PORTABLE MBA IN FINANCE AND ACCOUNTING CHAPTER 8 pdf

Many of the rules applicable to the operation of partnerships are set forthin the Uniform Partnership Act, which has been adopted in one form or another by 49 states.. Like the generalpa

PLANNING AND FORECASTING

to-THE SOFTWAR E ENTR EPR ENEUR

At approximately the same time that Jennifer, Jean, and George were hatchingtheir plans for entrepreneurial independence, Phil was cashing a seven-figurecheck for his share of the proceeds from the sale of the computer softwarefirm he had founded seven years ago with four of his friends Rather than rest

on his laurels, however, Phil saw this as an opportunity to capitalize on a plex piece of software he had developed in college Although Phil was con-vinced that there would be an extensive market for his software, there was

com-much work to be done before it could be brought to market The software had

to be converted from a mainframe operating system to the various popular crocomputer systems In addition, there was much marketing to be done prior

mi-to its release Phil anticipated that he would probably spend over $300,000 onprogrammers and salespeople before the first dollar of royalties would appear.But he was prepared to make that investment himself, in anticipation of retain-ing all the eventual profit

THE HOTEL VENTUR E

Bruce and Erika were not nearly as interested in high technology Directly lowing their graduation from business school, they were planning to constructand operate a resort hotel near a popular ski area They had chosen as theirlocation a beautiful parcel of land in Colorado owned by their third partner,Michael Rich in ideas and enthusiasm, the three lacked funds They were cer-tain, however, that they could attract investors to their enterprise The loca-tion, they were sure, would virtually sell itself

fol-THE PURPOSE OF THIS CHAPTER

Each of these three groups of entrepreneurs would soon be faced with whatmight well be the most important decision of the initial years of their busi-nesses: which of the various legal business forms to choose for the operation oftheir enterprises It is the purpose of this chapter to describe, compare, andcontrast the most popular of these forms in the hope that the reader will then

be able to make such choices intelligently and effectively After discussing thevarious business forms, we will revisit our entrepreneurs and analyze theirchoices

BUSINESS FORMS

Two of the most popular business forms could be described as the defaultforms because the law will deem a business to be operating under one of theseforms unless it makes an affirmative choice otherwise The first of these forms

is the sole proprietorship Unless he or she has actively chosen another form,the individual operating his or her own business is considered to be a sole pro-prietor Two or more persons operating a business together are considered apartnership (or general partnership), unless they have elected otherwise Both

of these forms share the characteristic that for all intents and purposes theyare not entities separate from their owners Every act taken or obligation as-sumed as a sole proprietorship or partnership is an act taken or obligation as-sumed by the business owners as individuals

Many of the rules applicable to the operation of partnerships are set forth

in the Uniform Partnership Act, which has been adopted in one form or another

by 49 states That Act defines a partnership as “an association of two or morepersons to carry on as co-owners a business for profit.” Notice that the defini-tion does not require that the individuals agree to be partners Although mostpartnerships can point to an agreement between the partners (whether written

or oral), the Act applies the rules of partnership to any group of two or morepersons whose actions fulfill the definition Thus, the U.S Circuit Court of Ap-peals for the District of Columbia, in a rather extreme case, held, over the de-fendant’s strenuous objections, that she was a partner in her husband’s burglary

“business” (for which she kept the books and upon whose proceeds she lived),even though she denied knowing what her husband was doing at nights As a re-sult of this status, she was held personally liable for damages to the wife of aburglary victim her husband had murdered during a botched theft

