.

 

Duty of Loyalty

 6.8. Members who are managers in a manager-managed LLC owe a duty of loyalty to the LLC to act honestly with the LLC, not to secretly compete with the LLC, not to usurp the LLC's opportunities, not to make secret profits, and not to represent any interests adverse to those of the LLC.  Ally has violated the duty of loyalty, and the LLC may recover lost profits and damages from her.

 

Duty of Care

 Jack is not liable to the LLC for ordinary negligence.  If the court had found that he had been grossly negligent, the LLC could have recovered.

VI. Answers to Business Ethics Cases

In this section, Professor Cheeseman has developed two ethics case scenarios.   Unlike the typical ethics cases in other chapters, these cases are both fictional.  They cover various issues involving limited liability companies.  They are great teaching tools for this chapter. 

Many of these fictional cases are based on real cases.

Business Ethics

 6.10. Whether the four had formed an LLC or a corporation, they would be able to limit their personal liability to that of their capital contribution.  Provided that there is no gross negligence involved in the design, production, or distribution of the toys, they are able to limit their liability to the amount of their capital contributions that are in the assets of Fuzzy.  There is nothing unethical in this. 

Turning to the insurance question, Allied will be liable to the full amount of the policy.  Most states require a minimum amount of product liability insurance for LLCs.  Provided they are at or above the statutory amount, there will be no aditional liability for having only $800,000 worth of insurance.  If they have less than the required amount, the members will probably be found to be grossly negligence and will then be personally liable, jointly and severally, for the remaining $1 million after the Allied's $800,000 and Fuzzy's $200,000 in assets.

 

Business Ethics.

 6.11.  Members in a member-managed LLC owe a duty of loyalty to the LLC.  Maggie will be liable for the damages of $100 million and will additionally be forced to disgorge her secret profit of $100 million as well.  She acted unethically by violating her duty of loyalty.

VII. Terms

agreement of conversion—Document that states the terms for converting an existing business to an LLC.

articles of organization—The formal documents that must be filed at the secretary of state’s office of the state of organization of an LLC to form the LLC.

articles of termination—Document that is filed with the secretary of state that terminates the LLC as of the date of filing or upon a later effective date specified in the document.

at-will LLC—An LLC that has no specified term of duration.

certificate of interest—Document that evidences a member’s ownership interest in an LLC.

derivative action—A lawsuit that a member may bring against an offending third party on behalf of his or her LLC when the LLC fails to bring the lawsuit or a request of the LLC to do so is excused.

direct lawsuit—A lawsuit that a member can bring against an LLC to enforce his or her personal rights as a member.

distributional interest—A member’s ownership interest in an LLC that entitles the member to receive distributions of money and property from the LLC.

duty of care—A duty owned by a member of a member-managed LLC and a manager of a manager-managed LLC to not engage in (1) a known violation of law, (2) intentional conduct, (3) reckless conduct, or (4) grossly negligent conduct that injures the LLC.

duty of loyalty—A duty owned by a member of a member-managed LLC and a manager of a manager-managed LLC to be honest in his or her dealings with the LLC and to not act adversely to the interests of the LLC.

legal entity—An LLC is a separate legal entity – an artificial person – that can own property, sue and be sued, enter into and enforce contracts, and such.

limited liability company (LLC)—An unincorporated business entity that combines the most favorable attributes of general partnerships, limited partnerships, and corporations.

limited liability company codes—State statutes that regulate the formation, operation, and dissolution of LLCs.

limited liability—Members are liable for the LLC’s debts, obligations, and liabilities only to the extent of their capital contributions.

manager-managed LLC—An LLC that has designated in its articles of organization that it is a manager-managed LLC.

member—An owner of an LLC.

member-managed LLC—An LLC that has not designated that it is a manager-managed LLC in its articles of organization.

operating agreement—An agreement entered into among members that governs the affairs and business of the LLC and the relations among members, managers, and the LLC.

statement of disassociation—A document filed with the secretary of state that gives constructive notice that a member has disassociated from an LLC.

term LLC—An LLC that has a specified term of duration.

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Uniform Limited Liability Company Act (ULLCA)—A model act that provides comprehensive and uniform laws for the formation, operation, and dissolution of LLCs.

windingup—The process of preserving and selling the assets of the LLC and distributing the money and property to creditors and members.

wrongful disassociation—Occurs when a member withdraws from (1) a term LLC prior to the expiration of the term or (2) an at-will LLC when the operating agreement eliminates a member’s power to withdraw.

Chapter 7Corporate Formation and Financing

A corporation is an artificial being, invisible, intangible, and existing only in the contemplation of law. Being the mere creature of the law, it possesses only those properties which the charter of its creation confers upon it, either expressly or as incidental to its very existence. These are such as supposed best calculated to effect the object for which it was created. Among the most important are immortality, and, if the expression may be allowed, individuality; properties by which a perpetual succession of many persons are considered the same, and may act as a single individual.

John Marshall, Chief Justice, U.S. Supreme Court

I. Teacher to Teacher Dialogue

We like to use the opening materials on corporations to meet two main objectives: one philosophical, one more down to earth. At the more practical level, we go through the mechanics of formation, financing, and operation of the corporate business format. Obviously these matters alone can and do take up most of the class time allowed. Yet, we always try to spend some time on the more provocative aspects of the corporate form of doing business. Why do we allow the creation of such important economic, political, and cultural entities while granting them the “privilege” of limited liability, perpetual existence, and the like? Are the trade-offs worth it when it comes to environmental callousness and the corporate scandals of recent years? Invariably, these questions create some wonderful group discussions and are a worthwhile diversion from the usual elicitation of the rules of the corporate road.

Corporations can provide many advantages for business including perpetual existence, limited liability, and numerous tax and other legal opportunities to massage the system. These advantages are not free, nor are they always easily obtained. Corporate law has always been more technically intricate and demanding of legal practitioners. It can also be more unforgiving to its users than sole proprietorships or partnerships if mistakes are made in its formation and financing. The stakes are simply greater because over eighty-five percent of business done in the U.S. uses the corporate format. This chapter illustrates how the corporate form is established legally and how it is infused with its financial lifeblood, i.e., money. In addition, the process of establishing the basic ground rules for the key players will be examined.

The formation of a corporation starts with a contracting process initiated by a person called a promoter. The word promoter has an unsavory connotation to many people. In the modern vernacular, many people think of a promoter as a person seeking to get rich by doubtful means or chicanery rather than legitimate work. Borderline sporting cum entertainment events have not done much to lessen this impression. In point of fact, the law of corporations has a much different expectation of the role of promoter.

A promoter of a new corporation is really the catalyst that brings together the diverse elements of law, finance, entrepreneurial talent, and technical competence that will eventually

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drive the fortunes of the new business entity. The role of promoter is also tied to the laws of contract, fiduciaries, and agency. He or she is expected to act for the benefit of the eventual corporation and can be expected to be personally liable for contracts entered into on its behalf in the interim.

The promoter’s main duties are bifurcated towards two main audiences—the state and potential investors. He or she will be involved in contracts with both of these constituencies. With regard to the state, the actual creation of the new corporate entity is the outgrowth of a document called the charter. This document is the foundation contract between the promoter and the state. The charter takes the form of a certificate of incorporation. This certificate provides the official state-sanctioned ground rules under which the new corporate entity will be allowed to do business. Violation of these ground rules can lead to an eventual corporate death penalty, the revocation of the charter. The second critical task of the promoter is to find legal methods for the start up of the corporation so that it may be infused with the financial lifeblood of money. The corporate form is unparalleled in its ability to be a fundraiser. These funds are generated by two basic methods—debt and equity financing.

Once the proper procedures for the establishment of the corporation have been complied with and adequate financing has been secured, the next step is to see what the basic ground rules will be for key players in this arena. The leading players will be the board of directors, shareholders, and officers of the corporation. The distinctions among these roles are sometimes blurred when it comes to the formation and management of corporations, yet each has its own agenda that demands satisfaction.

When most people are asked about the associations they have with the word “corporation,” they think of the large companies mentioned in the financial news of the day. Usually this group of companies will encompass those entities listed in the Fortune 500, the Dow Jones Industrial, or companies publicly traded on the New York or American Stock Exchanges. In terms of financial importance, these companies certainly do dominate the corporate landscape. The world of corporations has, however, a much less public face—the face of the closely held corporation held corporation. Blacks Law Dictionary defines a close corporation as one where the shares are held by a single or closely-knit group of shareholders. Generally there are no public investors and its shareholders are active in the conduct of the business. The vast majority of for-profit business entities using the corporate form are, in fact, closely held. Only five percent of all corporations are publicly traded. In closely held corporations, stock ownership is not widely dispersed, and control is held in virtual perpetuity through proxies and other mechanisms within the “closed” group.

What is interesting about the corporate landscape is that, except for some special rules set out in individual state close corporation statutes, the rules of corporate formation are virtually the same for both. The basic rights, duties, and expectations of shareholders, directors, and corporate officers are the same on paper for both large and small corporations. The reality is far different. The hows, whys, and wherefores of control over, for example IBM, are completely different from a small family business. Both entities must comply with the rules, however. Remember, most people who get in trouble with corporate law do so not because they are bad managers, directors, or shareholders. They get into trouble because they sometimes do not follow the rules of corporate formation and operation.

II. Chapter Objectives

Define corporation and list the major characteristics of a corporation.

Describe the process of forming a corporation.

Define common stock and preferred stock.

Define an S corporation and describe its tax benefits.

Describe the organization and operation of multinational corporations.

III. Key Question Checklist

How is the corporation established?

What express and implied powers does the corporation have?

How is a corporation financed?

What are the basic rules for key personnel involved in the formation and operation of a corporation?

What are the consequences of an ultra vires action?

What are the steps involved in the dissolution and termination of a corporation?

IV. Text Materials

Corporations were first formed in medieval times. England granted charters to trading companies in the 16th and 17th centuries. English corporate law applied in the colonies until 1776, after which the states developed their own corporation law. Initially corporate charters were granted by state legislatures, but eventually the states developed general corporation statutes to cover the formation, management, and dissolution of these organizations.

Section 1: Nature of a Corporation

The Corporation as a Legal “Person” – Corporations are artificial persons created by statute as separate legal entities.

Characteristics of Corporations – Corporations offer limited liability to shareholders to the extent of their capital contribution. They have no additional personal liability.

The shares are freely transferable, and may be sold, pledged, assigned, or gifted at any time, unless there is an agreement among the shareholders preventing this.

Corporations exist in perpetuity unless a specific duration is stated in the articles of incorporation.

The board of directors make the policy decisions and appoint the officers to run the operations of the corporation, giving it centralized management.

Revised Model Business Corporation Act (RMBCA) – This model is designed to provide uniform law regarding the formation, operation, and termination of corporations.

Public and Private Corporations – Government-owned public corporations are formed for specific government purposes. Private corporations are formed to conduct privately owned business.

Profit and Nonprofit Corporation – Private corporations are classified as for profit, if they can distribute profits to the shareholders, or nonprofit, if they are prohibited from distributing the profit to members, directors, or officers.

Publicly Held and Closely Held Corporations – Publicly held corporations have many shareholders and are usually traded on stock exchanges. Closely held corporations have shares

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that are owned by few shareholders. In the latter, there is usually a buy-and-sell agreement which restricts transfer of shares to only other current shareholders.

Professional Corporations – These corporations are formed by licensed professionals, and are identified by P.C., P.A., or S.C. The shareholders are called members, and most states grant them limited tort liability, requiring, instead, large insurance requirements.

Selecting a State for Incorporation – Corporations are incorporated in only one state, so the organization often selects one with the most favorable laws.

Domestic, Foreign, and Alien Corporations – Corporations are domestic in the state of their incorporation, and foreign in all other states, Most states require foreign corporations to obtain a certificate of authority to do business in their state. Alien corporations are incorporated in other countries, and most states place similar requirements on them to foreign corporations.

Section 2: Incorporation Procedures

Incorporators – Persons, corporations, partnerships, or other associations serve as the incorporators and sign the articles of incorporation.

Promoters’ Liability – The promoters organize and start the corporation, and usually enter into contracts on its behalf. If the corporation does not come into existence, the promoters have joint personal liability on all contracts that were signed. If the corporation is formed, a resolution must be passed by the board of directors in order for it to be bound by the contracts. Even then, the promoters are still liable unless the parties enter into a novation.

Articles of Incorporation – The corporate charter is the basic governing document for the corporation. It includes the name, number of authorized shares, address of the initial office and registered agent, and the name and address of each incorporator. This paper ia a matter of public record.

Amending the Articles of Incorporation – In order for the articles to be amended, the board must pass a resolution recommending the amendment and the shareholders must vote to support the change. The corporation will file an article of amendment with the secretary of state.

Corporate Status – Corporate existence begins when the articles are filed. After that, only the state can bring a proceeding to cancel or revoke the incorporation or involuntarily dissolve it. Failure to file articles is taken as conclusive proof of the nonexistence of the corporation.

Purpose – Most articles include a general-purpose clause allowing them to engage in any legal activities, but some state a limited-purpose clause, restricting their activities to specific purposes.

Registered Agents – The articles will indicate a registered office and registered agent for purpose of service.

Corporate Bylaws– The governing documents of an organization, bylaws are not filed with any government official. Bylaws establish the internal management structure and are adopted by the incorporators or the board.

They establish the time and method for the annual meeting, board meetings, special meetings, duties of board members, determine what a quorum is and the required vote, and establish committees.

The board may amend them at any time, unless this right is specifically reserved to the shareholders.

Corporate Seal – This design contains the name and date of incorporation and is often required on certain legal documents.

Organizational Meeting – Following the filing of the Articles of Incorporation, the directors meet to adopt bylaws, elect officers, and transact business.

C Corporation – Any corporation that does not qualify for or elect to become an S corporation, or any corporation with more than 75 shareholders. C corporations pay federal tax at the corporate level, and distribute profits to shareholders as dividends, which are taxed with personal income tax.

S Corporation – S corporations pay no federal tax at the corporate levels, but the income or loss is passed through to the individual shareholders and taxed with their personal income tax.

To be an S corporation, the organization must be a domestic corporation with 75 or fewer shareholders who are residents of the U.S., and must have only a single class of stock.

Close Corporation – These corporations consist of 50 or fewer shareholders and must be specifically cited as such in the articles filed with the secretary of state. It does not require a board of directors, but is managed by the shareholders. There may be multiple classes of stock. Close corporations are allowed to do away with many of the formalities of corporate operation.

Section 3: Financing the Corporation

Corporations finance their operation through equity securities (stocks) or debt securities.

Common Stock– This is an equity security that represents the residual value of the organization. It has no preference and no fixed maturity date. Holders of a common stock certificate have the right to vote for directors and receive dividends.

Par Value and No Par Value – Par share is the lowest price at which the share can be issued and is established by the corporation. No par shares are assigned no value.

Preferred Stock– This equity security is given preferences and rights over common stock. The preferred stock certificates usually hold no voting rights, but are given preference over other classes of stock.

Dividend preference preferred stock pays a fixed dividend at set periods. Liquidation preference grants the right to be paid prior to common stockholders. Usually these are established for a set dollar amount.

Cumulative preferred stock provides for the payment of any unpaid dividend arrearages before common stock dividends are paid. If the preferred stock is noncumulative, the corporation does not have to pay any missed dividends.

Participating preferred stock allows shareholders to participate in the profits along with common stockholders in addition to their fixed dividend. Most preferred stock is nonparticipating.

Convertible preferred stock establishes the terms for converting preferred stock into common stock in the future.

Redeemable Preferred Stock – This permits the corporation to call the stock at established terms in the future.

Authorized, Issued, and Outstanding Shares – The number of shares provided for by the Articles is the authorized share amount, and may be amended by shareholder vote. The issued shares are those that have been sold.

Treasury shares are shares of outstanding stock that have been repurchased by the corporation, and cannot be voted, nor are dividends paid on them. They may be reissued.

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Outstanding shares are all issued shares and reissued treasury shares.

Contribution to Be Paid for Shares – Any benefit may be exchanged for shares.

Debt Securities – Debt or fixed-income securities are created when the corporation borrows money from an investor. The three forms are debentures, long-term unsecured debt; bonds, long-term secured debts; and notes, short-term secured and unsecured debts.

The debt is usually evidence by an indenture agreement.

Section 4: Corporate Powers

Express Power – The express power of a corporation is derived from the constitutions of the U.S. and the states, federal and state statutes, the articles of incorporation, the bylaws, and resolutions of the board of directors, and may engage in almost every legal activity. A few activities like banking, insurance, and operation of a public utility require government agency approval.

Implied Powers – These powers allow the corporation to exceed its express powers in order to accomplish its stated purpose.

Ultra Vires Act – If a corporation exceeds either its express or implied powers, the shareholders can sue for an injunction to prevent the action from continuing or sue the officers or directors. The attorney general of the state of their incorporation may bring an action to enjoin the act or to dissolve the corporation.

Section 5: Dissolution and Termination of Corporations

Voluntary Dissolution – Voluntary dissolution can occur by a vote of the majority of the incorporators or directors if the corporation has not commenced business. If it has, dissolution requires a recommendation vote by the board and a majority vote of the shareholders. Articles of dissolution must be filed with the secretary of state to be effective.

Administrative Dissolution – The secretary of state will obtain an administrative dissolution if the corporation fails to file an annual report, to maintain a registered agent for 60 days or failed to file a change of registered agent, failed to pay a franchise fee, or if the stated period of duration in the articles has expired.

Judicial Dissolution – The attorney general for the state in which it is incorporated can institute a judicial action if the articles were procured by fraud or if it acted in ultra vires. The court will issue a decree of dissolution.

WindingUp, Liquidation, and Termination – A voluntary dissolved company’s affairs will be wound up and liquidated by the board; if involuntary, or if the board refuses, the court will appoint receivers to handle the matter.

Assets are paid first to cover the expenses of liquidation, then to creditors and preferred stockholders according to their rights, and finally to common stockholders.

International Branch Offices – Branch offices are not separate legal entities, but are mere offices of the corporation. The corporation is liable for any contracts or torts of a branch office or their employees and agents.

International Subsidiary Corporation – These are subsidiary corporations organized under the laws of a foreign country. Even though the parent corporation usually holds all the stock, there is a liability shield between the subsidiary and the parent so that the parent is not liable for contracts and tortious acts.

V. Answers to Business Law Cases

Legal Entity

7.1. Yes, Deister Corporation can be sued. Corporations are the most dominant form of business organization today. When a corporation is properly incorporated pursuant to the laws of the state of incorporation, the corporation becomes a separate legal entity for most purposes. Corporations are treated, in effect, as artificial persons created by the state that can sue or be sued in their own names. Deister was a business properly incorporated under the laws of the state of Pennsylvania. When the corporation became involved in a dispute with Sammak, Sammak decided to sue. Because the law views the corporation as a legal person for most purposes, Sammak was able to bring suit directly against the Deister Corporation. Blackwood Coal v. Deister Co., Inc., 626 F.Supp. 727 (E.D.Pa. 1985).

Limited Liability of Shareholders

7.2. No, the shareholders of USM cannot be held personally liable for the suit against the corporation. One of the most important features of a corporation is the limited liability of its shareholders. As separate legal entities, corporations are liable for their own contracts, debts, and torts. In a publicly held corporation shareholders are normally not responsible for a corporation’s debts, torts, claims, or contracts. USM was a publicly held corporation. Billy was injured in the course of his employment with USM. Since USM is considered a separate legal entity, Billy’s widow must look directly to the corporation to satisfy any judgment she may seek in a torts suit against USM. Billy v. Consolidated Mach. Tool Corp., 412 N.E.2d 934, 51 N.Y.2d 152 (N.Y.App. 1980).

Corporation

7.3. Marine Repair Services is a private, for-profit corporation. Private corporations are formed to conduct privately owned business. Private corporations may be further classified as either profit or not-for-profit. Profit corporations are created to conduct a business for profit and can distribute profits to shareholders in the form of dividends. Most private corporations fall into this category. Marine Repair Services was a privately owned corporation. Marine Repair Services was in the business of repairing shipping containers in order to make a profit. The purpose of the corporation was to increase the investment made in it by its shareholders. As such, Marine Repair Services was a for-profit corporation. O’Donnel v. Marine Repair Services, Inc., 530 F.Supp. 1199 (S.D.N.Y. 1982).

Corporation

7.4. Hutchinson Baseball Enterprises, Inc., is a private, nonprofit corporation. Nonprofit corporations are formed for charitable, educational, religious, or scientific purposes. Although nonprofit corporations may make a profit, they are prohibited by law from distributing this profit to their members, directors, or officers. Hutchinson Baseball Enterprises was formed for a charitable purpose, to promote Little League and other amateur baseball teams in Hutchinson, Kansas. Although the corporation does generate revenue from ticket sales and concession stands, this money is never distributed to Hutchinson’s officers or directors. All revenue that the corporation generates is used to fund the corporation’s activities. Because of the corporation’s nature, Hutchinson Baseball was incorporated under Kansas law as a nonprofit corporation.

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Hutchinson Baseball Enterprises, Inc. v. Commissioner of Internal Revenue, 696 F.2d 757 (10th Cir. 1982).

Corporation

7.5. Weldon Electric is a closely held corporation. A closely held corporation is one whose shares are owned by a few shareholders who are often family members, relatives, or friends. The shareholders, who are usually involved with the management of the corporation, sometimes enter into buy/sell agreements that prevent outsiders from becoming shareholders. Weldon Electronics was a corporation with only two shareholders, both friends and former partners. The two shareholders were also on the board of directors of the corporation and served as the corporation’s officers. Additionally, the corporation’s bylaws called for a buy/sell agreement to be reached to prevent outsiders from buying stock in the corporation. Because of these characteristics, Weldon Electronic can be described as a closely held corporation. Balvik v. Sylvester, 411 N.W.2d 383 (N.D. 1987).

Corporation

7.6. Florida Fashions was a domestic corporation in the state of Pennsylvania. This meant that Florida Fashions was a foreign corporation in the state of Florida, unlawfully doing business due to its failure to register. A corporation is a domestic corporation in the state in which it is incorporated. It is a foreign corporation in all other states and jurisdictions. Foreign corporations have to qualify, i.e., register, to conduct business in states other than their state of incorporation. Florida Fashions was illegally taking orders and doing business in Florida because the corporation had never qualified to conduct business in the state. Mysels v. Barry, 332 So.2d 38 (Fla.App. 1976).

Promoter’s Liability

7.7. The Allens and Handley should have joint personal liability for the failed project’s contractual obligations. Promoters are the individuals who organize and start a new corporation, negotiate and enter into contracts in advance of its formation, and file the papers necessary to incorporate. Promoters often enter into contracts on behalf of the corporation prior to its legal incorporation. If the proposed corporation never comes into existence, the promoters have joint personal liability for any contract signed on behalf of the proposed corporation. In this case, the Allens and Handley were acting as promoters for a proposed corporation which would build condominiums near Honolulu. In addition, the two parties signed several contracts on behalf of the proposed corporation, which included the security of a $69,500 loan. Therefore, when the proposed condominium project failed, and the corporation was never formed, Handley and the Allens became liable for these contracts. Handley v. Ching, 627 P.2d 1132 (Hawaii. App. 1981).

Promoter’s Contracts

7.8. Jacobson is incorrect, since a novation of the contract between the two parties did not occur. A corporation can become liable on a promoter’s contract by executing a novation. A novation is a three-party agreement whereby one party (the corporation) agrees to assume the contractual liability of another party (the promoter) with the consent of the original contracting party (the third party). When a novation is executed, the promoter is released from liability on the contract. In this case, Jacobson was the promoter who formed a contract for architectural services with

Stern. Jacobson later formed a corporation, Lake Enterprises, to own and operate the new casino for which Stern was drawing plans. Although the corporation may have adopted this promoter’s contract, Stern, the third party, never gave his consent for a novation. Thus, Jacobson remains liable for the contract with Stern, since a novation cannot occur without the consent of the third party. Jacobson v. Stern, 605 P.2d 198 (Nev. 1980).Preferred Stock

7.9. The one million shares of preferred stock issued by Commonwealth Edison on June 24, 1970, were shares of redeemable preferred stock. Redeemable preferred stock (or callable preferred stock) permits the corporation to redeem, i.e., buy back, the preferred stock at some future date. The terms of the redemption are established when the shares are issued. Corporations will usually redeem the shares when the current interest rate falls below the dividend rate of the preferred shares. Commonwealth Edison had set the dividend rate of the one million preferred shares higher than it wanted due to market conditions. Thus, when the market changed, Edison was able to buy back the stock for $110 a share, $10 a share more than it had to sell the shares for, because the preferred stock was redeemable. By issuing redeemable preferred stock, the corporation is able to protect itself from changing market conditions. The Franklin Life Insurance Company v. Commonwealth Edison Company, 451 F.Supp. 602 (S.D.Ill. 1978).

Debt Securities

7.10. The most important difference between the stock issued by United Financial and the debenture bonds is that the stock represents an equity (ownership) interest in the corporation, while the debenture bonds do not. A debenture bond is a debt security, and as such, does not represent an ownership interest in the corporation. Instead, the corporation borrows money from an investor to whom the debt security is issued. A debenture bond is a long-term, unsecured debt instrument, which is based on the corporation’s general credit rating. Therefore, if the corporation becomes insolvent, debenture holders are paid only after the secured creditors’ claims are met. In this case, those investing in United Financial received both shares of stock in the company, representing an ownership interest, and a debenture bond. While the debenture bonds paid a 5 percent interest rate, they did not represent an ownership interest in the company. Therefore, investors who bought one of the units offered by United Financial received both debt and equity securities. Jones v. H.F. Ahmanson & Company, 1 Cal.3d 93, 81 Cal.Rptr. 592 (Cal. 1969).

VI. Answers to Issues in Business Ethics Cases

7.11. Yes, Goodman can be held personally liable for the renovation contract with DDS. A corporation becomes liable for a contract entered into by a promoter before the corporation was formed if it agrees to be bound by ratification, adoption, or novation. Liability for the contract does not automatically transfer because the promoter was acting as the agent of a nonexistent principal when the contract was entered into. In this case, ratification of the promoter’s contracts was not allowed in the state of Washington, and no novation had occurred place. Therefore, if the newly formed corporation chose to be bound by the renovation contract, it would have to be by adoption. Upon adoption, the corporation becomes liable for the contract. However, the promoter remains personally liable on the contract, unless the third party agrees to release him. Since DDS did not agree to release Goodman from liability on the renovation contract, he remained personally liable with the newly formed corporation. Goodman v. Darden, Doman & Stafford Associates, 670 P.2d 648 (Wash. 1983).

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7.12. Neither Knoll nor Cogan owe a fiduciary duty to the debenture holders. The rights of the holder of a debt instrument are spelled out in the documents that accompany the debentures. Broad and abstract requirements of a fiduciary character ordinarily can be expected to have little or no role to play in the governance of a negotiated, commercial relationship. Simons v. Cogan, 542 A.2d 785 (Del. Ch. 1987).

VII. Terms

administrative dissolution—Involuntary dissolution of a corporation that is ordered by the secretary of state if the corporation has failed to comply with certain procedures required by law.

authorized shares—The number of shares provided for in the articles of incorporation.

bond—A long-term debt security that is secured by some form of collateral.

branch office—An office of a corporation offering no liability shield.

C corporation—A corporation with more than 75 shareholders or one that does not elect to become an S corporation. It is taxed at both the corporate level and dividends distributed to shareholders are taxed on the personal income tax.

close corporations—Small corporations that have made a special election in order to be able to dispense of many of the formalities required of corporations.

common stock certificate—A document that represents the common shareholder’s investment in the corporation.

debenture—A long-term unsecured debt instrument that is based on the corporation’s general credit standing.

debt securities—Securities that establish a debtor-creditor relationship in which the corporation borrows money from the investor to whom the debt security is issued.

double taxation—C corporations are taxed first at the corporate level and then the profits distributed by dividend payments are taxed as part of the personal income of the shareholders.

express powers—Powers given to a corporation by (1) the U.S. Constitution, (2) state constitutions, (3) federal statutes, (4) state statutes, (5) articles of incorporation, (6) bylaws, and (7) resolutions of the board of directors.

implied powers—Powers beyond express powers that allow a corporation to accomplish its corporate purpose.

indenture agreement—A contract between the corporation and the holder that contains the terms of a debt security.

issued shares—Shares that have been sold by the corporation.

judicial dissolution—Occurs when a corporation is dissolved by a court proceeding instituted by the state.

note—A debt security with a maturity of five years or less.

outstanding shares—Shares of stock that are in shareholder hands.

parent corporation—A corporation which owns all or most of the stock in a subsidiary corporation, but is separated by a liability shield.

preferred stock—A type of equity security that is given certain preferences and rights over common stock.

preferred stock certificate—A document that represents a shareholder’s investment in preferred stock in the corporation.

preferred stockholder—person who owns preferred stock.

redeemable preferred stock—Stock that permits the corporation to buy back the preferred stock at some future date.

S corporations—A corporate election designed to pass through taxation to the personal taxes of the shareholders, avoiding the double taxation of C corps.

subsidiary corporation—A corporation organized under the laws of a foreign country whose parent corporation owns all or most of the stock, but is not liable under contracts or for tortious acts.

termination—The ending of a corporation that occurs only after the windingup of the corporation’s affairs, the liquidation of its assets, and the distribution of the proceeds to the claimants.

treasury shares—Shares of stock repurchased by the company itself.

ultra vires act—An act by a corporation that is beyond its express or implied powers.

voluntary dissolution—A corporation that has begun business or issued shares can be dissolved upon recommendation of the board of directors and a majority vote of the shares entitled to vote.

windingup and liquidation—The process by which a dissolved corporation’s assets are collected, liquidated, and distributed to creditors, shareholders, and other claimants.

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Chapter 8Franchises and Special

Forms of Businesses

It has been uniformly laid down in this Court, as far back as we can remember, that good faith is the basis of all mercantile transactions.

J. Buller

I. Teacher to Teacher Dialogue

The objective of this chapter involves an introduction to the concept of franchising. The world of franchising combines concepts of marketing, management, finance, and many other diverse skills into a special kind of cooperative venture that is facilitated through the law. Like any “business marriage,” it can lead to the best of all worlds, or the worst. Careful planning, skilled research, and, most of all, a good faith willingness to let each participant do what he does best appears to be the key to today’s most successful franchise operations. Under the franchise system, there is ample evidence of the positive effects of good franchise planning. The original basic technology, patent, process, or other trademarked service or product is allowed to reach many more users or consumers through a franchise system. With intelligent planning and quality control, the original franchisor of the product or service can see phenomenal growth through the use of equity-sharing participants in that growth. Witness the fast food industry, convenience stores, food product production, all sorts of consumer good retailing systems, or even professional sports teams. All of these industries rely on the franchise concept to further their businesses.

Another interesting aspect of franchising is its tie to basic capitalism for the little guy. With sufficient start-up capital and a willingness to provide a lot of personal effort, the franchising concept allows the small businessperson to ride the coattails of the goodwill, advertising, and technology developed by large multinational enterprises.

There are some down sides to franchising as well. The “get rich quick” mentality of franchising has led to a number of abuses on the part of would-be franchisors. Many people have lost substantial sums of money trying to invest in pie-in-the-sky sales of bogus franchises. In addition, the franchise industry has seen more than its share of pyramid schemes, shallow capitalizations, adhesion contracts, and similar behavior in violation of the antitrust laws. It is interesting to note that many of the rules promulgated by the Federal Trade Commission are designed to protect persons about to enter into franchise agreements rather than the ultimate consumer of the franchise’s goods or services.

In addition, the franchise device has not always served the third party well. Because a franchisee is an independent contractor, the franchisor is not normally responsible to third parties for torts or contracts that the franchisee has been involved with. That may sound well and good in legal terms, but does it always make equitable sense? If the consumer of the goods or services thought he or she was dealing with a megacorporation, why not hold a megacorporation responsible rather than just its franchisee? Law works best when the benefit/burden balance is

fairly struck. Where large business entities grow through the utilization of its franchisee efforts, they should also be willing to take responsibility for their harm.

II. Chapter Objectives

Define a franchise and describe the various forms of franchises.

Describe the rights and duties of the parties to a franchise agreement.

Identify the contract and tort liability of franchisors and franchisees.

Define licensing and describe how trademarks and intellectual property is licensed.

Describe international franchising, partnering, and strategic alliances are used in global commerce.

III. Key Question Checklist

What are the basic elements of a franchise agreement?

What key terms are in the franchise agreement?

Have all statutory requirements been met regarding the franchise agreement?

Is there any breach of the essential contract agreement between the franchisor and franchisee?

What is involved in licensing?

What is involved in partnering, franchising, or creating a strategic alliance with other organizations in the global marketplace?

IV. Text Materials

Section 1: Franchise

Franchises are contracts that are employed when one party licenses the other to use their intellectual properties in the distribution and selling of goods and services. It allows the franchisor to reach new markets, gives the franchisee access to the franchisor’s knowledge, and allows for uniformity of product.

Types of Franchises – A distributorship franchise is when a franchisor manufactures a product and licenses retail dealers to sell the product.

Processing plant franchises occur when the franchisor provides a secret formulae or intellectual property to the franchisee, who then manufactures and distributes the product to retailers.

The franchisor licenses a franchisee to make and sell products or serves within a geographical area in a chain-style franchise.

Area franchises authorize the franchisee to negotiate and sell franchises on behalf of the franchisor within a geographical area.

State Disclosure Laws – Most states require franchisors to register and deliver documents to prospective franchisees.

FTC’s Franchise Rule – The FTC requires disclosure of the underlying facts if sales or earnings projections based on actual data, assumptions if based on hypotheticals, and the posting of an FTC notice on the disclosure statement.

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Trademarks and Trade Secrets – Registration of trademarks and service marks are filed with the PTO by franchisors and others. The use of these is licensed to franchisees; unauthorized use is actionable as trademark infringement.

Trade secrets are not registered, but the unauthorized use is considered misappropriation and unfair competition.

The Franchise Agreement – Prospective franchisees file an application with the franchisor that provides detailed information. If approved, the parties enter into a franchise agreement which covers, at a minimum, quality control standards, training requirements, covenants not to compete, and arbitration clauses.

Franchise Fees – The franchisee may be required to pay an initial license fee for the privilege of being granted a franchise, a royalty fee, an assessment fee for advertising and administration, lease fees for land and equipment, and the cost of supplies.

Termination of a Franchise – Most franchise agreements permit a franchisor to terminate “for cause,” which cannot be unreasonably applied.

A termination-at-will clause is generally held to be void as unconscionable. If a franchise is terminated without just cause, the franchisee can bring an action for wrongful termination.

Breach of the Franchise Agreement – The franchise agreement is a contract, and a nonbreaching party can bring suit for appropriate remedies.

Section 2: Liability of Franchisor and Franchisee

The franchisor and franchisee are separate legal entities, with the franchisee being treated as an independent contractor.

Apparent Agency – If the franchisee is considered an actual or apparent agent of a franchisor, the franchisor will be held liable for torts and contracts that the franchisee committed or entered into. This usually occurs when the franchisor leads a third party into believing that the franchisee is his agent. The courts will review the circumstances on a case-by-case basis.

Section 3: Licensing

When one party owns intellectual property and contracts to permit another to use the same, it is considered a license.

Section 4: Joint Venture

This arrangement allows two or more business entities to combine resources to pursue a single project. Each party has equal rights and owes each other the fiduciary duties of loyalty and care.

Joint Venture Partnership – Joint ventures may be operated as partnerships, with each joint venturer liable for all debts and obligations.

Joint Venture Corporations – Joint ventures may form a third corporation to operate the joint venture. The joint venture corporation is liable for its debts and obligations, while the joint venturers are liable only to the amount of their capital contribution.

Section 5: Strategic Alliance

Strategic alliances are arrangements between companies in the same industry to accomplish some objective, sharing risks and costs, combining technologies, and extending markets.

V. Answers to Business Law Cases

Franchise Agreement

8.1. H & R Block wins. The court held that June and Robert McCart had violated the covenant not to compete that was part of the franchise agreement with H & R Block. First, the court held that the covenant not to compete was reasonable in scope (tax preparation), time (for two years after termination of the franchise), and place (250 miles from the location of the franchise). Second, the court determined that although Robert had not signed the franchise agreement, he was still bound by its terms. The court reasoned that Robert had acted together with June to breach her agreement with Block and that he had knowingly participated in and aided June’s violation of the agreement. The court found that the opening of the new office under Robert’s name was a mere subterfuge designed to avoid June’s obligations under the franchise agreement.

The court held that the covenant not to compete was an enforceable provision of the franchise agreement that had been entered into between the parties. The court found that H & R Block had a valuable property right in its service mark, which was heavily advertised nationally, and that customers were attracted to the franchise office because of the company’s name recognition and goodwill. By including the covenant not to compete in its franchise agreements, Block preserved the value of this property right to itself alone after termination of the agreement. The court held that the McCarts had violated the covenant not to compete and issued an injunction enforcing provisions of the covenant. McCart v. H&R Block, Inc., 470 N.E.2d 756 (Ind.App. 1984).

Franchisor Disclosure

8.2. Dowmont, the franchisee, wins on its counterclaim against My Pie International, Inc. (My Pie). The court held that My Pie had violated the Illinois Franchise Disclosure Act when it granted the franchise to Dowmont to operate the restaurant in Glen Ellyn, Illinois, because My Pie had failed to register with the state of Illinois or to qualify for an exemption from registration, and had failed to provide proper disclosures to Dowmont as required by the act.

The Illinois Franchise Disclosure Act provides for a private cause of action to persons who have been harmed by a franchisor’s noncompliance with the act. The court held that My Pie’s violations of the act permitted Dowmont to rescind the franchise agreement and recover the royalties it had paid to My Pie during the course of the franchise. The court of appeals remanded the case to the trial court for determination of the royalty damages to be awarded to Dowmont.

Note: If My Pie had violated the disclosure requirement of the Federal Trade Commission Disclosure Rules (FTC Rules), the government could have sued My Pie, alleging a violation of the federal law. The FTC rules do not, however, provide for a private cause of action. Therefore, Dowmont could not have sued My Pie to rescind the franchise agreement and recover damages under the FTC Rules. My Pie International, Inc. v. Dowmont, Inc., 687 F.2d 919 (7th Cir. 1982).

Tort Liability

8.3. No, Georgia Girl Fashions, Inc. (Georgia Girl), the franchisor, is not liable for the conduct of its franchisee who had accused and detained Melanie McMullan as a shoplifter. The court noted that a franchisor and a franchisee are two separate legal entities. It further noted that a franchisor is not liable for the tortious conduct of a franchisee unless a principal-agent relationship has been

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established between the franchisor and the franchisee. A franchisee becomes an agent of the franchisor when the franchisor assumes the right to control the times and manner of executing the franchisee’s work, as distinguished from the right merely to require results in conformity with the franchise agreement. The court reviewed the franchise agreement and the circumstances of this case, and found that no agency relationship existed between Georgia Girl and its franchisee. The court of appeals affirmed the trial court’s judgment in favor of Georgia Girl.

Note: A franchise is always liable for its own tortious acts. Therefore, if the court held that the franchise in this case had wrongfully detained and falsely imprisoned McMullan, she could recover tort damages from the franchisee. McMullan v. Georgia Girl Fashions, Inc., 348 S.E.2d 748 (Ga.App. 1988).

Tort Liability

8.4. The trial court jury held the Seven-Up Company liable for the carton breaking and the Seven-Up bottle exploding, causing blindness in one of Sharon Koster’s eyes; the jury awarded her $150,000 in damages against Seven-Up. The law provides that a franchisor, like a manufacturer or supplier, may be liable to the consumer for its own negligence. Seven-Up alleged, however, that it could not be held liable for Koster’s injuries because it did not manufacture, handle, or require its franchisee, Brooks, to use the cartons manufactured by Olinkraft, Inc. The court rejected this argument, holding that a franchisor that retains the right to control the design of the product may be held liable for any injury that product may cause.

The court stated:

In this case, the Seven-Up Company not only floated its franchisee and the bottles of its carbonated soft drink into the so-called “stream of commerce.” The Company also assumed and exercised a degree of control over the “type, style, size, and design” of the carton in which its product was to be marketed. The carton was submitted to Seven-Up for inspection. With knowledge of its design, Seven-Up consented to the entry in commerce of the carton from which the bottle fell, causing the injury. The franchisor’s sponsorship, management, and control of the system for distributing 7-Up, plus its specific consent to the use of the carton, in our view, places the franchisor in the position of a supplier of the product for purposes of tort liability.

The court of appeals held that the case had been properly submitted to the jury based on the theory of breach of implied warranty. However, the court of appeals found that the trial court judge had given the jury an improper instruction regarding the doctrine of “inherently dangerous” products, and remanded the case for a new trial. Kosters v. Seven-Up Company, 595 F.2d 347 (6th Cir. 1979).

Trademark

8.5. The Kentucky Fried Chicken Corporation (KFC) is the franchisor of Kentucky Fried Chicken restaurants. Franchisees must purchase equipment and supplies from manufacturers approved in writing by KFC. Equipment includes cookers, fryers, ovens, and the like; supplies include carry-out boxes, napkins, towelettes, and plastic eating utensils known as “sporks.” These products are not trade secrets. KFC may not “unreasonably withhold” approval of any suppliers who apply and whose goods are tested and found to meet KFC’s quality control standards. The 10 manufacturers who went through KFC’s approval process were approved. KFC also sells supplies to franchisees in competition with these independent suppliers. All supplies, whether

produced by KFC or the independent suppliers, must contain “Kentucky Fried Chicken” trademarks.

Upon formation in 1972, Diversified Container Corporation (Diversified) began manufacturing and selling supplies to Kentucky Fried Chicken franchisees without applying for or receiving KFC’s approval. All the items sold by Diversified contained Kentucky Fried Chicken trademarks. Diversified represented to franchisees that its products met “all standards” of KFC and that it sold “approved supplies.” Diversified even affixed Kentucky Fried Chicken trademarks to the shipping boxes in which it delivered supplies to franchisees. Evidence showed that Diversified’s products did not meet the quality control standards set by KFC. KFC sued Diversified for trademark infringement. Who wins?

Both the trial court and the U.S. Court of Appeals found that Diversified had infringed upon KFC's trademarks.  Diversified argued that KFC had created illegal tying agreements by forcing franchisees to purchase their goods from only approved vendors.  Diversified had never requested that they be certified as an approved vendor.  KFC had never denied any supplier that had requested permission to use the trademarks, upon the supplier supplying proof of the quality of their goods.  The courts also noted that there are nine independent suppliers that have been approved.

The appeals court found, applying the per se rule, that there was no illegal tying agreement.  Franchisees were able to nominate other suppliers, all of which had been approved, to date.  Further, the franchisor has a strong argument in that requiring specific standards for the merchandise ensures a maintenance of the quality standards expected for the goods sold and distributed under the KFC label to consumers.

Finally, as to the matter involving the trademark infringement, the courts found that Diversified had willfully infringed in using the tradenames, trademarks, and colors of KFC on boxes, bags, and other items.  They had not indicated anywhere on the packaging that the product was made by Diversified, or was not authorized by KFC.  Under the circumstances, the courts determined that the intent to mislead the public was there, and that confusion was highly likely; for these reasons, Diversified was found to have infringed upon KFC's marks.  Kentucky Fried Chicken Corporation v. Diversified Container Corporation, 549 F.2d 368, 1977 U.S. App. Lexis 14128 (5th Cir.).