In contrast, a corporation is a legal entity separate from the legal identities

of its owners, the shareholders In the words James Thurber used to describe aunicorn, the corporation “is a mythical beast,” created by the state at the request

of one or more business promoters upon the filing of a form and the payment

of the requisite, modest fee Thereupon, in the eyes of the law, the tion becomes for most purposes a “person” with its own federal identificationnumber! Of course, one cannot see, hear, or touch a corporation, so it must in-teract with the rest of the world through its agents, the corporation’s officersand employees

corpora-Corporations come in different varieties The so-called professional poration is available in most states for persons conducting professional prac-tices, such as doctors, lawyers, architects, psychiatric social workers, and thelike A subchapter S corporation is a corporation that is the same as a regularbusiness corporation in all respects other than taxation These variations arediscussed later

cor-A fourth common form of business organization is the limited ship, which may best be described as a hybrid of the corporation and the gen-eral partnership The limited partnership consists of one or more generalpartners—who manage the business much in the same way as do the partners

partner-in a general partnership—and one or more limited partners, who are tially silent investors with no control over business operations Like the generalpartnership, limited partnerships are governed in part by a statute, the Uni-form Limited Partnership Act (or its successor, the Revised Uniform LimitedPartnership Act), which has also been adopted in one form or another by

essen-49 states

The limited liability company (LLC), is now available to entrepreneurs inall 50 states The LLC is a separate legal entity owned by “members” who may,but need not, appoint one or more “managers” (who may but need not be mem-bers) to operate the business A few states require that there be more thanone member, but the trend is toward allowing single-member LLCs An LLC

is formed by filing an application with the state government and paying the

prescribed fee The members then enter into an operating agreement settingforth their respective rights and obligations with respect to the business Moststates that have adopted the LLC have also authorized the limited liabilitypartnership, which allows general partnerships to obtain limited liability fortheir partners by filing their intention to do so with the state This form ofbusiness entity is normally used by professional associations that previously op-erated as general partnerships, such as law and accounting firms.

COMPAR ISON FACTORS

The usefulness of the five basic business forms could be compared on a ally unlimited number of measures, but the most effective comparisons willlikely result from employing the following eight:

virtu-1 Complexity and cost of formation What steps must be taken before your

business can exist in each of these forms?

2 Barriers to operation across state lines What steps must be taken to move

your business to other states? What additional cost may be involved?

3 Recognition as a legal entity Who does the law recognize as the operative

entity? Who owns the assets of the business? Who can sue and be sued?

4 Continuity of life Does the legal entity outlive the owner? This may be

especially important if the business wishes to attract investors or if thegoal is an eventual sale of the business

5 Transferability of interest How does one go about selling or otherwise

transferring one’s ownership of the business?

6 Control Who makes the decisions regarding the operation, financing,

and eventual disposition of the business?

7 Liability Who is responsible for the debts of the business? If the

com-pany cannot pay its creditors, must the owners satisfy these debts fromtheir personal assets?

8 Taxation How does the choice of business form determine the tax

payable on the profits of the business and the income of its owners?

FORMATION OF SOLE PROPR IETORSHIPS

Ref lecting its status as the default form for the individual entrepreneur, thesole proprietorship requires no affirmative act for its formation One operates

a sole proprietorship because one has not chosen to operate in any of the otherforms The only exception to this rule arises in certain states when the ownerchooses to use a name other than his own as the name of his business In suchevent, he may be required to file a so-called d /b/a certificate with the localauthorities, stating that he is “doing business as” someone other than himself

This allows creditors and those otherwise injured by the operation of the ness to determine who is legally responsible.

CORPOR ATIONS

In order to form a corporation, in contrast, one must pay the appropriate feeand must complete and file with the state a corporate charter (otherwiseknown as a Certificate of Incorporation, Articles of Incorporation, or similarname in the various states) The fee is payable both at the outset and annuallythereafter (often approximately $200) A promoter may form a corporationunder the laws of whichever state she wishes; she is not required to form thecorporation under the laws of the state in which she intends to conduct most

of her business This partially explains the popularity of the Delaware ration Delaware spent most of the last century competing with other statesfor corporation filing fees by repeatedly amending its corporate law to make it increasingly favorable to management By now, the Delaware corporation hastaken on an aura of sophistication, so that many promoters form their com-panies in Delaware just to appear to know what they are doing! In addition, it

corpo-is often less expensive under Delaware law to authorize large numbers ofshares for future issuance than it would be in other states Nevertheless, thestatutory advantages of Delaware apply mostly to corporations with manystockholders (such as those which are publicly traded) and will rarely be sig-nificant to a small business such as those described at the beginning of this

chapter Also, formation in Delaware (or any state other than the site of thecorporation’s principal place of business) will subject the corporation to addi-tional, unnecessary expense It is thus usually advisable to incorporate in thecompany’s home state.