Trademark

8.6. Ramada Inns wins. The court held that Gadsden Motel Company (Gadsden) had infringed on Ramada Inns’ trademarks and service marks by its unauthorized use of such marks. The franchise agreement granted Gadsden, the franchisee, a license to use the “Ramada Inns” marks during the course of the franchise. However, when Ramada Inns properly terminated the franchise agreement with Gadsden on November 17, 1983, Gadsden lost the right to use the Ramada Inn trademarks and service marks. Evidence showed, however, that Gadsden continued to use the “Ramada Inns” marks for at least six months past that date. Therefore, the court found that Gadsden had engaged in trademark infringement in violation of the Lanham Act. The court of appeals affirmed the trial court’s judgment which awarded Ramada Inns $47,165 in trademark infringement damages, $29,610 in lost franchise fees for the six-month “hold over” period, $15,000 for advertising to restore Ramada Inns’ good reputation, and $20,000 in attorney fees. Ramada Inns, Inc. v. Gadsden Motel Company, 804 F.2d 1562 (11th Cir. 1986).

Termination of a Franchise

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8.7. The dealership wins. The court found that Kawasaki USA had wrongfully terminated the franchise held by Kawasaki Shop of Aurora (Dealer). Illinois franchise law provides that a franchise agreement may not impose “unreasonable” restrictions on motor vehicle dealers. The court held that the site-control provision in the franchise agreement that required the franchisor’s written approval before the franchisee could relocate within its exclusive territory was an unreasonable restriction in violation of the law. The court cited evidence that Kawasaki USA had objected to the move because the dealer was creating a multiline franchise location from which it would sell Honda, Suzuki, and Yamaha motorcycles as well as Kawasaki motorcycles. The court held that a multiline franchise dealership was expressly permitted by the franchise agreement. Thus, Kawasaki was wrongfully using the site-control provision to violate the multiline dealership provision in the franchise agreement. Based on the evidence, the court held that Kawasaki USA had wrongfully terminated the Dealer and awarded the Dealer $323,690 as compensatory damages and $79,422 in attorney fees. Kawasaki Shop of Aurora, Inc. v. Kawasaki Motors Corporation, U.S.A., 544 N.E.2d 457 (Ill.App. 1989).

VI. Answers to Issues in Business Ethics Cases

8.8. Campbell was not an agent of Southland. Only Campbell managed the day-to-day activities of the store: she hired and fired employees, and set their wages; and the contract provided that the relationship was one of independent contractor. The only evidence of agency is the fact that the liquor license was issued to “Campbell Valerie Southland #13974,” but this is simply an identification of the licensee as a franchisee of Southland. The license was not issued to Campbell and Southland. The issue of agency is a matter of fact. Here, the factfinder determined that there was no agency relationship and that finding is supported by substantial evidence. Wickham v. The Southland Corporation, 168 Cal. App. 3d 49, 213 Cal. Rptr. 825 (Cal. App. 1985).

8.9. KFC did not engage in an illegal tying agreement. In order to have an illegal tying agreement, there must be two separate products. KFC’s franchise is a distribution type where the franchisees simply serve as a conduit through which the special chicken is sold. The desirability of the franchise depends on the quality of the product being sold. Here, the KFC seasonings are so closely related to the franchise itself, that they cannot be considered two separate products, so there can be no tying. KFC Corporation v. Marion-Kay Company, Inc., 620 F. Supp. 1160 (S.D. Ind. 1985.

VII. Terms

apparent agency—Agency that arises when a franchisor creates the appearance that a franchisee is its agent when in fact an actual agency does not exist.

area franchise—The franchisee is authorized to sell franchises on behalf of the franchisor within a geographical area.

chain-style franchise—The franchisor licenses the franchisee to make and sell its products or distribute services to the public from a retail outlet serving an exclusive territory.

distributorship franchise—The franchisor manufactures a product and licenses a retail franchisee to distribute the product to the public.

Federal Trade Commission (FTC)—Federal government agency empowered to enforce federal franchising rules.

franchise agreement—An agreement that the franchisor and the franchisee enter into that sets forth the terms and conditions of the franchise.

franchise—Established when one party licenses another party to use the franchisor’s trade name, trademarks, commercial symbols, patents, copyrights, and other property in the distribution and selling of good and services.

franchise fees—Fees stipulated in the franchise agreement to be paid to the franchisor by the franchisee.

FTC franchise rule—A rule set out by the FTC that requires franchisors to make full presale disclosures to prospective franchisees.

intellectual property—Intangible property rights like patents, trademarks, copyrights, service marks, or trade secrets.

joint venture—An arrangement where two or more business entities combine their resources to pursue a single project.

license—Business arrangement in which one party which holds a trademark, service mark, trade name, or other intellectual property licenses another party to use them in distribution of goods, services, or software.

processing plant franchise—The franchisor provides a secret formula or process to the franchisee, and the franchisee manufactures the product and distributes it to retail dealers.

trademarks and service marks—A distinctive mark, symbol, name, word, motto, or device that identifies the goods or services of a particular franchisor.

uniform franchise offering circular (UFOC)—A uniform disclosure document that requires the franchisor to make specific presale disclosures to prospective franchisees.

wrongful termination—Termination of a franchise without just cause.

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Chapter 9 Corporate Governance and the Sarbanes-Oxley Act

Corporation, n. An ingenious device for obtaining individual profit without individual responsibility.

Ambrose Bierce

I. Teacher to Teacher Dialogue

This chapter lends itself to the old “black letter” law approach because of the sheer volume of rules, definitions, and procedures set out in these materials. As mentioned in the overview, one of the most important aspects of this entire body of law is to constantly remind students that the use of the corporate form constitutes a favor, not an entitlement, in the eyes of the law. The law allows for many distinct advantages to the corporate entity; but what the law gives with one hand, it can take away with the other. How to protect those corporation-based prerequisites is really what this chapter is all about. Where the rules of the corporate law road are honored, safe passage and a restful reward are assured. Where they are not, personal liability looms near. Thus as a matter of teaching technique, I like to present this material in the following order:

1. A diagram of the corporate lines of authority.

2. The respective rights and duties of the various parties in that line of authority.

3. A listing of responsibilities and liabilities of these parties not only to each other, but also to key third parties such as shareholders and parties having a contract or tort nexus with the corporation.

In all three scenarios we try to give case examples that illustrate the rule of law being discussed. In the end, we wind up going full circle. If you play by the rules, the corporate format is hard to beat. If you don’t: caveat incorporamus.

*We like to use this chapter to remind students that the corporate world has, in many ways, a sort of bifurcated existence. The public face we see in the financial news involves the machinations of Wall Street and the large enterprises listed on the various stock exchanges. The other side of this coin is far less public, and yet many students will be involved with closely held companies either as employees and/or owners. We try to bring to the classroom the particular problems faced by these entities such as trying to retain family control over a small business in light of estate taxes which tend to punish those who are “land rich and cash poor.” Each of us has unique experiences from our lives before academia that will add value to the learning of our students.

II. Chapter Objectives

Describe the functions of shareholders, directors, and officers in managing the affairs of a corporation.

Describe a director’s and an officer’s duty of care and the business judgment rule.

Describe a director’s and an officer’s duty of loyalty and how this loyalty is breached.

Define piercing the corporate veil or alter ego doctrine.

Describe how the Sarbanes-Oxley Act affects corporate governance.

III. Key Question Checklist

Has a director or officer breached a fiduciary duty, and if so, which one?

When will a shareholder be held responsible for the actions or omissions to third parties?

When can a shareholder act against wrongful actions of a corporation?

How does Sarbanes-Oxley affect corporations?

IV. Text Materials

Section 1: Shareholders

The corporation shareholders are the owners of the corporation, and have the right to vote on the board and approve changes.

Shareholders’ Meetings – Annual meetings are held to elect the board and appoint auditors at the time prescribed by the bylaws. If a meeting is not held within 15 months of the last annual meeting, or within six months of the end of the fiscal year, shareholders may petition the courts to order a meeting. Special shareholder meetings can be called by the board or the holders of at lest ten percent of the voting stock to consider emergency items.

Notice of Meetings – Notice of meetings must be sent not less than 10 days nor more than 50 days before the meeting.

Proxies – Shareholders may appoint another person to act as their agent to vote at the meeting. The written document card granting permission is called a proxy.

Voting Requirements – Every corporation has at least one class of shares which has voting rights. Shareholders who own stock on a set date no more than 70 days before the meeting, the record date, may vote. A shareholders’ list is prepared containing the names, addresses, and class and number of shares of all eligible shareholders, which is then held available for inspection at the corporation’s office.

Quorum and Vote Required – Unless otherwise stated in the articles, a majority of the shares entitled to vote is necessary for there to be a quorum, and the majority vote of those shares will be treated as an affirmative vote.

Straight (Noncumulative) Voting – Unless otherwise stated in the articles or bylaws, votes for the directors are made through straight or noncumulative voting, with one share voted for each position.

Cumulative Voting – In cumulative voting, the stockholder can accumulate all of their votes and vote it among the candidates for directors as they wish.

Supramajority Voting Requirement – Either the articles or the bylaws may call for greater than the simple majority of shares to fulfill a quorum or vote requirement.

Voting Agreements – Voting trusts are shareholder agreements where the shareholders transfer their stock certificates to a trustee, who issues voting trust certificates to the shareholders. The legal title to the stock is held in the name of the trustee who is either directed to vote the shares or authorized to vote them as he sees fit. These are limited in duration and filed with the corporation.

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Shareholder voting agreements are agreements between shareholders that stipulate how their votes will be cast. They are not limited in duration, nor are they filed with the corporation.

Right to Receive Information and Inspect Books and Records – Corporations must send shareholders an annual financial statement. Shareholders have the absolute right to inspect the shareholders’ list, the articles, bylaws, and minutes of shareholder meetings. They may also inspect tax records and the minutes of the board of directors’ meetings if they demonstrate a “proper purpose.”

Dividends – Dividends, paid at the discretion of the board, are a distribution of profits to shareholders at a set record date.

Stock Dividends – These are distributions of additional stock shares in proportion to the amount of shares currently held to shareholders, in lieu of assets.

Derivative Lawsuits– The shareholders have the right to bring a lawsuit against someone harming the corporation in order to recover damages, if the board fails to commence action. The shareholder must have been a shareholder at the time the actionable offense occurred, must fairly and adequately represent the interests of the corporation, and must have made a written demand upon the corporation to take suitable action. The court may dismiss the suit if a majority of the directors determine that it is not in the best interests of the corporation. If successful, the plaintiff (shareholder) may recover reasonable expenses and attorneys’ fees, with the remainder of the money going to the corporation.

Piercing the Corporate Veil – Shareholders of a corporation usually have limited liability and are not personally liable for the debts of a corporation, unless they dominate and misuse it. When this occurs, courts of equity will pierce the corporate veil and hold the shareholders personally liable.

Public policy never has allowed the corporate form to act as a total shield from liability to third parties. From the very inception of corporate law, courts and legislators have clung to the back door option of holding someone personally liable where circumstances deemed it appropriate. A creature of the law should not be allowed to become a tool of circumvention of the law. Thus in the areas of crimes, tort, and generally undesirable behavior, a number of corporate shield-bursting mechanisms have always been in place. These have ranged from piercing the corporate veil to outright revocation of the continued existence of the corporation. In all these cases, the underlying premise is that the corporate form should not allow a person to do something that would otherwise be prohibited by public policy.

Section 2: Board of Directors

The board is responsible for the management, supervision, and long-term operation of the organization, making all major policy decisions. They initiate actions that are adopted as resolutions that will be submitted to the shareholders for vote.

They have an absolute right of inspection of all books and materials.

Selecting Directors – The board consists of both inside directors who are also officers of the corporation and outside directors who are not officers, but are selected for their business expertise.

Term of Office – The directors usually serve from election until the next shareholders’ meeting, unless the articles or bylaws call for staggered terms.

Meetings of the Board of Directors – The bylaws establish the times and places for regular meetings, as well as making provisions for special meetings to be held. The board may act without meeting if all the directors sign written consents that set forth the actions taken.

Quorum and Voting Requirement – The articles usually require that a simple majority of the board members be present to constitute a quorum.

Committees of the Board of Directors – Unless the articles or bylaws provide otherwise, the board may create committees to handle specific duties. These include executive committees, audit committees, nominating committees, compensation committees, and investment committees. However, these committees cannot declare dividends, initiate actions that require shareholder’s approval, appoint members to fill vacancies on the board, amend the bylaws, approve mergers, or authorize the issuance of shares.

Preemptive Rights – The articles or bylaws may allow current shareholders to purchase additional new shares based on the percentage of their current ownership, before these shares can be offered elsewhere.

Transfer of Shares – Shareholders may enter into agreements restricting the transfer of shares to unwanted persons. A right of first refusal requires that the shareholder who wishes to sell his stock first must offer them to the other parties to the agreement before selling them to anyone else.

A buy-and-sell agreement requires that a shareholder selling shares must sell them to other shareholders or to the corporation at a price specified in the agreement.

Section 3: Corporate Officers

At a minimum, a corporation must have a president, vice president, secretary, and treasurer. Some states allow one person to hold some or all of these offices simultaneously.

Agency Authority of Officers – The authority of officers and agents to bind a corporation may be express, implied, or apparent. Corporations may ratify unauthorized acts of its officers and agents. If the corporation does not ratify unauthorized acts, the officer or agent remains liable for the contract.

The Sarbanes-Oxley Act Improves Corporate Governance – This discusses several major provision of this Act, which applies only to public corporations, but with major implications to private companies and nonprofit organizations.

Section 4: Liability of Directors and Officers

Directors and officers owe a fiduciary duty of trust and confidence.

Duty of Obedience – Directors and officers must act within the authority granted them by the articles, bylaws, and resolutions.

Duty of Care – Directors and officers must use care and diligence, discharging their duties in good faith and ordinary prudent care, in a manner that they reasonably believe to be in the best interests of the corporation. Any director or officer who breaches this duty is personally liable to both the corporation and its shareholders.

Business Judgment Rule – The business judgment rule states that officers and directors are not liable for honest mistakes of judgment, as measured at the time the decision was made.

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Reliance on Others – Directors and officers may rely upon information gathered and presented by officers and employees, professionals within their area of expertise, and committees of board members.

Dissent to Directors’ Action – If an individual director opposes an action taken by the board, he/she may register his/her dissent in the minutes, file a written dissent with the secretary before adjournment, or send a written dissent by registered mail to the secretary immediately after the meeting.

Case 9.3: Smith v. Van Gorkom

Facts: After a meeting with Jay A. Pritzker, Van Gorkom, acting as chairman of the board, proposed to his fellow directors that they accept a cash-out merger offer by Pritzker, and that they not solicit other offers. Although none of the directors including Van Gorkom had actually read the merger agreement, they voted to accept the Pritzker offer after listening to a twenty-minute presentation by Van Gorkom.

Issue: Did Trans Union’s directors breach their duty of care?

Decision: Yes.

Reason: A corporate director is protected by the business judgment rule only if he acted (1) on an informed basis, (2) in good faith, and (3) in the honest belief that the action taken was in the best interest of the corporation. Here, all of the directors breached their duty of care by not acting on an informed basis, i.e., by not reading the merger agreement they have neglected the shareholders’ interest. An ordinary person in the position of a director would have insisted upon a copy of the agreement and time to read it prior to voting.

Duty of Loyalty – The directors and officers must subordinate their personal interests to those of the corporation and its shareholders. The most common breaches of the duty to loyalty include usurping a corporate opportunity, self-dealing, competing with the corporation, and making a secret profit.

Indemnification and D & O Insurance – Directors and officers protect themselves from personal liability for actions that they took on behalf of the corporation by having the corporation purchase directors’ and officers’ liability insurance, which will require the insurance company to defend the director or officer sued in their corporate capacity, and to pay any claims. Many corporations indemnify their directors and officers for the cost of litigation, judgments, and settlements.

Section 5: Criminal Liability

Corporate directors, officers, employees, and agents are personally liable for any crimes that they commit on behalf of the corporation. The corporation may be held liable for the crimes of its directors, officers, employees, and agents under agency law, if they were acting within the scope of their employment.

V. Answers to Business Law Cases

Shareholders Meeting

9.1. Yes, Ocilla can force the board of directors of Direct Action to hold the shareholders meeting at an earlier date. The purpose of an annual shareholders meeting is to elect directors, choose an independent auditor, and to take other actions. Under the MCBA, any shareholder may petition

the court and obtain an order that such a meeting be held. The last annual stockholders meeting held by Direct Action took place on September 19, 1986. The corporation did not plan for another shareholders meeting to be held until January 27, 1988, over 16 months after the previous meeting. Under the MBCA, Ocilla, as a shareholder, can obtain a court order to compel Direct Action to hold the shareholders meeting at an earlier date. Because of the importance of shareholders meetings, the MBCA allows shareholders to force corporations to hold the meetings on an annual basis. Ocilla Industries, Inc. v. Katz, 677 F. Supp. 1291 (E.D.N.Y. 1987).

Special Shareholders’ Meeting

9.2. Shoenholtz wins since the special shareholders meeting was properly called. Special shareholders meetings may be called by the board of directors, or by the holders of at least 20 percent of the voting shares of the corporation. Special meetings may be held to consider important or emergency issues, such as a corporate merger, or the removal of a director. The corporation is required to give the shareholders written notice of the place, day, and time of annual and special meetings. If the meeting is a special meeting, the purpose of the meeting must also be stated. Since Shoenholtz owned over 10 percent of the voting shares of Rye Hospital, this gave him the right to request a special meeting. The notice given to Rye’s shareholders was adequate, in that it stated the time, date, and purpose of the meeting. Because the special shareholders meeting was requested by an authorized party and proper notice was given to the shareholders, the meeting was properly called. Rye Psychiatric Hospital Center, Inc. v. Shoenholtz, 476 N.Y.S.2d 339 (A.D. 2 Dept. 1984).

Right to Inspect Records

9.3. Yes, Helmsman’s request should be allowed. Shareholders have a right to inspect corporate records. The MBCA requires a shareholder to have a proper purpose for such an inspection. Proper purposes include deciding how to vote in a shareholders election, examining the propriety of paying dividends, and investigating corporate mismanagement. The MBCA requires shareholders to give written notice to the corporation to exercise their inspection rights. Helmsman held 25 percent of A&S’s outstanding stock. As a shareholder, Helmsman had the right to inspect A&S’s outstanding stock. As a shareholder, Helmsman had the right to inspect A&S’s books. Helmsman wrote to A&S requesting the inspection, and stated several valid purposes for its request. Among the purposes for the inspection were to gather information in order to make an informed decision voting in the shareholders election, and determining why Helmsman had received no dividends on its stock. Because Helmsman was a stockholder making a valid request for inspection, the court allowed Helmsman to inspect most of A&S’s records. Helmsman Management Services, Inc. v. A&S Consultants, Inc., 525 A.2d 160 (Del. Ch. 1987).

Dividends

9.4. Gay’s Super Markets wins the suit. The payment of dividends is at the discretion of the board of directors. The directors are responsible for determining when, where, how, and how much will be paid in dividends. Corporations often do not pay dividends, but retain profits in the corporation to be used for research expense, internal expansion, and other anticipated needs. Courts will only order a corporation to declare a dividend if the directors have abused their discretion in not paying. Gay’s Super Markets’ board stated valid reasons, such as expansion, for not granting a dividend at their January 1972 meeting. This decision was well within the board’s discretion. Because Gay’s had usually decided to retain earnings due to increased competition

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and planned expansion, the court did not interfere with their decision. Gay v. Gay’s Super Markets, Inc., 343 A.2d 577 (Maine Sup. 1976).

Duty of Loyalty

9.5. Hellenbrand wins since he can obtain an injunction to prevent Berk from leasing the club. Directors and officers of corporations owe the corporation a duty of loyalty. This duty requires that officers and directors subordinate their own personal interests to those of the corporation and its shareholders. The duty of loyalty prevents officers and directors from competing with the corporation and usurping corporate opportunities. Berk was an officer of a corporation, and a vice president of Comedy Cottage, Inc. Berk usurped a corporate opportunity when he arranged for the Comedy Cottage’s lease to be drawn in his own name. When this action was discovered, Berk used his former position to retain the lease and open his own Comedy Club. This new club was in direct competition with his old corporation. Because of these two actions, the court held that Berk had breached his duty of loyalty to the Comedy Cottage, and granted Hellenbrand the injunction he sought. Comedy Cottage, Inc. v. Berk, 495 N.E.2d 1006 (Ill.App. 1986).

Duty of Loyalty

9.6. Chelsea wins and can recover from Gaffney and his partners. Directors and officers of a corporation owe a duty of loyalty to the corporation. Part of this duty is to not compete with the corporation, unless full disclosure of the competing activity is made, and a majority of the disinterested shareholders approve of the activity. Directors and officers cannot use the facilities, personnel, or funds of the corporation for their own benefit. The corporation can recover any profits made by the nonapproved competition and any other damages caused to the corporation. Gaffney and his partners were all officers of Ideal. Gaffney and the others set up a competing business without informing the corporation or its shareholders. They also used Ideal’s assets and facilities to build their own business and recruit customers for it. These actions by Gaffney and the other officers constituted a breach of their duty of loyalty to Ideal, and the corporation was able to recover damages from them. Chelsea Industries, Inc. v. Gaffney, 449 N.E.2d 320 (Mass. Sup. 1983).