The charter sets forth the corporation’s name (which cannot be ingly similar to the name of any other corporation operating in the state) aswell as its principal address The names of the initial directors and officers ofthe corporation are often listed Most states also require a statement of corpo-rate purpose Years ago this purpose defined the permitted scope of the cor-poration’s activities A corporation which ventured beyond its purposes riskedoperating “ultra vires,” resulting in liability of its directors and officers to itsstockholders and creditors Today virtually all states allow a corporation to de-fine its purposes extremely broadly (e.g., “any activities which may be lawfullyundertaken by a corporation in this state”), so that operation ultra vires is gen-erally impossible Still directors are occasionally plagued by lawsuits brought

confus-by stockholders asserting that the diversion of corporate profits to charitable

or community activities runs afoul of the dominant corporate purpose, which

is to generate profits for its stockholders The debate over the responsibility

of directors to so-called corporate “stakeholders” (employees, suppliers, tomers, neighbors, and so forth) currently rages in many forms but is normallynot a concern of the beginning entrepreneur

cus-Corporate charters also normally set forth the number and classes of uity securities that the corporation is authorized to issue Here an analysis of abit of jargon may be appropriate The number of shares set forth in the charter

eq-is the number of shares authorized, that eq-is, the number of shares that the rectors may issue to stockholders at the directors’ discretion The number ofshares issued is the number that the directors have in fact issued and is obvi-ously either the same or smaller than the number authorized In some cases, acorporation may have repurchased some of the shares previously issued by thedirectors In that case, only the shares which remain in the hands of sharehold-ers are outstanding (a number obviously either the same or lower than thenumber issued) Only the shares outstanding have voting rights, rights toreceive dividends, and rights to receive distributions upon full or partial liqui-dation of the corporation Normally, we would expect an entrepreneur to au-thorize the maximum number of shares allowable under the state’s minimumincorporation fee (e.g., 200,000 shares for $200 in Massachusetts) and thenissue only 10,000 or so, leaving the rest on the shelf for future financings, em-ployee incentives, and so forth

di-The charter also sets forth the par value of the authorized shares, anotherantiquated concept of interest mainly to accountants The law requires onlythat the corporation not issue shares for less than the par value, but it can, andusually does, issue the shares for more Thus, typical par values are $0.01 pershare or even “no par value.” Shares issued for less than par are watered stock,subjecting both the directors and holders of such stock to liability to otherstockholders and creditors of the corporation

Corporations also adopt bylaws, which are not filed with the state but areavailable for inspection by stockholders These are usually fairly standard docu-ments describing the internal governance of the corporation and setting forthsuch items as the officers’ powers and notice periods for stockholders’ meetings.

LIMITED PARTNERSHIPS

As you might expect, given the limited partnership’s hybrid nature, the law quires both a written agreement among the various general and limited part-ners and a Certificate of Limited Partnership to be filed with the state, alongwith the appropriate initial and annual fees The agreement sets forth the part-ners’ understanding of the items discussed earlier regarding general partner-ships The certificate sets forth the name and address of the partnership, itspurposes, and the names and addresses of its general partners In states wherethe Revised Uniform Limited Partnership Act has been adopted, it is no longernecessary to reveal the names of the limited partners, just as the names of cor-porate stockholders do not appear on a corporation’s incorporation documents

re-LIMITED LIABILITY COMPANIES

The LLC is formed by filing a charter (e.g., a Certificate of Organization) withthe state government and paying a fee (usually similar to that charged for theformation of a corporation) The charter normally sets forth the entity’s nameand address, its business purpose, and the names and addresses of its managers(or persons authorized to act for the entity vis-à-vis the state if no managersare appointed) The same broad description of the entity’s business which isallowable for modern corporations is acceptable for LLCs The members ofthe LLC are also required to enter into an operating agreement that sets forththeir rights and obligations with regard to the business These agreements aregenerally modeled after the agreements signed by the partners in a general orlimited partnership