Indemnification

9.7. Yes, Young is entitled to indemnification for the loss he incurred in defending the suit brought against him and Pool Builders. Corporate directors may be indemnified for certain personal liability and litigation expenses associated with suits against the corporation. A director or officer who wins a lawsuit must be indemnified by the corporation for the reasonable costs of litigation. This is called mandatory indemnification. Young was a director of Pool Builders and defended a suit brought against him and the corporation. Because Young won the suit, he was entitled to mandatory indemnification. This meant that the corporation had to reimburse Young for all costs he incurred. Lawson v. Young, 486 N.E.2d 1177 (Ohio App. 1954).

Derivative Shareholder Lawsuit

9.8. Yes, Sam Dotlich can file a shareholders derivative suit on behalf of the corporation. If someone harms a corporation, the directors of the corporation have the authority to bring an action on behalf of the corporation to recover damages or gain other relief. A shareholder may not bring a lawsuit that asserts a claim that belongs to the corporation unless: (1) the corporation

has a claim against a director, officer, or some other person, (2) the shareholder has made a demand on the directors to pursue this claim, and (3) the directors have refused to pursue the claim. Sam Dotlich had the right to sue on behalf of Dotlich Brothers, Inc., because another director, Monnie Dotlich, had harmed the corporation. The harm was in the form of retaining property bought by the corporation in his own name. Sam had asked the corporation’s board of directors to take action in regards to this matter, but they had refused. The board’s refusal gave Sam the right to file a shareholders derivative suit. Dotlich v. Dotlich, 475 N.E.2d 331 (Ind. App. 1985).

Piercing the Corporate Veil

9.9. Yes, Walters can be held personally liable, because Wildhorn Ranch, Inc., was merely his alter ego. When a shareholder dominates a corporation and does not maintain any separation between himself and the corporation, that corporation is merely his alter ego. When this occurs, the shareholder may be held personally liable for the corporation’s debts and obligations. A shareholder may be held liable if the corporation fails to follow the necessary formatting required by applicable statutes, such as holding shareholders meetings, and keeping minutes of these meetings. In this case, Walters dominated the affairs of Wildhorn Ranch, Inc., and ran the corporation without observing any of the necessary corporate formalities. Walters paid Wildhorn’s debts with money from his other corporations, kept no minutes of shareholders meetings, and held the meetings in his living room. Because Walters failed to separate himself from the corporation, he was found liable for the corporation’s torts and other debts. Geringer v, Wildhorn Ranch, Inc., 760 F.Supp. 1442 (D. Colo. 1988).

VI. Answers to Issues in Business Ethics Cases

9.10. Bank, as the controlling shareholder of Corporation, breached its fiduciary duty to the minority shareholders. In selling its control of the corporation, the controlling shareholder has an obligation to conduct a reasonably adequate investigation of the buyer. The Bank here placed control in a man whose public records are overwhelmingly negative. They knew from personal experience his fraudulent character. Moreover, they hoped to recover from him a debt owed to them arising out of fraud. The turns of the deal guaranteed that Ray would loot the corporation. Ray had no other way to pay back the contractual price that they had negotiated with him. Ray’s long, long trail of financial failure should have precluded the Bank from dealing with him. Debaun v. First Western Bank and Trust Company, 46 Cal. App.3d 791, 120 Cal.Rptr. 354 (Cal. App. 1975).

9.11. The District Court correctly found Farms to be the alter ego of Chemicals. First, Farms did not have a separate financial existence. The $10,000 investment created a thin corporation (diaphanous) that depended upon its parent Chemicals for transfusions of working capital. Second, the nature of the loans to Farms from Chemicals reveals that whenever Farms could not pay its debts Chemicals wrote a check for payment. There were no corporate resolutions authorizing these extraordinary “loans.” Third, the use of Chemicals’ offices and computers justify the district court’s finding of joint use and ownership of property. Finally, regardless of whether the fraudulent papers were signed by Thomas as Farms’ president or Thomas as Chemical the corporate entity was appropriately disregarded. Observance of corporate for-malities is only one aspect of corporateness; by itself it does not create a separate existence for an entity. United States of America v. Jon-T Chemicals, Inc., 768 F.2d 868 (5th Cir. 1985).

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VII. Terms

annual financial statement—A statement provided to the shareholders that contains a balance sheet, an income statement, and a statement of changes in shareholder equity.

annual shareholders’ meeting—Meeting of the shareholders of a corporation that must be held annually by the corporation to elect directors and to vote on other matters.

article 8 of the UCC—The article of the UCC that governs transfer of securities.

board of directors—A panel of decision makers, the members of which are elected by the shareholders.

business judgment rule—A rule that says directors and officers are not liable to the corporation or its shareholders for honest mistakes of judgment.

controlling shareholder—A shareholder that owns a sufficient number of shares to control the corporation effectively.

cumulative voting—A shareholder can accumulate all of his or her votes and vote them all for one candidate or split them among several candidates.

derivative lawsuit—A lawsuit a shareholder brings against an offending party on behalf of the corporation when the corporation fails to bring the lawsuit.

direct lawsuit—A lawsuit that a shareholder can bring against the corporation to enforce his or her personal rights as a shareholder.

dissension—When an individual director opposes the action taken by the majority of the board of directors.

dividend—Distribution of profits of the corporation to shareholders.

duty of care—A duty that corporate directors and officers have to use care and diligence when acting on behalf of the corporation.

duty of loyalty—A duty that directors and officers have not to act adversely to the interests of the corporation and to subordinate their personal interests to those of the corporation and its shareholders.

duty of obedience—A duty that directors and officers of a corporation have to act within the authority conferred upon them by the state corporation statute, the articles of incorporation, the corporate bylaws, and the resolutions adopted by the board of directors.

fiduciary duty—Duty of loyalty, honesty, integrity, trust, and confidence owed by directors and officers to their corporate employers.

inside director—A member of the board of directors who is also an officer of the corporation.

limited liability—Liability that shareholders have only to the extent of their capital contribution. Shareholders are generally not personally liable for debts and obligations of the corporation.

negligence—Failure of a corporate director or officer to exercise the duty of care while conducting the corporation’s business.

officers—Employees of the corporation who are appointed by the board of directors to manage the day-to-day operations of the corporation.

outside director—A member of the board of directors who is not an officer of the corporation.

piercing the corporate veil—A doctrine that says if a shareholder dominates a corporation and uses it for improper purposes, a court of equity can disregard the corporate entity and hold the shareholder personally liable for the corporation’s debts and obligations.

preemptive rights—Rights that give existing shareholders the option of subscribing to new shares being issued in proportion to their current ownership interest.

proxy—The written document that a shareholder signs authorizing another person to vote his or her shares at the shareholders’ meetings in the event of the shareholder’s absence.

quorum—The number of directors necessary to hold a board of directors’ meeting or transact business of the board. Also, the required number of shares that must be represented in person or by proxy to hold a shareholders’ meeting. The RMBCA establishes a majority of outstanding shares as a quorum.

ratification—The acceptance by a corporation of an unauthorized act of a corporate officer or agent.

record date—A date specified in the corporate bylaws that determines whether a shareholder may vote at a shareholders’ meeting.

regular meeting—A meeting held by the board of directors at the time and place established in the bylaws.

retained earnings—Profits retained by the corporation and not paid out as dividends.

right of inspection—A right that shareholders have to inspect the books and records of the corporation.

self-dealing—If the directors or officers engage in purchasing, selling, or leasing of property with the corporation, the contract must be fair to the corporation, otherwise, it is voidable by the corporation. The contract or transaction is enforceable if it has been fully disclosed and approved.

shareholder voting agreements—Agreement between two or more shareholders agreeing on how they will vote their shares.

special meeting—A meeting convened by the board of directors to discuss new shares, merger proposals, hostile takeover attempts, and so forth.

special shareholders’ meetings—Meetings of shareholders that may be called to consider and vote on important or emergency issues, such as a proposed merger or amending the articles of incorporation.

stock dividend—Additional shares of stock paid as a dividend.

straight voting—Each shareholder votes the number of shares he or she owns on candidates for each of the positions open.

supramajority voting requirement—A requirement that a greater than majority of shares constitutes a quorum of the vote of the shareholders.

usurping a corporate opportunity—A director or officer steals a corporate opportunity for him- or herself.

voting trust—The shareholders transfer their stock certificates to a trustee who is empowered to vote the shares.

Chapter 10

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Corporate Acquisitions and Multinational Corporations

To supervise wisely the great corporations is well; but to look backwards to the days when business was polite pillage and regard our great business concerns as piratical institutions carrying letters of marque and reprisal is a grave error born in the minds of little men. When these little men legislate they set the brakes going uphill.

Elbert Hunnard

I. Teacher to Teacher Dialogue

The world of corporate combinations through mergers and the like has been turned upside down in recent history. Several factors have contributed to the frenzy of activity on the street, not all of it well motivated. As with so many of these sort of fundamental changes to how society orders its affairs, there is no one underlying motive or rhyme or reason to it, and arguments pro and con can be heard from he halls of academia to Wall Street.

The proponents for changes first argue mergers, takeovers, and consolidation are simply marketplace adjustments that reflect attempts to correct inefficiencies in the marketplace. Where a company is poorly managed, running on “cruise control,” and is not sufficiently lean and mean, it should be swallowed up by more efficient competitors. This view literally adopts the law of the jungle where only the strong survive. A really open marketplace rewards the most efficient in economic terms, and drags on that efficiency are doomed to failure and absorption in the end. The Law and Economics Movement proponents argue that the mechanisms of the law should not only allow this natural business evolution to take place, but that to stifle it would do harm to society in the end.

On the other side of the coin, a number of commentators have argued that runaway activity in the areas of mergers, acquisitions, buyouts, and the like bred a whole new generation of unethical, short-term thinking, financial charlatans whose only real self-interest is their personal bank accounts. Critics of the merger phenomenon point to the endless game-playing going on in this arena. They argue that what has been created is a big time casino where the chips are bigger than ever. Out of that gaming mentality, the larger society has had to pay for numerous financial scandals because the original players were not really motivated by the long-term good of society. In addition, long-term growth, research, and development of essential business fundamentals have been cast aside in the name of greenmail, corporate spin-offs, tax manipulation, and golden parachutes. The net result of this sort of short-term thinking is that while the financial market manipulators are playing high stakes poker, our industrial, financial, and transportation infrastructure has sunk into a quagmire of noncompetitiveness on the world marketplace.

The truth probably lies somewhere in between these poles when it comes to business combinations. Time will ultimately tell if recent history has reflected a transition cost to stay competitive as a nation, or if we are frittering away our industrial base at the gaming table. However it all turns out, each and every one of us will ultimately share in the ultimate benefit or burden.

II. Chapter Objectives

Describe the process for soliciting proxies from shareholders and engaging in proxy contests.

Define shareholder proposal and identify when a shareholder can include a proposal in proxy materials.

Describe the process for approving a merger or share exchange.

Define a tender offer and describe poison pills, white knight mergers, greenmail, and other defensive maneuvers to prevent a hostile takeover.

Analyze the lawfulness of state anti-takeover statutes.

III. Key Question Checklist

How are shareholders authorized to vote?

Has a merger, consolidation, or other forms of combination taken place?

What is a tender offer?

If a corporation is coming to an end, how can it be legally ended?

IV. Text Materials

Section 1: Proxy Solicitation

A proxy authorizes the proxy holder to vote the shareholder’s shares at the next meeting.

Federal Proxy Rules – The SEC has the authority to regulate solicitation of proxies. Full disclosure of the subject matter, who is soliciting the proxy, and other pertinent information must be sent to the shareholder, and a copy of the proxy and all solicitation material must be filed with the SEC at least 10 days before the materials are sent to shareholders.

Antifraud Provision – Material misrepresentation and omissions are prohibited, and can result in both civil and criminal actions.

Proxy Contests – Insurgent shareholders challenging incumbent directors and management in a proxy fight will attempt to collect the greatest number of votes.

Management may either provide a list of shareholders and their addresses to the challengers, or mail the proxy solicitation materials for them.

Reimbursement and Expenses – If a proxy contest involves issues of policy, the corporation must reimburse the incumbent management whether they win or lose; the dissenting group is reimbursed only if they are successful. If the contest involves personal matter, neither side may recoup expenses.

Section 2: Shareholder Resolution

The SEC has adopted rules permitting shareholders to submit resolutions to be considered in a shareholder vote. The submitting shareholder must have held at least 1000 shares for a minimum of two years and the resolution must not exceed 550 words. These resolutions are usually made at the same time that the corporation is soliciting proxies.

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Business Ethics: Shareholder Resolution – The teamsters were trying to, first, improve human rights worldwide by introducing a resolution banning child labor and forced labor. They should be applauded for the social consciousness of the matter, recognizing that this might mean less profit in the future. They may have also hoped that this would bring some business back to fellow union members. Although du Pont is supportive of the general intent, they seemed to have no interest in banning these practices that are so prevalent in some parts of the world.

Section 3: Mergers and Acquisitions

Mergers – When one corporation is absorbed into another and ceases to exist, the surviving corporation gains all the rights, privileges, obligations, and liabilities of the merged corporation.

Consolidations – When two corporations combine to form an entirely new corporation, it is considered a consolidated corporation.

Share Exchanges – In a share exchange, both corporations retain separate legal existences, but one corporation, the parent, acquires all of the shares of the other, the subsidiary.

Required Approvals for a Merger or Share Exchange – Ordinary mergers or share exchanges require the recommendation of both boards and an affirmative vote of the majority of the shareholders, unless a supramajority is required by the articles or bylaws. The approval of the surviving corporation’s shareholders is not required if the number of voting shares are increased by less than 20 percent.

The approved articles of merger or share exchange must be filed with the secretary of state, who usually issues a certificate of merger or share exchange.

If the parent corporation owns 90 percent or more of the stock in the subsidiary corporation, a short-form merger procedure requiring only the approval of the board of the parent corporation is employed.

Sale or Lease of Assets – A corporation may dispose of all or substantially all of its property upon the recommendation of the board and an affirmative vote of the majority of the shareholders.

Dissenting Shareholder Appraisal Rights – Shareholders objecting to a short-form merger or an ordinary merger have a right to dissent and receive payment of the fair market value of their shares, upon written notice to the corporation, provided that they have not voted in favor of the action. When the action is taken, the dissenting shareholders must be paid. If they are dissatisfied with the payment, they may petition the court to determine if the payment is fair.

Section 4: Tender Offers

Tender Offers – If the board of the targeted corporation does not approve the merger, the acquiring corporation can make a tender offer for the shares directly to the shareholders. This is often referred to as a hostile tender offer, and can be made for all or a portion of the shares.

The Williams Act – This amendment to the SEC Act regulates all tender offers and establishes disclosure requirements and antifraud provisions.

Tender Offer Rules – The Williams Act does not require that a tender offeror notify the target company or the SEC prior to making the offer, but once made, all terms and conditions must be disclosed.

The offer cannot close for at least 20 business days, and may be extended for 10 business days if either the number of shares or price is increased.

The fair price rule requires that the increased price must be paid for all shares, even those previously tendered.

The pro rata rule requires that if too many shares are offered, they must be purchased on a pro rata basis.

Antifraud Provisions – Fraudulent, deceptive, and manipulative practices can result in civil and/or criminal charges.

Leveraged Buyouts – The tender offeror identifies a target and, with the aid of a loan from a commercial bank and junk bonds sales from an investment broker, commences a hostile takeover of the target.

Fighting a Tender Offer – Incumbent management has a number of tools available to fight a tender offer. The easiest include persuading shareholders it is not in their interests, issuing additional stock, and creating ESOPs.

Some have tried using delaying lawsuits alleging violations of antitrust or security laws.

Management may choose to sell a crown jewel, making it less attractive, or adopting a poison pill defensive strategies calling for expiration or significant increases in contracts should the company be taken over.

White knight mergers are mergers with friendly parties that will leave the target corporation intact.

Some organizations resort to Pac-Man or reverse tender offers and try to take over the tender offeror.

Flip-over and flip-in rights plans provide for conversion of existing shareholders stocks (flip-over) or debt-securities (flip-in) in the acquirer.

The tender offeror may respond to these techniques with a standstill agreement and not purchase any additional stock or with greenmail, where they agree to discontinue their takeover if the target firm buys back the stock at a premium.

Business Judgment Rule – Boards of directors are protected from shareholder actions if they made informed, honest decisions in good faith.

Section 5: Shareholder Resolutions

Many states have enacted antitakeover statutes aimed at protection of corporations incorporated within their borders that have been challenged as unconstitutional.

V. Answers to Business Law Cases

Proxy Disclosure

10.1. Yes, Sanford E. Lockspeiser, a shareholder of Western Maryland Company, stated a claim for relief for violation of federal proxy disclosure rules. The core of Lockspeiser’s complaint was that Western only disclosed the acreage of its mineral and timber holdings and the book value of these assets, when it should have disclosed the tonnage of mineral holdings, timber holdings in board feet, and the actual value of the assets owned by Western. The test for determining the

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materiality of an omission from a proxy statement is set forth in TSC Industries v. Northway, Inc., 426 U.S. 438, 96 S. Ct. 2126 (1976):

An omitted fact is material if there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote. It does not require proof of a substantial likelihood that disclosure of the omitted fact would have caused the reasonable investor to change his vote. What the standard does contemplate is a showing of a substantial likelihood that, under all the circumstances, the omitted fact would have assumed actual significance in the deliberations of the reasonable shareholder.

The court held that the information about the coal and timber reserves and the actual market value of Western’s assets was significant for a shareholder to make a choice because there was no established market for the company’s stock and First Boston Company, the investment banker hired by Western to give a fairness opinion, did not independently evaluate Western’s assets. The court held that Lockspeiser stated a claim for relief alleging material omission in Western’s proxy materials. Lockspeiser v. Western Maryland Company, 768 F.2d 558 (4th Cir. 1985).

Proxy Contest

10.2. The Gladwins win. The court held that Medfield Corporation’s proxy materials contained multiple instances of material misstatements and material omissions of fact in violation of Section 14(a) of the Securities Exchange Act of 1934 and the applicable proxy disclosure rules adopted by the Securities and Exchange Commission. The court held that Medfield had (1) failed to disclose the nature and extent of Medfield’s liabilities, (2) failed to disclose self-dealing by a director, and (3) unlawfully impugned the character, integrity, and personal reputation of a rival candidate for office. The court ordered a new election. It also directed that Medfield’s new proxy solicitation materials include corrections of all illegal misstatements and omissions, a statement that prior solicitations were in violation of Section 14(a) and SEC proxy rules, and an explanation that the resolicitation was the result of a lawsuit. Gladwin v. Medfield Corporation, 540 F.2d 1266 (5th Cir. 1976).

Proxy Contest

10.3. Fairchild Engine and Airplane Corporation wins. The court held that the corporation could pay both the incumbents’ and insurgents’ costs in waging the proxy contest. If a proxy contest is fought over policy issues and not for personal reasons, the incumbent management is reimbursed for the costs of the proxy contest whether they win or lose it. Based on the fact that the proxy contest in this case was waged over policy issues, the court held that the incumbent directors were entitled to have their costs and expenses of the proxy contest to be paid by Fairchild.

Also, if an insurgent group is successful in unseating incumbent directors in a proxy contest waged over policy issues, the corporation may, upon approval of the majority of the shareholders, reimburse the insurgent directors for their costs and expenses of waging the proxy contest. In this case, the court permitted the insurgents to be reimbursed for the costs of the proxy contest because (1) the contest related to policy issues, (2) the insurgents were successful in the proxy contest, and (3) the majority of the shareholders ratified the payment of these expenses to the insurgents. Thus in this case, Fairchild paid for both sides’ costs of the proxy contest. Rosenfeld v. Fairchild Engine and Airplane Corporation, 128 N.E.2d 291 (N.Y.App. 1955).

Shareholder Resolution

10.4. Yes, the Medical Committee’s proposed shareholder resolution could be stated in terms to meet the requirements of Section 14(a) to be included in Dow Chemical’s proxy materials. If a shareholder meets the ownership requirements of Section 14(a) (which the Committee met), he has a right to place a proposal in the proxy materials of the corporation if the proposal relates to the corporation’s business, concerns a policy issue and not the day-to-day operations of the corporation, and does not solely relate to a social or religious purpose.

In this case, Dow Chemical was manufacturing napalm, a chemical substance that was used as a defoliant in Vietnam during the Vietnam conflict. Napalm, which was often dropped from airplanes, caused damage to humans who were burned by it and those who were exposed to it. There was substantial public criticism and demonstration against Dow for making napalm. In addition, many young people of college age refused to work for Dow because of its manufacture of napalm.

These reasons—the bad publicity and inability to recruit young professionals—were sufficient to support the Committee’s request to include its shareholder proposal in Dow’s proxy materials. In addition, the Committee could have also asserted that Dow’s manufacture of napalm made it susceptible to product liability lawsuits by those injured by it. Each of these are reasons that the Committee could have asserted to support the inclusion of its shareholder proposal in Dow’s proxy materials. Merely stating that the making of napalm violated the Commission’s credo for the concern for human life would not be sufficient to require the proposal to be included in Dow’s proxy materials. Medical Community for Human Rights v. Securities and Exchange Commission, 432 F.2d 659 (D.C.Cir. 1970).

Dissenting Shareholder Appraisal Rights

10.5. No, John Bershad may not obtain dissenting shareholder appraisal rights. To obtain appraisal rights, a dissenting shareholder must (1) file a written objection to the merger prior to the vote of shareholders, (2) not vote in favor of the proposed merger, and (3) make a written demand for payment of his shares. Failure to comply with these statutory procedures results in loss of appraisal rights.