OUT OF STATE OPER ATION OF SOLE

PROPR IETORSHIPS AND PARTNERSHIPS

Partly as a result of both the Commerce clause and Privileges and Immunitiesclause of the U.S Constitution, states may not place limits or restrictions onthe operations of out-of-state sole proprietors or general partnerships that aredifferent from those placed on domestic businesses Thus, a state cannot forceregistration of a general partnership simply because its principal office is lo-cated elsewhere, but it can require an out-of-state doctor to undergo the samelicensing procedures it requires of its own residents

OUT OF STATE OPER ATION OF

CORPOR ATIONS, LIMITED PARTNERSHIPS,

AND LIMITED LIABILITY COMPANIES

Things are different, however, with corporations, limited partnerships, andLLCs As creations of the individual states, they are not automatically entitled

to recognition elsewhere All states require (and routinely grant) qualification

as a foreign corporation, limited partnership, or LLC to nondomestic entitiesdoing business within their borders This procedure normally requires thecompletion of a form very similar to a corporate charter, limited partnershipcertificate, or LLC charter, and the payment of an initial and annual fee simi-lar in amount to the fees paid by domestic entities This requirement, inciden-tally, is one reason not to form a corporation in Delaware if it will operateprincipally outside that state Much litigation has occurred over what consti-tutes “doing business” within a state for the purpose of requiring qualification.Similar issues arise over the obligation to pay income tax, collect sales tax, oraccept personal jurisdiction in the courts of a state Generally these cases turn

on the individualized facts of the particular situation, but courts generally lookfor offices or warehouses, company employees, widespread advertising, ornegotiation and execution of contracts within the state

Perhaps more interesting may be the penalty for failure to qualify Moststates will impose liability for back fees, taxes, interest, and penalties Moreimportant, many states will bar a nonqualified foreign entity from access to itscourts and, thus, from the ability to enforce obligations against its residents

In most of these cases, the entity can regain access to the courts merely by ing the state the back fees and penalties it owes, but in a few states access willthen be granted only to enforce obligations incurred after qualification wasachieved, leaving all prior obligations unenforceable

pay-R ECOGNITION OF SOLE Ppay-ROPpay-R IETOpay-RSHIPS

AS A LEGAL ENTITY

By now it probably goes without saying that the law does not recognize a soleproprietorship as a legal entity separate from its owner If Phil, our computerentrepreneur, were to choose this form, he would own all the company’s assets;

he would be the plaintiff in any suits it brought, and he would be the defendant

in any suits brought against it There would be no difference between Phil, theindividual, and Phil, the business

R ECOGNITION OF PARTNERSHIPS AS A LEGAL ENTITY

A general partnership raises more difficult issues Although most states allowpartnerships to bring suit, be sued, and own property in the partnership name,this does not mean that the partnership exists for most purposes separately from

its partners As will be seen, especially in the areas of liability and taxation, nerships are very much collections of individuals, not separate entities.

part-Ownership of partnership property is a particularly problematic area Allpartners own an interest in the partnership, which entitles them to distributions ofprofit, much like stock in a corporation This interest is the separate property ofeach partner and is attachable by the individual creditors of a partner in the form

of a “charging order.” Each partner also owns the assets of the partnership jointlywith his other partners This form of ownership (similar to joint ownership of afamily home by two spouses) is called tenancy in partnership Each partner mayuse partnership assets only for the benefit of the partnership’s business; such assetsare exempt from attachment by the creditors of an individual partner, although notfrom the creditors of the partnership Tenancy in partnership also implies that, inmost cases of dissolution of a partnership, the ownership of partnership assets de-volves to the remaining partners, to the exclusion of the partner who leaves in vio-lation of the partnership agreement or dies The former partner is left only withthe right to a dissolution distribution in respect of her partnership interest