In this case, Bershad failed to comply with the statutory requirements. He failed to make a written objection to the merger prior to the vote of shareholders, he tendered his shares for the merger and received payment for his shares, and he failed to make a written demand for payment of his shares. The court held that since Bershad did not meet the statutory procedure, he did not qualify to bring an action to recover dissenting shareholder appraisal rights or any other remedy. Bershad v. Curtiss-Wright Corporation, 535 A.2d 840 (Del. 1987).

Tender Offer

10.6. Mobil Corporation wins. The court held that Marathon Oil Company had violated Section 14(e) of the Williams Act. Section 14(e) prohibits fraudulent, deceptive, and manipulative practices in connection with tender offers. The court held that both the stock option and Yates Field option that Marathon granted to U.S. Steel was a fraudulent, deceptive, and manipulative practice in violation of Section 14(e).

First, the stock option was fraudulent in that it gave U.S. Steel the right to purchase 30 million shares of Marathon common stock for $90 per share. This was fraudulent because it was below the fair market value of the stock, which was currently around $125 per share. This stock option violated Section 14(e) because it subsidized U.S. Steel’s purchase of Marathon. No other suitor, particularly Mobil, was given this same right.

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Second, the Yates Field option which gave U.S. Steel the irrevocable right to purchase Marathon’s interest in Yates Field for $2.8 billion if a third party gained control of Marathon violated Section 14(e). This was because the fair market value of Marathon’s interest in the Yates Field was worth up to $3.6 billion. This is called selling the “crown jewel” because Marathon was selling one of the most important assets that attracted Mobil to make the tender offer for Marathon’s share in the first place.

The court held that both the stock option and Yates Field option granted by Marathon to U.S. Steel violated Section 14(e) of the Williams Act. The court ordered that U.S. Steel’s $125 per share offer be kept open for a reasonable time but free of the inhibiting and unlawful impact of these two options. Note: U.S. Steel acquired Marathon Oil through a tender offer and follow-up merger. Mobil Corporation v. Marathon Oil Company, 669 F.2d 366 (6th Cir. 1981).

Tender Offer

10.7. Yes, the actions of Fruehauf’s management violated the business judgment rule. The business judgment rule requires management of a company to act in good faith and in the best interests of the corporation’s shareholders. Management must not put their personal interests before those of the company’s shareholders. In this case, the court held that the management and directors of Fruehauf violated the business rule in the following respects:

1. The payment of a breakup fee to Merrill Lynch—which was payable even if the management-led MBO was not misuse of the corporation’s funds. This was really a payment by competing management-led MBO to Merrill Lynch out of the corporate treasury.

2. The “no shop” agreement violated Fruehauf management’s responsibility to shareholders to find the best and highest price for their shares. This can hardly be done when management has agreed not to look for a higher bidder to compete with their own bid for the company.

3. Fruehauf management’s continued preference for their own bid over that of the Edelman group by giving Merrill Lynch information not given to the Edelman group was a violation of their duty to give all suitors an equal opportunity to bid for the company.

4. Granting such lucrative “golden parachutes” to themselves, which would be triggered by their own bid for the company and used as their equity investment to purchase the company, violated their fiduciary duty to the shareholders.

The court held that all of the actions by Fruehauf’s management was a breach of their fiduciary duties to shareholders and a violation of the business judgment rule. The court enjoined Fruehauf management from instituting their actions. Edelman v. Fruehauf Corporation, 798 F.2d 882 (6th Cir. 1986).

Poison Pill Defense

10.8. Household International, Inc., wins. The court held that the “flip-over” Rights Plan adopted by the directors of Household did not violate the business judgment rule. The court cited the fact that the Plan was adopted to ward off future advances and was not adopted in reaction to a specific threat. Thus, the court held that such preplanning for the contingency of hostile takeover reduces the risk that, under the pressure of a takeover bid, management will fail to exercise reasonable judgment.

The court also held that the Plan was reasonable because it was not absolute. That is, the consequences of the Rights Plan can be avoided if the potential takeover company negotiates with the management of Household regarding the terms of a merger or other form of acquisition.

Further, the court held that the proxy contest was for control of Household. The court held that there was no showing of bad faith on the part of Household’s directors who receive the benefit of the business judgment rule in their adoption of the Rights Plan. In addition, the court held that Household demonstrated that the Rights Plan was reasonable in relation to the threat posed. Moran v. Household International, Inc., 500 A.2d 1346 (Del. 1985).

State Antitakeover Statute

10.9. The court held that Wisconsin’s antitakeover statute was lawful and did not conflict with the federal Williams Act or violate the Commerce Clause of the U.S. Constitution. The Court of Appeals reached this decision by applying the reasoning used by the U.S. Supreme Court in upholding a state antitakeover statute in CTS Corporation v. Dynamics Corporation of America, 481 U.S. 69, 107 S. Ct. 1637 (1987).

The court in the present case held that the Williams Act regulates the process of tender offers, i.e., timing, disclosures, proration, best price rule, and such. None of these provisions are violated by the Wisconsin act; it does not alter any of the procedures governed by federal regulation. The court also held that the Wisconsin act does not unduly burden interstate commerce. It is an accepted part of the business landscape in this country for states to create corporations, prescribe their powers, and regulate their internal affairs. Wisconsin has done no more than that in this case. The court held that the Wisconsin antitakeover statute did not conflict with the Williams Act or violate the Commerce Clause of the U.S. Constitution. Amanda Acquisition Corporation v. Universal Foods, 877 F.2d 496 (7th Cir. 1989), cert. denied 110 S.Ct. 367, 107 L.Ed.2d 353 (1989).

VI. Answers to Issues in Business Ethics Cases

10.10. The fair value of minority shareholders’ shares of Universal Pictures Company is $92.75 per share. Defendant claims that Universal, at the time of the merger, was a weak wasting asset in a declining industry and calculated the fair value of its shares at that time as $52.36. The dissenting shareholders describe a different view of the corporation. Their Universal is described as a company ideally situated to profit from both a rejuvenated theatrical market and the emerging new highly profitable television market in which it has established itself. The appraiser agreed with the stockholders. However, he refused to give the benefit of all inferences as to the specific value factors they maintained and arrived at a value of $91.76. The court revised the figure to $92.75. Francis I. Du Pont & Co. v. Universal City Studios, Inc., 312 A.2d 344 (Del. Ch. 1973).

10.11. Realist is not liable to Royal. The court of appeals held that although Section 14(a) gives a normal shareholder the right to sue incumbent management for alleged false and misleading statements in management’s proxy materials, a proxy contestant does not have this same right even though the contestant is a shareholder in the target corporation. The court stated that giving a proxy contestant a private right of action for damages would not advance the underlying purpose of Section 14(a), that is, to protect normal shareholders from fraudulent conduct. The court also found no causal nexus between Royal’s alleged injury and Realist’s secret merger negotiations with Ammann. The court stated, “The only injury the plaintiffs suffered was caused by their involvement as combatants in an election they won—but one where, in retrospect, they would rather not have entered.” Royal Business Group, Inc. v. Realist, Inc., 933 F.2d 1056 (1st Cir. 1991).

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VII. Terms

business judgment rule—A rule that protects the decisions of the board of directors, who act on an informed basis, in good faith, and in the honest belief that the action taken was in the best interests of the corporation and its shareholders.

consolidation—Occurs when two or more corporations combine to form an entirely new corporation.

crown jewel—A valuable asset of the target corporation’s that the tender offeror particularly wants to acquire in the tender offer.

dissenting shareholder appraisal rights—Shareholders who object to a proposed merger, share exchange, or sale or lease of all or substantially all of the property of a corporation have a right to have their shares valued by the court and receive cash payment of this value from the corporation.

fair price rule—A rule that says any increase in price paid for shares tendered must be offered to all shareholders, even those who have previously tendered their shares.

fiduciary duty—The duty the directors of a corporation owe to act carefully and honestly when acting on behalf of the corporation.

greenmail—The purchase by a target corporation of its stock from an actual or perceived tender offeror at a premium.

merger—Occurs when one corporation is absorbed into another corporation and ceases to exist.

Pac-Man tender offer—Occurs when a corporation that is the target of a tender offer makes a reverse tender offer for the stock of the tender offeror.

pro rata rule—A rule that says shares must be purchased on a pro rata basis if too many shares are tendered.

proxy card—A written document signed by a shareholder that authorizes another person to vote the shareholder’s shares.

proxy contest—When opposing factions of shareholders and managers solicit proxies from other shareholders, the side that receives the greatest number of votes wins the proxy contest.

proxy statement—A document that fully describes (1) the matter for which the proxy is being solicited, (2) who is soliciting the proxy, and (3) any other pertinent information.

Section 14(a)—Provision of the Securities Exchange Act of 1934 that gives the SEC the authority to regulate the solicitation of proxies.

Section 14(e)—A provision of the Williams Act that prohibits fraudulent, deceptive, and manipulative practices in connection with a tender offer.

share exchange—When one corporation acquires all the shares of another corporation and both corporations retain their separate legal existence.

short-form merger—A merger between a parent corporation and a subsidiary corporation that does not require the vote of the shareholders of either corporation or the board of directors of the subsidiary corporation.

state antitakeover statutes—Statutes enacted by state legislatures that protect corporations incorporated in or doing business in the state from hostile takeovers.

target corporation—The corporation that is proposed to be acquired in a tender offer situation.

tender offer—An offer that an acquirer makes directly to a target corporation’s shareholders in an effort to acquire the target corporation.

tender offeror—The party that makes a tender offer.

Williams Act—An amendment to the Securities Exchange Act of 1934 made in 1968 that specifically regulates all tender offers.

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Chapter 11Investor Protection

and Online Securities Transactions

Fraud is infinite in variety: sometimes it is audacious and unblushing: sometimes it pays a sort of homage to virtue, and then it is modest and retiring: it would be honesty itself, if it could only afford it.

Lord MacNaghten

I. Teacher to Teacher Dialogue

One of the most unfortunate aspects of our overly litigious society is the notion that the government must somehow “cover” every loss. Witness the current costs of the so-called S & L bailout, which has already achieved the dubious distinction of being this country’s most costly financial debacle. We do not mean to say that we should allow every innocent depositor to suffer the losses incurred by the managers of these institutions. Nor can we afford to allow our financial institutions to lose their foundations of reliance and trust. The government does have a proper role and duty to support this financial infrastructure. But should the rules remain the same for stock investors as opposed to depositors? Many commentators argue that when investment choices are made, these choices should bring a higher degree of awareness and risk.

It is a risk that must be fully emphasized at the outset of these materials. No government, no agency, no set of statutory protections can immunize a stock investor from the basic economic reality of stock investment—risk of loss. This risk was there before the Great Depression, and will be there no matter how many SECs, CFTCs, and the like we create.

Assume a sporting event were to be contested under the following conditions:

a. All the players were well trained.

b. The rules of the game were fully explained to the players.

c. Those rules are fairly and evenhandedly applied to the players.

d. An even playing field is used as a site for the contest.

With all these suppositions in place, can you rest assured your team will win? Or you can hope that, win or lose, your team was engaged in a fair contest?

In the broadest sense, the buying and selling of securities is similar to an athletic event. Each participant goes into the game with his or her own self-interest in mind. And all the fair rules in the world will not change one essential truth of these or any other contests—there will be winners and there will be losers. That reality must always be kept in mind from the outset by anyone seeking to make his or her fortune through the sale or purchase of securities. Risk is inherent in the nature of this activity, and anyone who fails to appreciate that simple fact should not be there in the first place.

It is most difficult for professionals to master the ins and outs of the financial markets, let alone the casual investor. Yet the lure of playing this game is so strong that every year millions of people invest hard-earned money with nothing more than high hopes and a prayer. Securities law was designed to at least give some substance to those hopes and prayers. That substance is public information upon which investment choices can be rationally made. These laws are not designed to assure a win in this high-risk game, but rather to provide a more even playing field.

The great financial stock market crash of 1929 and the ensuing Depression brought on by that calamity brought to the fore the need to create a greater governmental role in securities markets. Prior to that period, the sale of stocks in corporations remained essentially unregulated except for the common law doctrines of fraud and the like. Manipulative and unscrupulous trading practices coupled with a lot of hopes and prayers all pointed to a need for a better set of ground rules by which this game could be played.

The basic rules of the game go back to the Securities Act of 1933 and the Securities Exchange Act of 1934 that created the Securities and Exchange Commission. Over the years, the Commission’s role has greatly increased with the advent of new technologies like programmed trading and the need to expand its regulatory framework into the financial services arena. Because of recent scandals in this sector of the economy, a number of new white-collar crimes have been added to the government’s arsenal for dealing with abuses. All in all, it has made the specialized practice of securities law or SEC accounting more difficult, yet more challenging, than ever.

II. Chapter Objectives

Define a security for purposes of federal and state securities laws.

Describe how securities are registered with the Securities and Exchange Commission.

Describe the requirements for qualifying for intrastate and small offering exemptions from registration.

Describe the requirements for qualifying for a private placement exemption from registration.

Define insider trading that violates Section 10(b) of the Securities Exchange Act of 1934.

Describe the liability of tippers and tippees for insider trading.

Describe the criminal liability and penalties for violating federal securities laws.

Describe short-swing profits that violate Section 16(b) of the Securities Exchange Act of 1934.

Describe how the Racketeer Influenced and Corrupt Organizations Act (RICO) applies to securities, law, and cases.

Describe state blue-sky securities laws.

III. Key Question Checklist

What are the key elements of the Securities Act of 1933?

What are the key elements of the Securities Act of 1934?

What other related statutes may apply?

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IV. Text Materials

Section 1: The Securities and Exchange Commission (SEC)

The SEC is an administrative agency reporting to the president and charged with adopting rules relative to securities, investigating violations, and regulating security brokers and advisors.

Definition of a Security – Securities are interests or instruments that are expressly mentioned in securities acts, stock, bonds, debentures, warrants, and investment contracts.

Case 11.1. Securities and Exchange Commission v. Edwards

Facts: Edwards was chairman, CEO, and sole shareholder in ETS Payphones, Inc., a package deal which sold payphones with a 5-year leaseback and operation by ETS, and a guaranteed monthly return and final payout. The payphones failed to generate sufficient revenues for ETS to make the guaranteed payouts. ETS defaulted and then declared bankruptcy. The SEC brought an action against Edwards and ETS, alleging that they had failed to register the sale-and-leaseback arrangement as a security with the SEC, committing securities fraud. The District Court held that the scheme was, in fact, a security, but the Court of Appeals reversed. The SEC appealed to the U.S. Supreme Court.

Issue: Is the payphone sale-and-leaseback agreement that guaranteed a fixed rate of return a security and therefore subject to federal securities laws?

Decision: Yes.

Reason: The Supreme Court held that the intention of Congress was to regulate investments in all forms, and that an investment arrangement offering a fixed rate of return is subject to the provisions of the federal securities law.

Section 2: Going Public, The Securities Act of 1933

The Securities Act of 1933 regulates the issuance of securities, requiring registration of a registration statement with the SEC. An issuer or investment banker sells the securities through an initial public offering.

Registration Statement – Issuers must file a registration statement with the SEC containing descriptions of the security being offered, the registrant’s business, management information, pending litigation, how the proceeds will be used, government regulations that affect the issued security, the degree of competition in the industry, and any special risk factors.

Registration statements become effective 20 days after filing, unless the SEC requires additional information. A new 20-day period starts with every amendment, although the registrant can request an acceleration of the effective date.

Prospectus – This is a written disclosure document that helps investors evaluate the risk involved.

Limitations on Activities During the Registration Process – Section 5 of the Securities Act limits types of activities during the prefiling period, when the issuer is restricted from selling or offering the security, and cannot condition the market. The waiting period starts after the registration is filed and continues until the SEC declares it effective, during which the issuer cannot sell the security, but they can make oral offers to sell it, distribute a preliminary prospectus and a summary prospectus, as well as publish tombstone ads. In the posteffective period after the registration is effective and until all of the securities are sold or withdrawn, the issuer can close all deals.

Sales of Unregulated Securities – Investors may rescind the purchase and recover damages for securities that should have been registered and were not.

Regulation A Offerings – A simplified registration process has been developed for sales of up to $5 million during a twelve-month period.

SCOR forms allow small businesses to raise up to $1 million by answering a number of questions on a simplified disclosure form, with offering prices at the rate of common stock, but not less than $5 per share.

Violations of the Securities Act of 1933 – Violations may result in penalties.

Private Actions – The act imposes civil liabilities on violators of Section 5. Private parties may choose to rescind the purchases or sue for damages. Civil liability is also imposed for damages when a registration statement misstates or omits a material fact under the doctrines of fraud and negligence.

SEC Actions – The SEC can issue a consent order where the defendant agrees to not violate any SEC laws in the future, but does not admit to any wrongdoing; it can bring an action for an injunction; or it can ask for ancillary relief.

Criminal Liability – Criminal liability of fines of up to $5000 and five years in prison may be imposed on anyone willfully violating the Securities Act.

Section 3: Private and Other Transactions Exempt from Registration

Nonissuer Exemption – Average investors do not have to file a registration statement prior to reselling securities.

Intrastate Offerings – An exemption is given to allow local investors to invest without the need of SEC registration provided the issuer is a resident of the state, they are doing business in the state, and the purchasers are residents of the state.

Private Placements – This exemption allows issuers to raise capital from an unlimited number of investors without a dollar limit if the individual investors have a net worth of at least $1 million with an annual income over the last two years of at least $200,000, if they are an organization with at least $5 million in assets, or if they are insiders to the issue.

Small Offerings – Rule 504 exempts sales not exceeding $1 million in twelve months.

Resale Restrictions – Intrastate, private placements, and small offering are restricted and cannot be resold for a limited period after purchase.

Preventing Transfer of Restricted Securities – Investors are required to sign an affidavit that they are aware that the securities are not transferable, place a legend on the stock certificate describing the restriction, and notify the transfer agent not to record a transfer of any securities that would violate the restriction.

Rule 144A – Qualified institutional investors may buy unregistered securities without being subject to holding periods.

Securities Exempt from Registration – Exempt securities include those issued by any government within the United States, short-term notes and drafts with a maturity date of nine months or less, securities issued by nonprofits, those issued by financial institutions and common carriers, insurance and annuity contracts, stock dividends and splits, and exchanged securities. Once exempt, always exempt.

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Section 4: Trading in Securities – The Securities Exchange Act of 1934

Section 10(b) and Rule 10b-5 – These prohibit the use of manipulative and deceptive devices, or engaging in any acts that would be considered fraudulent or deceitful, or making any untrue statements or omitting material facts by an issuer in the sale or transfer of any security.

Insider Trading – When company employees or advisors use material nonpublic information to profit, it is considered insider trading and illegal.

Insiders – Insiders are defined as officers, directors, and employees of the company; lawyers, accountants, consultants, and other agents; and others who owe a fiduciary duty to the organization.

Case 11.3. United States v. O’Hagan

Facts: James O’Hagan, a partner in the law firm of Dorsey & Whitney, began purchasing call options for Pillsbury stock. Each option gave O’Hagan the right to purchase 100 shares. In the meantime, Grand Metropolitan hired Dorsey and Whitney to represent it in a secret tender offer for stock of Pillsbury. When the tender offer was publicly announced, Hagan had purchased 5,000 shares at $39 per share; those shares went to $60. The SEC investigated, and the Justice Department charged O’Hagan with criminally violating Section 10(b) and Rule 10b-5. O’Hagan lost.

Issue: Can a defendant be criminally convicted of violating Section 10(b) and Rule 10b-5 based on misappropriation theory?

Decision: Yes.

Reason: The misappropriation theory comports with Section 10(b)’s language, and it was property applied in this case.

Tipper-Tippee Liability – The person who discloses information to the tippee is the tipper, and is liable for the profits made by the tippee, who is liable for acting on information that is not public.

Violations of the Securities and Exchange Act of 1934 – Both civil and criminal penalties may be assessed for violations.

Private Actions – Although not expressed in Section 10(b) and Rule 10b-5, courts have implied a right for private parties to rescind the contracts or recover damages.

SEC Actions – The SEC may enter into consent orders, seek injunctions, or seek court orders for disgorgement.

Criminal Liability – Section 32 of the SEA makes it a criminal offense to knowingly violate the provisions. Further, additional fines can be laid under Sarbanes-Oxley.

Sarbanes-Oxley Act – The SEC may issue an order prohibiting any violator from serving as an officer or director of a public company.

Section 5: Short-Swing Profits

Section 16(a) defines insiders as any executive officers, directors, or ten percent shareholders.

Section 16(b) – Profits from trades involving securities occurring within six months of each other belong to the company.

SEC Section 16 Rules – The SEC has adopted various rules concerning Section 16. They have defined an officer as one who performs policy-making functions, relieved insiders of liability for transaction that occurred within the 6 months before becoming an insider, and continue to hold them responsible for transactions that occur within 6 months of being an insider.

Section 6: State Securities Laws

Most states have enacted blue-sky laws, which require the registration of certain securities, while exempting others.

V. Answers to Business Law Cases

Definition of a Security

11.1. Yes, the Dare sales scheme is a security that should have been registered with the Securities and Exchange Commission (SEC). In SEC v. W.J. Howey Co., the U.S. Supreme Court defined an “investment contract” as a scheme that involves (1) an investment of money (2) in a common enterprise (3) with the profits to come solely from the efforts of others. The Supreme Court stated that this definition should be broadly and flexibility construed.

The court applied the Howey test in the instant case and held that the Dare multilevel sales scheme was an investment contract. There was obviously an investment of money in a common enterprise. The only difficult issue was whether the Dare plan derived profits for the investors from the efforts of others. The court held that the word “solely” should not be read literally. The court held although investors must exert some effort—mainly convincing friends, neighbors, and others to attend the Adventure Meetings—primarily their profits came from the efforts of others, i.e., from the efforts of the Dare people at the meetings to convince the attendees to sign up and pay money for one of the Adventure levels.

The court held that the Dare multilevel sales scheme was an “investment contract” and therefore a security that had to be registered with the SEC before it was sold. The court held that Turner had sold unregistered securities in violation of securities laws and granted an injunction against Turner from selling any more Dare plans.

Note: Previous purchasers could sue to rescind the purchase agreement and recover the money they paid. Securities and Exchange Commission v. Glenn W. Turner Enterprises, Inc., 474 F.2d 476 (9th Cir. 1973).

Definition of a Security

11.2. The notes issued by the Co-Op are “securities.” In order for the defendant, Ernst & Young, to be subject to federal securities laws in this case, the instrument at issue must be found to be a security. The U.S. Supreme Court found the note issued by the Co-Op to be a security, thus subjecting the Co-Op’s auditor, Ernst & Young, to a securities lawsuit. The Supreme Court applied a “family resemblance test” in finding the note a security. The Court reasoned that the notes were securities because (1) the Co-Op sold them to raise capital, (2) there was common trading in the notes, (3) the public reasonably perceived from advertisements for the sale of the notes that they were investments, and (4) there was no risk-reducing factor that would make the application of the Securities Acts unnecessary. Thus, the notes are securities that are subject to federal securities laws. Reeves v. Ernst & Young, 495 U.S. 56, 110 S.Ct. 945, 108 L.Ed.2d 47 (1990).

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Transaction Exemption

11.3. No, the sale of the Continental securities by Wolfson and his family and associates does not qualify for an exemption from registration as a sale “not by an issuer, underwriter, or dealer.” The Court held that an issuer includes any person who directly or indirectly controls the issuer. In this case, Wolfson controlled Continental. He was its largest shareholder, made the policy decisions for the corporation, and controlled and directed the company’s officers.

The court found that the defendants had tried to conceal the sale of the securities by selling them over an 18-month period through many different brokers. The court held that these sales constituted a major “distribution” of Continental securities that should have been registered with the Securities Exchange Commission if the sales did not qualify for an exemption from registration. The court held that the securities sales did not qualify as a sale “not by an issuer” because Wolfson had been found to have been in control of the issuer of the securities—Continental. The court held that Wolfson and his family and associates should have registered the securities with the SEC, and that they had violated Section 5 of the Securities Act of 1933 because they had not registered the securities.

Note: On the witness stand, the defendants took the position that they operated at a level of corporate finance far above such “details” as securities laws and were too busy with “large affairs” as to bother themselves with such minor matters as securities laws. The court, obviously, rejected this defense. United States v. Wolfson, 405 F.2d 779 (2nd Cir. 1968).

Insider Trading

11.4. No, Chiarella is not criminally liable for violating Section 10(b) of the Securities Exchange Act of 1934. The U.S. Supreme Court reversed the trial court’s judgment that had convicted Chiarella on all counts. The Court of Appeals affirmed the conviction by holding that anyone—an insider or not—who receives material nonpublic information may not use that information to trade in securities until the information is made public. The U.S. Supreme Court rejected this rule, holding that a person is not liable for insider trading under Section 10(b) unless he owes a duty to disclose the information. The Supreme Court held that this duty only arises if the person owes a fiduciary duty to the company in whose shares he has traded.

The Supreme Court held that Chiarella did not owe a fiduciary duty to the target companies of whose shares he purchased. The court stated:

Not every instance of financial unfairness constitutes fraudulent activity under Section 10(b). The element required making silence fraudulent—a duty to disclose—is absent in this case. No duty could arise from Chiarella’s relationship with the sellers of the target company’s securities for Chiarella had no prior dealings with them. He was not their agent, he was not a fiduciary, and he was not a person in whom the sellers had placed their trust and confidence. He was, in fact, a complete stranger who dealt with the sellers only through impersonal market transactions. We hold that a duty to disclose under Section 10(b) does not arise from the mere possession of nonpublic market information.

The U.S. Supreme Court reversed Chiarella’s conviction. Chiarella v. United States, 445 U.S. 222, 100 S.Ct. 1108, 63 L.Ed.2d 348 (1980).

Section 10(b)

11.5. The plaintiff investors win and may sue the defendants for the alleged violations of Section 10(b) of the Securities Exchange Act of 1934. The defendants had asserted that the common-law defense of in pari delicto (“unclean hands”) prohibited the plaintiffs from suing because they had participated in the fraud with the defendants, i.e., the plaintiffs thought they were trading on “inside information” when they purchased the TONM securities. Under the in pari delicto theory, if two parties to illegal conduct are mutually or equally at fault, they cannot use the court system to sue the other party to the illegal conduct. The issue in the instant case is whether the in pari delicto theory should be applied to securities laws.

The U.S. Supreme Court held that the in pari delicto theory does not apply to actions brought for alleged violations of securities laws. Thus, the plaintiffs in this case who had participated in the insider-trading scheme with the defendants could sue the defendants for disclosing false inside information to them. The Supreme Court stated: “We conclude that the public interest will most frequently be advanced if defrauded tippees are permitted to bring suit and to expose illegal practices by corporate insiders and broker dealers to full public view for appropriate sanctions.” The court held that the in pari delicto theory did not apply to suits alleging violations of Section 10(b) and that the plaintiffs could maintain their lawsuit against the defendants. Bateman Eichler, Hill Richards, Inc. v. Berner, 472 U.S. 299, 105 S.Ct. 2622, 86 L.Ed.2d 215 (1985).

Insider Trading

11.6. The Sullair Corporation (Sullair) wins and, under Section 16(b) of the Securities Exchange Act of 1934, may recover the profits made by Hoodes on the sale and purchase of the securities of Sullair securities. The court held that Section 16(b) is a “flat rule” which imposes strict liability for profits earned by any officer or director or 10 percent shareholder who purchases and sells or sells and purchases equity securities of his corporation within a period of less than six months.

The court found that Hoodes, who was an officer of Sullair, was a statutory insider for purposes of Section 16(b). The court held that the Section 16(b) rule applied whenever the defendant held his position at the time of the initial transaction that gave rise to his liability. The court found that the two transactions—the sale of securities by Hoodes on July 20 and the purchase of securities on August 20—had occurred within six months of each other and were covered by Section 16(b). The court held that the corporation could recover $11,350 from Hoodes—the difference between the price he sold the original 6,000 shares for on July 20, 1982 ($38,350) and the fair market value of the 6,000 shares he purchased on August 20, 1982 ($27,000). Sullair Corporation v. Hoodes, 672 F.Supp. 337 (N.D.Ill. 1987).

VI. Answers to Issues in Business Ethics Cases

11.7. Business Ethics: No, each of the limited partnership offerings does not alone qualify for a private placement offering exemption from registration. To qualify for a private placement offering, the following requirements must be met: (1) there is no dollar limit on the amount of securities sold; (2) there is no limit on the number of accredited investors, but there is a limit of 35 unaccredited investors; and (3) disclosure of material financial and other information must be made to the investors.

In applying these requirements to the instant case, the court held that (1) Intertie had not kept track of the qualifications or the number of unaccredited investors; (2) the investors were not given material financial and other information about Intertie or its financial difficulties: (3) the investors were not informed that the limited partnerships could not support themselves or that partnership funds were being commingled; and (4) the investors were not informed that Intertie

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and the limited partnerships was a pyramid or “Ponzi” scheme whereby the funds raised in later partnership offerings were used to support earlier partnerships. The court held that each limited partnership did not on its own qualify for a private placement exemption because there were too many unaccredited investors and the investors were not provided with adequate disclosure of material information.

Integration: In addition, the court integrated all of the thirty limited partnership offerings into one offering. Separate securities offerings will be integrated if they are made about the same time, involve the same class of securities, are sold for the same consideration, and the proceeds are used for the same purpose. Here, the court found the existence of sufficient factors to integrate the offerings. The court held that this one integrated offering did not qualify for a private placement exemption from registration because there were too many unaccredited investors and material financial and other information was not disclosed to the investors. The court issued an injunction against Murphy. Securities and Exchange Commission v. Murphy, 626 F.2d 633 (9th Cir. 1980).

11.8. R. Foster Winans, a reporter for the Wall Street Journal, was one of the writers of the “Heard on the Street” column, a widely read and influential column in the Journal. This column frequently included articles that discussed the prospects of companies listed on national and regional stock exchanges and the over-the-counter market. David Carpenter worked as a news clerk at the Journal. The Journal had a conflict of interest policy that prohibited employees from using nonpublic information learned on the job for their personal benefit. Winans and Carpenter were aware of this policy.

Kenneth P. Felis and Peter Brant were stockholders at the brokerage house of Kidder Peabody. Winans agreed to provide Felis and Brant with information that was to appear in the “Heard” column in advance of its publication in the Journal. Generally, Winans would provide this information to the brokers the day before it was to appear in the Journal. Carpenter served as a messenger between the parties. Based on this advance information, the brokers bought and sold securities of companies discussed in the “Heard” column. During 1983 and 1984, prepublication trades of approximately 27 “Heard” columns netted profits of almost $690,000. The parties used telephones to transfer information. The Wall Street Journal is distributed by mail to many of its subscribers.

Eventually, Kidder Peabody noticed a correlation between the “Heard” column and trading by the brokers. After an SEC investigation, criminal charges were brought against defendants Winans, Carpenter, and Felis in U.S. district court. Brant became the government’s key witness. Winans and Felix were convicted of conspiracy to commit securities, mail, and wire fraud. Carpenter was convicted of aiding and abetting the commission of securities, mail, and wire fraud. The defendants appealed their convictions. Can the defendants be held criminally liable for conspiring to violate, and aiding and abetting the violation of Section 10(b) and Rule 10b-5 of securities law? Did Winans act ethically in this case? Did Brant act ethically by turning government’s witness?

R. Foster Winans was a reporter for the Wall Street Journal in the early 1980s, when he wrote a column called "Heard on the Street,” in which he discussed the future prospects of companies and their securities.    His positive comments would increase the value of the stock; his negative would deflate the value.  Winans leaked his columns to Peter Brant and Kenneth Felis in exchange for a share of the profits.   When this was discovered, Winans was found guilty of the federal crimes of mail and wire fraud, and insider trading. 

Winans acted unethically by artificially creating a desire for the stocks through his column (a violation of Section 10(b))and collaborating with Felis, Brany, and Carpenter to cash in on this.  Because the defendants used by telephone and mail systems (telephone calls and the mail distribution of the Wall Street Journal), they were found to be in violation of the Rule 10b-5.

The question of whether Brandt acted ethically by turning government's witness is one that can be debated by the students.  Was he just trying to get off easier, or was he truly repented of his acts?  Is there honor amongst thieves?

In fact, in 1988 he had a book Trading Secrets published by St. Martins of New York, which detailed his activities in insider trading.   New York had enacted a "Son of Sam" statute.  These statutes preclude criminals from making a profit on a crime, and require both the author and publisher to relinguish all profits from sales of such materials over to the New York victim's compensation agency.   Simon & Schuster, another publisher, had brought suit and the Supreme Court held that the "Son of Sam" law violates the Freedom of Speech Clause of the U.S. Constitution.   United States v. Carpenter , 484U.S. 19. 108 S.Ct. 316, 1987 U.S.Lexis 4815 (U.S.Sup.Ct.).

VII. Terms

due diligence defense—A defense to a Section 11 action that, if proven, makes the defendant not liable.

final prospectus—A final version of the prospectus that must be delivered by the issuer to the investor prior to or at the time of confirming a sale or sending a security to a purchaser.

insider trading—When an insider makes a profit by personally purchasing shares of the corporation prior to public release of favorable information or by selling shares of the corporation prior to the public disclosure of unfavorable information.

Insider Trading Sanctions Act of 1984—A federal statute that permits the SEC to obtain a civil penalty of up to three times the illegal benefits received from insider trading.

intrastate offering exemption—An exemption from registration that permits local businesses to raise capital from local investors to be used in the local economy without the need to register with the SEC.

posteffective period—The period of time that begins when the registration statement becomes effective and runs until the issuer either sells all of the offered securities or withdraws them from sale.

prefiling period—A period of time that begins when the issuer first contemplates issuing the securities and ends when the registration statement is filed. The issuer may not condition the market during this period.

private placement exemption—An exemption from registration that permits issuers to raise capital from an unlimited number of accredited investors and no more than 35 nonaccredited investors without having to register the offering with the SEC.

Private Securities Litigation Reform Act of 1995—Provides a safe harbor from liability for companies that make forward-looking statements that are accompanied by meaningful cautionary statements of risk factors.

prospectus—A written disclosure document that must be submitted to the SEC along with the registration statement and given to prospective purchasers of the securities.

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Racketeer Influenced and Corrupt Organizations Act (RICO) – A federal statute that provides for both criminal and civil penalties.

registration statement—Document that an issuer of securities files with the SEC that contains required information about the issuer, the securities to be issued, and other relevant information.

restricted securities—Securities that were issued for investment purposes pursuant to the intrastate, private placement, or small offering exemption.

Section 10(b)—A provision of the Securities Exchange Act of 1934 that prohibits the use of manipulative and deceptive devices in the purchase or sale of securities in contravention of the rules and regulations prescribed by the SEC.

Section 11—A provision of the Securities Act of 1933 that imposes civil liability on persons who intentionally defraud investors by making misrepresentations or omissions of material facts in the registration statement or who are negligent for not discovering the fraud.

Section 12—A provision of the Securities Act of 1933 that imposes civil liability on any person who violates the provisions of Section 5 of the act.

Section 16(a)—A section of the Securities Exchange Act of 1934 that defines any person who is an executive officer, a director, or a 10 percent shareholder of an equity security of a reporting company as a statutory insider for Section 16 purposes.

Section 16(b)—A section of the Securities Exchange Act of 1934 that requires that any profits made by a statutory insider on transactions involving short-swing profits belong to the corporation.

Section 24—A provision of the Securities Act of 1933 that imposes criminal liability on any person who willfully violates the 1933 act or the rules or regulations adopted thereunder.

Section 32—A provision of the Securities Exchange Act of 1934 that imposes criminal liability on any person who willfully violates the 1934 act or the rules or regulations adopted thereunder.

Securities Act of 1933—A federal statute that primarily regulates the issuance of securities by corporations, partnerships, associations, and individuals.

Securities and Exchange Commission (SEC)—Federal administrative agency that is empowered to administer federal securities laws. The SEC can adopt rules and regulations to interpret and implement federal securities laws.

Securities Exchange Act of 1934—A federal statute that primarily regulates the trading in securities.

security—(1) An interest or instrument that is common stock, preferred stock, a bond, a debenture, or a warrant, (2) an interest or instrument that is expressly mentioned in securities acts, and (3) an investment contract.

small offering exemption—For the sale of securities not exceeding $1 million during a 12-month period.

tippee—The person who receives material nonpublic information from a tipper.

tipper—A person who discloses material nonpublic information to another person.

waiting period—A period of time that begins when the registration statement is filed with the SEC and continues until the registration statement is declared effective. Only certain activities are permissible during the waiting period.

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Chapter 12Employment, Worker Protection, and Immigration Laws

It is difficult to imagine any grounds, other than our own personal economic predilections, for saying that the contract of employment is any the less an appropriate subject of legislation than are scores of others, in dealing with which this Court has held that legislatures may curtail individual freedom in the public interest.

Justice Stone

I. Teacher to Teacher Dialogue

This chapter reviews the major legislative enactments that have been superimposed upon the employer/employee relationship. In many ways, government is a silent third party whose presence is pervasive at the bargaining table. It sets the rules not only of how the bargain is to be struck, but it also has had a much more active involvement in the ongoing employment relationship after the initial bargain is struck. This three-part marriage of employer, employee, and Uncle Sam is not always a happy one.

A phrase commonly used in the area of pension and employee benefits law is “golden ball and chain.” This description is meant to illustrate the two-sided nature of the prerequisites associated with the employment relationship. On one side, the gold comes from the financial security afforded by a steady income and the various employment-related insurance protections designed to protect one from the vicissitudes of life. The ball and chain aspect comes from the price paid for those perks. This cost not only includes the obvious time and energy commitments involved in doing one’s job, but also the lost opportunity costs associated with having chosen one employer over others. For many the employment relationship becomes one of love-hate or at least a standoff based on economic necessity.

In the past, the dominant contractual form this relationship has taken has been found in the employment at will doctrine. This doctrine assumes that given equal bargaining power, and absent express or implied agreement to the contrary, either the employee or employer may end the relationship. This termination can come about at any time, for any reason, bilaterally or unilaterally. The doctrine has long been under fire as being myopic on two main scores: It presumes equality of bargaining power between the employer and employee and that the employment relationship is totally a private contractual matter between the contracting parties.

Recent cases and legislative enactments have greatly eroded the doctrine. On the legislative front, a number of states have decided that public policy interests in favor of certain kinds of activities must take precedent over the employer/employee relationship. Examples would include retirement fund laws, protecting jobs of employees that need to take time off for medical emergencies for themselves or their immediate family, setting minimum pay rates, and employee health and safety protections. In addition, a number of courts have seen fit to interpret employer handbooks, written and oral job policies, and other acts as indicia of an implied contract between

the employer and employee. What may have appeared originally to be the employee’s economic ball and chain has also become the employer’s.

The simple truth is that there is a growing involvement of government at every step of the employer-employee relationship. It sets the ground rules for hiring, working conditions, paying for harm, termination, and ultimate payment of pensions and or death benefits. It all has come a long way from the simplistic and archaic notion that the employment contract is only the business of the immediate parties involved.

II. Chapter Objectives

Define the employment at-will doctrine.

Explain how state workers’ compensation programs work and describe the benefits available.

Describe the employer’s duty to provide safe working conditions under the Occupational Safety and Health Act.

Describe the minimum wage and overtime pay rules of the Fair Labor Standards Act.

Explain the rules governing private pensions under the Employment Retirement Income Security Act.

III. Key Question Checklist

Define the employer-employee relationship.

What restrictions are placed on that relationship?

What government rules apply to the employer-employee relationship?

What employees are covered under FMLA?

What are the current requirements for employers under IRCA?

What are the ERISA rules affecting private pensions?

IV. Text Materials

Section 1: Employment at Will

Most employees are at-will employees, which means that they do not have employment contracts and can be discharged at any time, as well as being able to leave at any time. This does not mean that an at-will employee that is wrongfully discharged cannot sue the employer for damages and other remedies.

Exceptions to the Employment At-Will Doctrine – At-will employees cannot be discharged if they are members of labor unions and the discharge would be in violation of either federal labor laws or collective bargaining agreements. They are also protected from wrongful discharge if an implied-in-fact contract was created or if the termination violates public policy, like discharging someone on juror duty or an employee called up for active service.

Wrongful discharge tort actions can be based in fraud, brought for intentional infliction of emotional distress or defamation of character.

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Section 2: Workers’ Compensation

These acts were enacted by the states in order to respond to the problems caused by the common law practice, which required employees to sue employers if they were injured on the job. Common law subjected the employee to a lengthy litigation process with uncertain results.

Workers’ Compensation Insurance – Employers are required to purchase insurance or to be self-insured in order to cover workers’ compensation claims for employees.

Employment-Related Injury – Claimants must prove that their injuries arose from their work in order to get recovery.

Exclusive Remedy – Workers’ compensation is an exclusive remedy and the employee may not sue the employer for damages unless the employer intentionally causes the injuries.

Section 3: Occupational Safety

The Occupational Safety and Health Act was enacted in 1970, establishing OSHA and imposing record-keeping requirements on employers.

Specific and General Duty Standards – OSHA standards address both specific duties, like establishing safety requirements for equipment, and general duty standards, such as providing a work environment free from hazards.

Section 4: Fair Labor Standards Act (FLSA)

Child Labor – The FLSA forbids the use of oppressive child labor, and allows the Department of Labor to establish regulations defining permissible child labor.

Minor Wage and Overtime Pay Requirements – FLSA establishes minimum wage and overtime pay requirements for hourly employees. Managers, administrative workers, and professionals are excluded from these requirements. Workers cannot be required to work more than 40 hours in a week unless they are paid time-and-a-half. The 40 hours apply to every week in the pay cycle.

Business Ethics: Microsoft Violates Employment Law – Microsoft’s attempt to classify these employees as independent contractors clearly failed a number of the IRS’s tests and was a practice clearly aimed at cost savings. Approximately 35 percent of employee costs are in the form of benefits, employment tax share paid by employer, and administrative costs, which would not have to be paid for an independent contractor. Additional savings from the stock options would accrue.

Section 5: Family and Medical Leave Act

Passed in 1993, FMLA provides certain employees unpaid time off from their job for medical emergencies involving themselves, their children, spouse, or parent, provided that they have performed more than 1250 work hours over the previous twelve-month period.

Section 6: Consolidated Omnibus Budget Reconciliation Act (COBRA)

COBRA provides that a terminated employee or his beneficiaries must be offered the opportunity to continue his group health insurance at the group rate plus administration fees.

Section 7: Employee Retirement Income Security Act (ERISA)

If employers offer pension plans, ERISA establishes the record-keeping, disclosure, and other requirements that will apply to them. It also establishes how and when an employee will become vested in the plan.

Section 8: Immigration Reform and Control Act (IRCA)

The U.S. Immigration and Naturalization Service administer both the IRCA and the Immigration Act of 1990. Every employer is required to complete an INS Form I-9 for every employee, ensuring that the employee is either a U.S. citizen, or qualified to work within the U.S. borders.

Section 9: Government Programs

Unemployment Compensation – Employers are required to pay unemployment contributions to assist employees that are temporarily unemployed under FUTA and various state laws. Unemployment compensation packages are administered by the state.

Social Security – The Social Security system provides limited retirement and death benefits to certain employees and their beneficiaries.

FICA requires that both employers and employees make contributions into the Social Security fund, just as the Self-Employment Contributions Act requires that self-employed individuals make similar contributions.

V. Answers to Business Law Cases

Workers’ Compensation

12.1. Albanese wins. In general, if an employee is incapacitated by a mental or emotional disorder causally related to a series of specific stressful work-related incidents, the employee is entitled to compensation. In defining whether an employee has a “mental or emotional disorder,” the terms are used in a general sense rather than a specific one. Although Albanese had been employed by Atlantic Steel Company for approximately twenty years, the court determined that his current condition was not the result of general stress or the wear and tear of working, but specific stressful episodes. These specific stressful episodes, which occurred over a relatively short period of time as compared to his twenty years of employment, combined with the casual nexus between Albanese’s working conditions and his emotional disorder, entitles Albanese to compensation under the Workers’ Compensation Act. Albanese’s Case, 389 N.E.2d 83 (Mass 1979).

Occupational Safety

12.2. The Occupational Safety and Health Review Commission prevails because an employer is required to furnish a safe place of employment for its employees. The court stated that to violate the Occupational Safety and Health Act, the secretary must prove that (1) the employer failed to render its workplace “free” of a hazard that was (2) recognized, and (3) causing or likely to cause death or serious physical harm. In this case, the failure to pressure test a pressure vessel before activation was an apparent and obvious hazard that was likely to cause serious injury. Furthermore, it created an extremely high probability of rupture and ensuing harm. Thus, the court stated that it is clear the hazard at issue here was both “recognized” and likely to cause

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serious harm, as well as preventable by the simple expedient of pressure testing. Getty Oil Company v. Occupational Safety and Health Review Commission, 530 F.2d 1143 (5th Cir. 1976).

ERISA

12.3. The secretary of labor wins because the trustees breached their fiduciary duty in violation of the Employee Retirement Income Security Act (ERISA). ERISA requires that an administrator or trustee of a pension benefit plan administer the plan as a fiduciary. A fiduciary is required to perform his duties regarding the plan with the “care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man acting in like capacity and familiar with such matters would use in the conduct of an enterprise of like character and with like aims.” The court held that the obligation to act prudently requires the plan fiduciaries to act as a prudent man participating in a similar transactions such as by obtaining a fair return commensurate with prevailing or market rates on planned investments. In the present case, the trustees failed to act prudently. They failed to require evidence of the borrower’s ability to repay the loans, to charge fair market rates of interest, to enter into a written agreement describing the terms and conditions of the loans, and to repay the loans when they became due. Thus, the court found that the trustees had violated their fiduciary duties and required them to resign their positions as trustees of the plan. McLaughlin v. Rowley, 698 F. Supp. 1333 (N.D. Tex. 1988).

Unemployment Benefits

12.4. The CTA wins. The court following Sec. 602(A) of the Unemployment Insurance Act stated “an individual shall be ineligible for benefits for the week (or time period) in which he has been discharged for misconduct connected with his work.” The court defined misconduct as behavior that is willful or a wanton disregard of an employer’s interests. Such interests include the intentional and substantial disregard of the employee’s duties and obligations to his employer. In this case, Devon Overstreet’s use of cocaine prior to reporting for work constituted a deliberate violation of her employer’s policy and indicated a disregard of the standards of behavior that the employer had the right to inspect. Overstreet v. Illinois Department of Employment Security, 522 N.E.2d 185 (Ill.App. 1988).

VI. Answers to Issues in Business Ethics Cases

12.5. The intentional tort exception did not apply in this case. The undisputed evidence compels no other conclusion than that there was no intentional tort. Though a number of employees had received shocks from the apparatus, there is no evidence that anyone, except for the decedent, suffered a similar electrocution. All of those employees who previously received the shocks suffered no more than a transient physical buzz or numbing. These minor incidents occurred over a period where there was a continuous, daily use of the apparatus at a busy manufacturing assembly line. Given these circumstances, an electrocution could not have been envisioned as a certain danger.

Moreover, it is undisputed that the Nordyne’s management, once aware of the apparatus’s problem, took measures, however effective they may have been, to repair the apparatus. Nordyne’s management also took another safety measure: warning the employees of the possibility of shocks. If anything, these remedial measures would have diminished the likelihood of any future electrical shocks. These measures would not have made an electrocution a certainty.

To be sure, there was a risk of an injury arising from the use of the testing apparatus. Some, such as the plaintiff’s expert, may even assert that the risk was quite high because the apparatus was defectively designed and built. However, given the record presented here, including the pleadings, briefs, affidavits, and deposition testimony of Bryson and Kendra, there is simply no evidence indicating that the electrocution injury was certain to occur at Nordyne’s manufacturing plant in Holland, Michigan, on April 20, 1988. Glockzin v. Nordyne, Inc., 815 F. Supp. 1050 (N.D. Mich. 1992).

12.6. Employees can engage in self-help under certain circumstances under OSHA regulations. The secretary of labor has promulgated a regulation providing that an employee may choose not to perform his assigned tasks if he has a reasonable apprehension of death or serious injury coupled with a reasonable belief that no less drastic alternative is available, without being subject to subsequent discrimination. The issue here is whether that regulation is valid. The fundamental purpose of OSHA is to prevent occupational deaths and serious injuries. This legislation is broad in nature. It would be anomalous to construe this act as to not allowing the employee to withdraw from a dangerous workplace. Further, there is an affirmative duty on all employers to provide a safe workplace. Since an OSHA inspector cannot be present all the time, this regulation allows the employee to get the benefit of a safe workplace in all circumstances. The regulation is valid. Whirlpool Corp. v. Marshall, Secretary of Labor, 445 U.S. 1, 100 S.Ct. 883, 63 L.Ed.2d 154 (1980).

VII. Terms

at-will employees—Employees who do not have employment contracts.

Consolidated Omnibus Budget Reconciliation Act (COBRA)—Federal law that permits employees and their beneficiaries to continue their group health insurance after an employee’s employment has ended.

Employee Retirement Income Security Act (ERISA)—A federal act designed to prevent fraud and other abuses associated with private pension funds.

Federal Insurance Contributions Act (FICA)—A federal act that says employees and employers must make contributions into the Social Security fund.

Federal Unemployment Tax Act (FUTA)—A federal act that requires employers to pay unemployment taxes; unemployment compensation is paid to workers who are temporarily unemployed.

general duty—A duty that an employer has to provide a work environment “free from recognized hazards that are causing or are likely to cause death or serious physical harm to his employees.”

Immigration Reform and Control act of 1968 (IRCA)—A federal statute that makes it unlawful for employers to hire illegal immigrants.

implied-in-fact contract—A contract where agreement between parties has been inferred because of their conduct.

INS Form I-9—A form that must be filled out by all U.S. employers for each employee; states that the employer has inspected the employee’s legal qualifications to work.

Occupational Safety and Health Act—A federal act enacted in 1970 that promotes safety in the workplace.

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public policy exception—An exception to the employment at-will doctrine that states an employee cannot be discharged if such discharge violates the public policy of the jurisdiction.

Self-Employment Contributions Act—A federal act that says self-employed persons must pay Social Security Taxes equal to the combined employer-employee amount.

Social Security—Federal system that provides limited retirement and death benefits to covered employees and their dependents.

specific duty—An OSHA standard that addresses a safety problem of a specific duty nature (e.g., requirement for a safety guard on a particular type of equipment).

workers’ compensation acts—Acts that compensate workers and their families if workers are injured in connection with their jobs.

wrongful discharge—The discharge of an employee in violation of a statute, an employment contract, or public policy, or tortiously. As a result, the employee can recover damages and other remedies.

Chapter 13Equal Opportunity in Employment

What people have always sought is equality of rights before the law. For rights that were not open to all equally would not be rights.

Cicero

I. Teacher to Teacher Dialogue

Discrimination and equal opportunity are hard materials to present to students. As instructors, we need to be careful to first clearly define the terms illustrated by the two sides of the word “discrimination.” Second, be sure to present both sides of every argument. This is especially important in the most controversial areas such as affirmative action. After all arguments have been listed, be sure to have students engage in open debate, allowing all sides to be heard, not just the politically correct ones. If the class as a whole wants to take only one side, we owe it to fair inquiry and academic freedom to put forward opposite views, even if we personally do not support those views. Teaching these materials is never easy, but remains always exciting. As the Rev. Martin Luther King Jr. once said, “It may be true that the law cannot make a man love me. But it can keep him from lynching me, and I think that’s pretty important.”

Few American legal issues are inflamed with more controversy than discrimination in the workplace. The genesis of our nation’s heritage is rooted in a diversity of peoples who immigrated to the New World in order to flee the royalist, class, or caste systems that so often predestined their opportunities for social and economic advancement. The U.S. Declaration of Independence, and the government founded on it, became the first major system of self-governance premised on the assumption that all persons are born equal and should be treated equally in the eyes of the law. As we all know, that equality has often been a hope rather than a reality for many. For all of the rhetoric in the early days of the United States, freedom and equality meant equality only for free or freed men, not women, and slavery still existed in many of the states.

The same diversity that has been a source of national pride has also been the basis of disparate treatment of persons in the workplace for many years. The term “discriminate” has within it two distinct and opposite meanings. On the positive side, discrimination is simply a fact of life. We are not all equal in all ways. We have different talents, strengths, levels of training, and abilities. Employers, in turn, should be allowed and expected to seek utilization of these divergent talents and strengths in their own best interests. To discriminate in the positive sense is to reward ability and merit on its face. The positive aspect of discrimination really says that uniqueness should be discerned, differentiated, distinguished, and rewarded in the workplace. In the end, economic marketplace factors are blind to any other factors but job performance. Like it or not, positive discrimination is a simple economic necessity that is no different than the laws of nature and cannot be ignored. For example, you cannot expect the average man on the street to play golf as well as Tiger Woods. He, in turn, is duly rewarded for these talents.

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The negative side of discrimination is found in wrongful selection processes. For a society founded on a premise of equality, we have certainly had more than our share of unequal treatment in the workplace. The negative side of discrimination is inequality of treatment based on wrongful motive, justifications, or rationalizations. Each choice not based on talent, ability, and merit is a step away from the inherent basis of equality before the law. Wrongful discrimination is like cancer. Sooner or later, once it is allowed to grow unchecked, it will kill. None of us can afford to look the other way and say: “It’s not my problem.” Wrongful discrimination against any group is a wrong upon the society at large. Almost everyone appreciates that fact intuitively, if not intellectually.

One element that provides hope for positive change is goodwill. Where people of goodwill cling to the basic rightness of equity before the law, that equity will eventually result in a changed culture. Until then, law and our courts will continue to be the testing grounds for this monumental change in the social order. It may sound corny, but we all must do our part to live and let live.

We like to point out to my students that within the next 5 to 10 years, Caucasians will become a minority, as the Latin population continues to soar. Shifts in the work force as more women get degrees and seek employment will further affect the current job situations.

II. Chapter Objectives

Describe the scope of coverage of Title VII of the Civil Rights Act of 1964.

Identify race, color, and national origin discrimination that violates Title VII.

Identify sex discrimination—including sexual harassment—that violates Title VII.

Describe the scope of coverage of the Age Discrimination in Employment Act.

Describe the protections afforded by the Americans with Disabilities Act of 1990.

III. Key Question Checklist

What type of discrimination is being alleged?

What statutory remedies are available?

Which remedy is most suitable for your case?

IV. Text Materials

Section 1: Equal Employment Opportunity Commission (EEOC)

The EEOC is the federal administrative agency responsible for enforcing most of the federal antidiscrimination laws.

Section 2: Title VI of the Civil Rights Act

Title VII of the Civil Rights Act, the Fair Employment Practices Act, was passed to eliminate job discrimination in the hiring, maintaining, and termination of employees based on the protected classes of race, color, national origin, sex, and religion.

Scope of Coverage of Title VII – Title VII applies to employers of 15 or more employees, all employment agencies, labor unions with 15 or more members, state and local governments, and most federal agencies. Any employee, including undocumented aliens, may bring an action under Title VII.

Forms of Title VII Actions – Title VII prohibits both disparate-treatment and disparate-action discrimination. Disparate-treatment is the situation in which an employer treats a specific individual less favorable based on their race, color, national origin, sex, or religion. Disparate-impact discrimination is when an employer discriminates against an entire protected class. To prove disparate-action, the plaintiff must show a causal link.

Procedure for Bringing a Title VII Action – The complainant must first file a complaint with the EEOC. The EEOC will then elect to either sue the employer on the employee’s behalf or issue a right to sue letter to the complainant giving the employee the right to bring the suit himself.

Remedies for Violation of Title VI – A successful plaintiff may recover back pay, reasonable attorneys’ fees, and equitable remedies.

Race, Color, and National Origin Discrimination – Title VII protects against discrimination based on broad categories of race, the color of one’s skin, and the country of a person’s ancestry.

Sex Discrimination – This is applied equally to both men and women. The Pregnancy Discrimination Act forbids discrimination because of pregnancy or the potential for becoming pregnant.

Sexual Harassment – Sexual harassment in the workplace includes lewd remarks, touching, intimidation, posting indecent materials, verbal and physical conduct of sexual nature, among other behaviors. The courts will look to see if the work environment is hostile or abusive, as opposed to being merely an offensive utterance, and whether the action unreasonably interferes with work performance.

Same-Sex Discrimination – The Supreme Court has held that same-sex discrimination violates Title VII.

Religious Discrimination – Although religious discrimination is prohibited under Title VI, the right of an employee to practice his religion is not absolute. Employers must make reasonable accommodations for religious observances and practices, as long as they do not pose an undue hardship.

Defenses to a Title VII Action – Employers can refute claims of discrimination by proving that they selected or promoted employees based on merit or seniority. Further, the courts allow discrimination based on protected classes if it can be shown to be a bona fide occupational qualification (BFOQ),

Case 13.2: International Union, etc. v. Johnson Controls, Inc.

Facts: A primary ingredient in Johnson Control’s battery manufacturing process is lead, occupational exposure to which entails health risks, including the risk of harm to any fetus carried by a female employee. After eight of its employees became pregnant while maintaining blood lead levels exceeding that were noted by the Occupational Safety and Health Administration (OSHA) as critical for a worker planning to have a family, respondent announced a policy barring all women, except those whose infertility was medically documented, from jobs involving actual or potential lead exposure exceeding the OSHA standard. Petitioners, a group including employees affected by respondent’s fetal-protection policy, filed a class action in the District Court, claiming that the policy constituted sex discrimination violating Title VII of the Civil Rights Act of 1964, as amended. The court granted summary judgment for respondent, and the Court of Appeals affirmed. The latter court held that the proper standard for evaluating the policy

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was the business necessity inquiry applied by other Circuits and that respondent was entitled to summary judgment because petitioners had failed to satisfy their burden of persuasion as to each of the elements of the business necessity defense. Respondent was entitled to summary judgment because its fetal-protection policy is reasonably necessary to further the industrial safety concern that is part of the essence of respondent’s business.

Issues: Is Johnson Control’s fetal-protection policy a BFOQ?

Decision: Title VII, as amended by the Pregnancy Discrimination Act (PDA), forbids sex-specific fetal-protection policies.

Reason: Blackmun, J. By excluding women with childbearing capacity from lead-exposed jobs, respondent’s policy creates a facial classification based on gender and explicitly discriminates against women on the basis of their sex under Sec. 703(a) of Title VII. Moreover, in using the words “capable of bearing children” as the criterion of exclusion, the policy explicitly classifies on the basis of potential for pregnancy, which classification must be regarded, under the PDA, in the same light as explicit sex discrimination. The Court of Appeals erred in assuming that the policy was facially neutral because it had only a discriminatory effect on women’s employment opportunities, and because its asserted purpose, protecting women’s unconceived offspring, was ostensibly benign. The policy is not neutral because it does not apply to male employees in the same way as it applies to females, despite evidence about the debilitating effect of lead exposure on the male reproductive system. Also, the absence of a malevolent motive does not convert a facially discriminatory policy into a neutral policy with a discriminatory effect.

Respondent cannot establish a BFOQ. Fertile women, as far as appears in the record, participate in the manufacture of batteries as efficiently as anyone else. Moreover, respondent’s professed concerns about the welfare of the next generation do not suffice to establish a BFOQ of female sterility.

Title VII, as amended by the PDA, mandates that decisions about the welfare of future children be left to the parents who conceive, bear, support, and raise them rather than to the employers who hire those parents or the courts. An employer’s tort liability for potential fetal injuries and its increased costs due to fertile women in the workplace do not require a different result. The incremental cost of employing members of one sex cannot justify a discriminatory refusal to hire members of that gender.

Section 3: Civil Rights Act of 1866

This act was enacted to give freed slaves the same rights as Caucasians, prohibiting racial and national origin.

Section 4: Equal Pay Act

The Equal Pay Act protects both sexes from pay discrimination based on sex, covering all private, state, and local employees, but not federal employees. Pay disparity is not allowed if the jobs require equal skill, effort, responsibility, and similar working conditions. It is allowed in payment systems based on seniority, merit, quantity or quality of product, and shift differentials.

Employees may bring a private action seeking back pay and liquidated damages. The successful employee will have their pay raised to the level of the other worker.

Section 5: Age Discrimination in Employment Act

ADEA prohibits discrimination against employees who are age 40 or older. It covers all nonfederal employers with at least 20 employees, labor unions with at least 25 members, employment agencies, and most state, local, and federal employees. The Older Workers Benefit Protection Act extended this protection to employee benefits.

Protected Age Categories – Originally, ADEA covered workers between 40 and 65, it has been extended twice to cover all employees over 40.

Successful plaintiffs can recover back pay, attorneys’ fees, and equitable remedies.

Section 6: Americans with Disabilities Act

Title 1 of the ADA – This law prohibits discrimination against individuals with qualified disabilities, and covers employers with 15 or more employees, with the exception of the federal government, corporations wholly owned by the U.S., and bona-fide tax-exempt private clubs. Title 1 requires employers to make reasonable accommodations for employees with disabilities if it does not cause an undue burden on the employer.

Qualified Individual with a Disability – Any person who, with or without reasonable accommodation, can perform the essential functions of a job, is considered to be a qualified individual with a disability. To be disabled, one must have an impairment that substantially limits a major life activity, have a record of the impairment, and be regarded as being impaired.

Forbidden Conduct – Title 1 restricts an employer from asking about the disability, but may query the applicant’s ability to perform job-related functions. Medical examinations may be given only after an offer has been extended, but may be a condition of starting work, provided all employees are subject to the same test.

Procedures and Remedies – The complainant must first file a complaint with the EEOC. The EEOC will then elect to either sue the employer on the employee’s behalf or issue a right to sue letter to the complainant giving the employee the right to bring the suit himself.

Successful plaintiffs may recover hiring with back pay, reinstatement to a position, attorneys’ fees, compensatory damages, and punitive damages.

Section 7: Affirmative Action

Affirmative action plans provide preferential treatment to members of protected classes. These plans must be narrowly tailored to achieve a compelling interest, and are highly controversial.

Reverse Discrimination - The courts have held that reverse discrimination is illegal, if the affirmative action plan is based on percentage quotas, and have allowed the majority class to sue under Title VII.

Section 8: State and Local Government Antidiscrimination Laws

Most state and local governments have adopted similar laws prohibiting discrimination.

V. Answers to Business Law Cases

Sex Discrimination

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13.1. Yes, the practice of requiring female employees to make larger contributions to the pension fund than male employees constitutes sex discrimination in violation of Title VII. Although the Supreme Court acknowledged that as a class, women do live longer than men, it is not true that all individuals of the respective classes will do so. In fact, many women do not live as long as the average man and many men outlive the average woman. It is clear that any individual’s life expectancy is based on a number of factors, of which sex is only one.

Note: Although the Supreme Court found a violation of Title VII, it reversed the District Court’s award of retroactive relief to the entire class of female employees and retirees. In doing so, the court cited the potential economic impact that such an award would cause to insurance companies and pension plans. Thus, the challenged practice was only outlawed in the future. City of Los Angeles Department of Water and Power v. Manhart, 435 U.S. 702, 98 S.Ct. 1370, 55 L.Ed.2d 657 (1978).

Hostile Work Environment

13.2. Yes, the conduct of the male employees and manager of RDC in this case constitutes sexual harassment in violation of Title VII by creating a hostile work environment. The court held that an employer can be held liable for sexual harassment of its employees under the doctrine of respondeat superior (let the master answer) if the employer either (1) had actual knowledge of the harassment or (2) the harassment was so pervasive that an inference of constructive knowledge arises. In this case, Huddleston made out a prima facie case against RDC for the sexual harassment attributable to the sales manager of RDC. Huddleston v. Roger Dean Chevrolet, Inc., 845 F.2d 900 (11th Cir. 1988).

National Origin Discrimination

13.3. Yes, the FBI is liable for a pattern or practice of discrimination in violation of Title VII. The court held that the FBI’s actions constituted unlawful national origin discrimination against Hispanic agents. As a remedy, the court ordered that those Hispanic agents who had been discriminated against would be awarded additional seniority to make them whole had such discrimination not occurred. The court ordered that an independent panel be created to decide these claims. In addition, the court ordered the FBI to overhaul its system of promoting Hispanic agents and those from other minority groups to eliminate any discriminatory practice. The court did not grant an award of back pay. Perez v. Federal Bureau of Investigation, 714 F.Supp. 1414 (W.D. Texas 1989).

Religious Discrimination

13.4. No, TWA is not liable for religious discrimination in violation of Title VII. The Supreme Court held that TWA had taken all actions necessary to reasonably accommodate Hardison’s religious preference. The court held that TWA could not force other employees to work in place of Hardison without violating the collective bargaining agreement with the union that would be a violation of federal labor law.

The Supreme Court also held that TWA did not have to meet Hardison’s request to work only a four-day workweek. The court reasoned that this would give Hardison an employment benefit that would be based on religion, which would itself be religious discrimination against the other employees of TWA. Further, the court held that this would cause an undue hardship on TWA by

requiring it to hire and train a part-time employee to work Saturdays only or to incur the additional cost of paying overtime wages to a current employee to work overtime on Saturdays. Thus, TWA did not violate Title VII. Trans World Airlines v. Hardison, 432 U.S. 63, 97 S.Ct. 2264, 53 L.Ed.2d 113 (1977).

Bona Fide Occupational Qualification

13.5. No, the city and county of Honolulu are not liable for violating Title VII. The court held that the ability to communicate clearly in English was a bona fide occupational qualification (BFOQ) for the position. Because of the required contact with a sometimes-contentious public, the ability to speak clear English was one of the most important skills required for the position. Since Fragante’s English oral skills were hampered by his accent and manner of speaking, he did not meet the bona fide occupational qualification for the job, and was therefore properly denied the position. The court found that the inability to communicate well in English was not a cover for unlawful discrimination. Fragante v. City and County of Honolulu, 888 F.2d 591 (9th Cir. 1989).

Age Discrimination

13.6. Fite wins the lawsuit. At age 57, Fite was protected by the Age Discrimination in Employment Act. The court held that the Association engaged in unlawful age discrimination when it retired Fite. The court found that the Association’s stated reason for retiring Fite—his poor job performance—was a mere pretext for engaging in age discrimination. Fite made a prima facie case of age discrimination against the association. The court affirmed a jury award of $270,000 damages and $71,373 attorneys’ fees against the Association. Fite v. First Tennessee Production Credit Association, 861 F.2d 884 (6th Cir. 1989).

VI: Answers to Issues in Business Ethics Cases

13.7. Rawlinson proved a prima facie case of sex discrimination by showing that the racially neutral height and weight restrictions disparately impacted upon women. The trial court found that the height rule excluded over 32 percent of women but less than 2 percent of men. The weight requirement excluded over 22 percent of women but less than 2.5 percent of men. Together, these restrictions would exclude over 41 percent of women but less than 1 percent of men. Dothard argues that height and weight are job related, because they have a relationship to strength that is required. The court held that a strength test should be given to establish strength, rather than using height and weight, for which there was no correlation proven.

The essence of a prison guard’s job is to maintain order. A woman’s relative ability to maintain order in a male, maximum security, unclassified prison could be directly reduced by her womanhood. There is a basis for expecting that sex offenders who have attacked women before would do so again in prison. Also, there is a real risk from other prisoners who are deprived of a normal, heterosexual environment. This is a threat not only to the victim, but also to the safety of the other inmates. Thus, in this case, the applicant’s womanhood directly undermines her ability to do the job. (NOTE: Generally, the woman should be able to decide what employment risks she wants to take. Here, it is not her safety that the court is protecting; it is the safety of the other inmates. ALSO NOTE: There is no evidence that women guards are more subject to attacks than men guards; this was an assumption made by the state.) Dothard, Director, Department of Public Safety of Alabama v. Rawlinson, 433 U.S. 321, 97 S.Ct. 2720, 53 L.Ed.2d 786 (1977).

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13.8. Machakos wins. The court held that Title VII of the Civil Rights Act of 1964 prohibits racial discrimination against all races, including whites. In this case, the court found that the CRD had engaged in reverse discrimination against Machakos in violation of Title VII. The court found that the CRD’s systematic policy of unlawful minority preference in hiring had adversely impacted the plaintiff, ordered that Machakos be promoted, and awarded Machakos back pay retroactive to when she should have been promoted had the CRD not discriminated against her. Machakos v. Attorney General of the United States, 859 F.2d 1487 (D.C. Cir. 1988).

VII. Terms

affirmative action—Policy that provides that certain job preferences will be given to minority or other protected class applicants when an employer makes an employment decision.

Americans with Disabilities Act (ADA) of 1990—Imposes obligations on employers and providers of public transportation, telecommunications, and public accommodations to accommodate individuals with disabilities.

bona fide occupation qualifications (EFOQ)—Employment discrimination based on a protected class (other than race or color) is lawful if it is job related and a business necessity. This exception is narrowly interpreted by the courts.

disparate impact discrimination—Occurs when an employer discriminates against an entire protected class. An example would be where a facially neutral employment practice or rule causes an adverse impact on a protected class.

disparate treatment discrimination—Occurs when an employer discriminates against a specific individual because of his or her race, color, national origin, sex, or religion.

Equal Employment Opportunity Commission (EEOC)—The federal administrative agency responsible for enforcing most federal antidiscrimination laws.

equal opportunity in employment—The right of all employees and job applicants (1) to be treated without discrimination and (2) to be able to sue employers if they are discriminated against.

Equal Pay Act of 1963—Protects both sexes from pay discrimination based on sex extends to jobs that require equal skill, equal effort, equal responsibility, and similar working conditions.

Pregnancy Discrimination Act—Amendment to Title VII that forbids employment discrimination because of “pregnancy, childbirth, or related medical conditions.”

qualified individual with a disability—A person who (1) has a physical or mental impairment that substantially limits one or more of his or her major life activities, (2) has a record of such impairment, or (3) is regarded as having such impairment.

religious discrimination—Discrimination against a person solely because of his or her religion or religious practices.

reverse discrimination—Discrimination against a group that is usually thought of as a majority.

sex discrimination—Discrimination against a person solely because or his or her gender.

sexual harassment—Lewd remarks, touching, intimidation, posting pinups, and other verbal or physical conduct of a sexual nature that occur on the job.

Title VII of the Civil Rights Act of 1964 (Fair Employment Practices Act)—Intended to eliminate job discrimination based on five protected classes: race, color, religion, sex, or national origin.

Chapter 14International and World Trade Law

“International law, or the law that governs between nations, has at times, been like the common law within states, a twilight existence during which it is hardly distinguishable from morality or justice, till at length the imprimatur of a court attests its jural quality.”

Justice Cardozo

I. Teacher to Teacher Dialogue

From the teaching perspective, this chapter presents challenges that are similar to those of trying to bring ethics into mainline business law teaching. In both cases, we have had an awareness of the importance of these issues all along. But they have tended to be treated as peripheral or collateral to the substantive black letter law that occupied most of our class time. Well, history has a way of overcoming the present. And recent history has shown us that we can no longer afford to treat either ethics or international law as some sort of “back burner” item only to be casually honored with a tip of the hat. These topics need to be integrated into every aspect of what we teach. This chapter is designed to help you as teachers identify the basic infrastructure of international law for further elaboration in later chapters.

We start off this chapter with an opening discussion on the practical difficulties involved in the enforcement of international law. This material always stirs a good opening debate among students as to just what the practical limitations in this area are. The word oxymoron is defined as a combination of contradictory or incongruous words or phrases. To many, the term international law represents one such example. At best, defining international law along the traditional domestic lines of a body of rules of behavior and mechanisms designed to enforce those rules cannot work as well when the protagonists are sovereign nations. By definition, sovereignty incorporates the notion of freedom from external controls and supreme power over one’s own affairs. Perhaps that might be a starting point to resolve this oxymoronic dilemma. A nation does need to have ultimate control over its internal affairs, but its national interests and the welfare of its citizens do not end at its borders. Nations, just like individuals, can only find protection for their own rights when they are willing to honor the rights of others. Law eventually works its way through to a system of cooperative behavior for the larger mutual good. Law, domestic or international, calls for some sacrifice of individual freedoms for the betterment of the corporate body. This is the fundamental reality upon which all law is ultimately based. Consequences of the failure to honor that reality at the global level are readily apparent to all of us. If the role of law is to act as a mechanism for civilization and to make violence the last resort, then international law is a goal worth striving for by all nations, even at the cost of some of their respective autonomies.

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II. Chapter Objectives

Describe the federal government’s power under the Foreign Commerce and Treaty Clauses of the U.S. Constitution.

List and describe the sources of international law.

Describe the functions and governance of the United Nations.

Describe the North American Free Trade Agreement and other regional economic organizations.

Describe the World Trade Organization and explain how its dispute resolution procedure works.

III. Key Question Checklist

Who has the authority to act—the federal government or the states?

What are the sources of international law?

What are the main international organizations that may be used to help resolve international disputes between nations?

What are some of the legal principles used to help resolve international disputes?

IV. Text Materials

The law that governs affairs between nations is called international law. There is no single legislative source, nor single world court that interprets international law. There are several courts and tribunals that decide international disputes of parties that agree to appear before them. There is also no world executive branch that can enforce international laws, so nations often do not recognize laws enacted by other countries or international organizations.

Section 1: The United States and Foreign Affairs

The Foreign Commerce Clause vests Congress with the power to regulate commerce with foreign nations and the Treaty Clause empowers the president, by and with the advice and consent of the Senate, to make treaties.

Section 2: Sources of International Law

Treaties and Conventions – A treaty is a formal agreement between two (bilateral) or more (multinational) nations that is signed and ratified by each party. Conventions are treaties that are sponsored by international organizations and normally have many signatories.

Custom – Custom describes a practice that two or more nations follow when dealing with each other. It is consistent and recurring, and is acknowledged as binding.

General Principles of Law – These are principles of law that are recognized by civilized nations and are common to the national laws of the parties.

Judicial Decisions and Teachings – The judicial decisions and writings of the most qualified scholars of the various nations involved in the dispute.

Section 3: The United Nations

The U.N. was created by a multinational treaty with an eye toward maintaining peace and security in the world, promoting economic and social cooperation, and protecting human rights.

Governance of the UN – The UN is composed of the General Assembly, which is the legislative body of the UN and is composed of all member nations; the Security Council, composed of 15 members, five of which are permanent members, and ten which serve two-year terms; and the Secretariat, which administers the day-to-day operations under the secretary-general, who is elected by the General Assembly.

International Court of Justice – The World Court is the judicial branch of the UN, and is located in The Hague. It consists of fifteen judges who serve nine-year terms, with not more than two from any single nation.

UN Agencies – There are a number of autonomous agencies dealing with a number of economic and social problems including UNESCO, INICEF, the IMF, the World Bank, and IFAD.

The International Monetary Fund (IMF) – The IMF is an agency of the UN that helps to promote sound monetary, fiscal, and macroeconomic policies throughout the world by providing assistance to needy countries. It provides short-term loans to its over 180 member nations.

The World Bank – The World Bank is financed by contributions from developed nations, and provides money to developing countries in order to fund humanitarian purposes and to relieve poverty. It provides money to build roads, dams, water projects, hospitals, and develop agriculture, in the form of long-term low-interest loans, as well as debt relief for these same loans.

Section 4: Regional International Organizations

There are several regional organizations whose purpose is to promote peace and security as well as economic, social, and cultural development.

The European Union – The Common Market is composed of a number of countries in Western and Eastern Europe. The Council of Ministers is composed of representatives from each member nation and vote on significant issues and changes to the treaty. The EU commission is independent of the member nations and has the authority to enact legislation and enforce its regulations. The EU has eliminated custom duties among its member nations, has established common customs tariffs, and has created a single monetary unit and a common monetary policy.

North American Free Trade Agreement (NAFTA) – In 1992, NAFTA was signed by the U.S., Mexico, and Canada, creating a massive free-trade zone, eliminating or reducing most of the tariffs, duties, and quotas among the three countries, and establishing special protection for favored industries. The results are lower prices for a wide variety of goods, and a competitive supernational trading region that can compete with Asia or the EU.

Free Trade Area of the Americas – FTAA was created as an extension of NAFTA, and would be composed of all the nations of North, Central, and South America, reducing trade barriers and creating a trading zone with seamless economic borders.

Latin, Central, and South American Economic Communities – There are several regional organizations combining Latin American countries and the Caribbean, including the Central American Common Market, MERCOSUR, the Caribbean Community, and the Andean Common Market.

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Asian Economic Communities – Since 1967, the Association of South East Asian Nations has operated as a cooperative community.

African Economic Communities – There are several economic communities in Africa, including ECOWAS, the Economic and Customs Union of Central Africa, EAC, and the Organization of African Unity.

Middle Eastern Economic Communities – The best known economic organization is OPEC, which consists of eleven oil-producing and exporting countries. Another organization that was established as an economic trade area is the Gulf Cooperation Council.

Regional Courts – Regional courts have been created by treaty to handle disputes among signatories, but usually lack the mechanisms to enforce their judgments.

Section 5: The World Trade Organization (WTO)

The WTO was created as a multilateral treaty that establishes trade agreements and limits tariffs and trade restrictions among its more than 130 member nations. The WTO has been referred to as the “Supreme Court of Trade,” and has the jurisdiction to enforce trade agreements.

China Joins the WTO – In 2002, China became a member of the WTO and a full partner in the world’s trading system. Their admission is not without critics who question the lack of environmental protection for their industrialized economy, and worry over the flood of jobs moving from the U.S. to China.

WTO Dispute Resolution – The WTO hears and decides trade disputes between member nations. Disputes are heard by a three-member panel made up of professional judges from member nations. Their report is referred to the dispute settlement body of the WTO, which adopts the findings unless a consensus of the members votes otherwise. Most of the reports are adopted. There is an appellate body to which a party can appeal any decision, made up of three members selected from member nations. The proceedings, including appeals, are completed within 12 months.

Section 6: National Courts Decide International Disputes

Most cases involving international law are heard by the courts of individual nations, including almost all of the cases involving international business transactions. In the U.S., these are brought in federal district courts.

Judicial Procedure – Most international contracts will include a choice of forum clause which designates which nation’s court will have jurisdiction to hear disputes, and a choice law clause that designates which country’s laws will be applied.

The Act of State Doctrine – This doctrine states that judges in one country cannot question the validity of an act committed by another country within that other country’s borders, based on the principle that a country has absolute authority over what transpires within its own borders.

The Doctrine of Sovereign Immunity – The doctrine of sovereign immunity establishes that countries are immune from lawsuits in the courts of other countries.

Exceptions from the Doctrine of Sovereign Immunity – The U.S. grants immunity to qualified countries, as codified under FSIA, which provides that a foreign country is not immune if it has waived its immunity or if the action is based upon commercial activities carried on in the U.S. by a foreign country, or is carried on outside the U.S. but directly impacts the U.S.

International Arbitration – An alternative to litigation is arbitration, which is a nonjudicial method of dispute resolution. An arbitration clause is usually included in the contract, specifying which country’s laws will be applicable. An arbitrator issues an award instead of a judgment.

Jewish Law and the Torah – Jewish law is based on the Torah, which prescribes all the rules of religious, political, and legal life. Problems are determined by Halakhah (rabbinic jurisprudence) and are administered by rabbi-judges sitting as the Beis Din, or house of judgment.

Islamic Law and the Koran – The Islamic law system is derived from the Koran, the Sunnah, and reasonings by Islamic scholars. Islamic law was frozen in the tenth century when scholars closed the door on independent reasoning. Today, Islamic law (Shari’a) is used primarily in marriage, divorce, inheritance, and criminal law, and is ignored in commercial transactions.

Hindu Law – Dharmasastra - Hindu law is based on neither civil codes nor court decisions, but on the works of private scholars that were recorded in law books (smitris/dharmasastra) as the doctrine of proper behavior. Most Hindu law is concerned with family matters and the law of succession.

V. Answers to Business Law Cases

Act of State Doctrine

14.1. The private United States lending bank wins. The borrowing bank, Banco National de Costa Rica that was wholly owned by the government of Costa Rica, is not protected by the Act of State Doctrine, even though the government of Costa Rica has enacted a law prohibiting the repayment of foreign debt. The United States District Court held that the Act of State Doctrine did not preclude the court from hearing and deciding the case. The Act of State Doctrine provides that judges of one country cannot question the validity of an act committed by another country within that country’s own borders. This restraint is based upon the doctrine of separation of powers, that only the executive branch of government, and not the judicial branch, may arrange affairs with foreign governments. However, in the instant case, the court held that the source of the debt was in New York, not Costa Rica, since the court considered where the loan and promissory notes were signed and where the money was to be repaid. Thus, the U.S. District court can hear and decided the case. Libra Bank Limited v. Banco Nacional de Costa Rica, 570 F. Supp. 870 (S.D.N.Y. 1983).

Forum Selection Clause

14.2. Unterweser Reederei GMBH (Unterweser) is correct that the forum selection clause in its contract with Zapata Off-Shore Company (Zapata) is enforceable. A forum selection clause (or choice of forum selection) is a clause in a contract that designates which nation’s courts have jurisdiction to hear cases or disputes that arise concerning the performance of the contract. In the instant case, the contract between Unterweser, a German corporation, and Zapata, a United States corporation, contained a clause that provided that “Any dispute arising must be treated before the London Court of Justice.” The United States Supreme Court stated that a forum selection clause should be specifically enforced unless it is clearly shown that such enforcement would be unreasonable or unjust or that the clause was obtained by fraud or overreaching. In the instant case, the Supreme Court found that the forum selection clause had been agreed to by sophisticated companies who conducted international business. The court found no unfairness in the clause, fraud, or overreach in its inclusion in the Unterweser-Zapata contract. Therefore, the Supreme Court held that the forum selection clause designating the London Court of Justice as the tribunal to hear the dispute between Unterweser and Zapata was valid and enforceable. M/S

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Bremen and Unterweser Reederei, GMBH v. Zapata Off-Shore Company, 407 U.S. 1, 92 S.Ct. 1907 (1972).

VI. Answers to Issues in Business Ethics Cases

14.3. The actions of the Bank of Jamaica were “commercial activities,” excluded from the doctrine of sovereign immunity. While “commercial activity” is not defined in the FSIA, legislative history indicates that lines of credit were intended to be covered. Contracts for the purchase of goods were clearly considered commercial activity. Here the contract is for the purchase of a service. Once a government enters into a contract, it must play by the contract rules. Further, the test is not whether the government enters into commercial activity frequently, but whether this particular activity was commercial. Chisholm & Co. v. Bank of Jamaica, 643 F.Supp 1393 (S.D. Fla. 1986).

14.4. Texas Trading and Milling Corporation (Texas Trading) wins. The U.S. district court held that the Federal Republic of Nigeria (Nigeria) could not raise the doctrine of sovereign immunity to avoid paying for the cement it had ordered from Texas Trading. The doctrine of sovereign immunity provides that countries are immune from lawsuits in the courts of another country. The United States has enacted the Foreign Sovereign Immunities Act of 1976 (FSIA), which provides an exception to this general rule where a foreign nation is involved in a “commercial activity” that is carried on in the United States, but causes a “direct effect” in the Untied States. The district court found that Nigeria was carrying on a “commercial activity” when it signed the contract to purchase cement from Texas Trading to be used in building roads, dams, and other infrastructure in the country. The court also held that this commercial activity had a “direct effect” in the United States because many U.S. companies contracted to sell Nigerian cement. The district court held that the contract in the instant case fell within the “commercial activity” exception of the FSIA, and therefore that the doctrine of sovereign immunity did not protect the country of Nigeria from lawsuit in the court of the United States. Texas Trading & Milling Corp. v Federal Republic of Nigeria, 647 F.2d 300 (2nd Cir. 1981).

VII. Terms

Act of State Doctrine—States that judges of one country cannot question the validity of an act committed by another country within that other country’s borders. It is based on the principle that a country has absolute authority over what transpires within its own territory.

appellate body—A panel of seven judges selected from WTO member nations that hears and decides appeals from decisions by the dispute settlement body.

arbitration clause—A clause contained in many international contracts that stipulates that any dispute between the parties concerning the performance of the contract will be submitted to an arbitrator or arbitration panel for resolution.

arbitration—A form of ADR in which the parties choose an impartial third party to hear and decide the dispute.

choice of forum clause—Clause in an international contract that designates which nation’s court has jurisdiction to hear a case arising out of the contract. Also known as a forum-selection clause.

choice of law clause—Clause in an international contract that designates which nation’s laws will be applied in deciding a dispute.

custom—The second source of international law, created through consistent recurring practices between two or more nations over a period of time that have become recognized as binding.

dispute settlement body—A board comprised of one representative from each WTO member nation that reviews panel reports.

doctrine of sovereign immunity—States that countries are granted immunity from suits in courts of other countries.

European Community (Common Market)—Comprises many countries of Western Europe; created to promote peace and security plus economic, social, and cultural development.

European Court of Justice—The judicial branch of the European Community located in Luxembourg. It has jurisdiction to enforce European Community law.

extradition—Sending a person back to a country for criminal prosecution.

Foreign Commerce Clause—Clause of the U.S. Constitution that vests Congress with the power “to regulate commerce with foreign nations.”

Foreign Sovereign Immunities Act—Exclusively governs suits against foreign nations that are brought in federal or state courts in the United States; codifies the principle of qualified or restricted immunity.

general principles of law—The third source of international law, consisting of principles of law recognized by civilized nations. These are principles of law that are common to the national law of the parties to the dispute.

International Court of Justice—The judicial branch of the United Nations that is located in The Hague, the Netherlands. Also called the World Court.

international law—Laws that govern affairs between nations and that regulate transactions between individuals and businesses of different countries.

judicial decisions and teachings—The fourth source of international law, consisting of judicial decisions and writings of the most qualified legal scholars of the various nations involved in the dispute.

national courts—The courts of individual nations.

Panel—A panel of three WTO judges that hears trade disputes between member nations and issues “a panel report.”

sources of international law—Sources that international tribunals rely on in settling international disputes.

treaties and conventions—The first source of international law, consisting of agreements or contracts between two or more nations that are formally signed by an authorized representative and ratified by the supreme power of each nation.

Treaty Clause—Clause of the U.S. Constitution that states the president “shall have the power...to make treaties, provided two-thirds of the senators present concur.”

United Nations—An international organization created by multilateral treaty in 1945.

World Trade Organization—An international organization of more than 130 member nations created to promote and enforce trade agreements among member nations.

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