R ECOGNITION OF CORPOR ATIONS AND LIMITED

LIABILITY COMPANIES AS LEGAL ENTITIES

The corporation and LLC are our first full-f ledged separate legal entities.Ownership of business assets is vested solely in the corporation or LLC as aseparate legal entity The corporation or LLC itself is plaintiff or defendant insuits and is the legally contracting party in all its transactions Stockholders andmembers own only their stock or membership interests and have no directownership rights in the business’s assets

R ECOGNITION OF LIMITED PARTNERSHIPS AS

A LEGAL ENTITY

The limited partnership, as a hybrid, is a little of both partnership and ration The general partners own the partnership’s property as tenants in part-nership operating in the same manner as partners in a general partnership Thelimited partners, however, have only their partnership interests and no directownership of the partnership’s property This is logically consistent with theirroles as silent investors If they directly owned partnership property, theywould have to be consulted with regard to its use

corpo-CONTINUITY OF LIFE

The issue of continuity of life is one which should concern most entrepreneurs,because it can affect their ability to sell the business as a unit when it comes

time to cash in on their efforts as founders and promoters The survival of thebusiness as a whole in the form of a separate entity must be distinguished fromthe survival of the business’s individual assets and liabilities.

Sole Proprietorships

Although a sole proprietorship does not survive the death of its owner, its vidual assets and liabilities do In Phil’s case, for example, to the extent thatthese assets consist of the computer program, filing cabinets, and the like, theywould all be inherited by Phil’s heirs, who could then choose to continue thebusiness or liquidate the assets as they pleased Should they decide to continuethe business, they would then have the same choices of business form whichconfront any entrepreneur However, if Phil’s major asset were a governmentlicense, qualification as an approved government supplier, or a contract with asoftware publisher, the ability of the heirs to carry on the business might beentirely dependent upon the assignability of these items If the publishing con-tract is not assignable, Phil’s death may terminate the business’s major asset Ifthe business had operated as a corporation, Phil’s death would likely have beenirrelevant (other than to him); the corporation, not Phil, would have been party

indi-to the contract

Partnerships

Consistent with the general partnership’s status as a collection of individuals,not an entity separate from its owners, a partnership is deemed dissolved uponthe death, incapacity, bankruptcy, resignation, or expulsion of a partner This

is true even if a partner’s resignation violates the express terms of the ship agreement Those assets of the partnership that may be assigned devolve

partner-to those partners who are entitled partner-to ownership, pursuant partner-to the rules of ancy in partnership These rules favor the remaining partners if the formerpartner has died, become incapacitated or bankrupt, been expelled, or re-signed in violation of the partnership agreement If the ex-partner resignedwithout violating the underlying agreement, she or he retains ownership rightsunder tenancy in partnership Those who thus retain ownership may continuethe business as a new partnership, corporation, or LLC with the same or newpartners and investors or may liquidate the assets at their discretion The soleright of any partner who has forfeited direct ownership rights is to be paid

ten-a dissolution distribution ten-after the pten-artnership’s liten-abilities hten-ave been pten-aid orprovided for

Corporations

Corporations, in contrast, normally enjoy perpetual life Unless the chartercontains a stated dissolution date (extremely rare), and as long as the corpora-tion pays its annual fees to the state, it will go on until and unless it is voted out

of existence by its stockholders The death, incapacity, bankruptcy, tion, or expulsion of any stockholder is entirely irrelevant to the corporation’sexistence Such a stockholder’s stock continues to be held by the stockholder, isinherited by his heirs, or is auctioned by creditors as the circumstances de-mand, with no direct effect on the corporation.

resigna-Limited Partnerships

As you may have guessed, the hybrid nature of the limited partnership dictatesthat the death, incapacity, bankruptcy, resignation, or expulsion of a limitedpartner will have no effect on the existence of the limited partnership Thelimited partner’s partnership interest is passed in the same way as that of astockholder’s However, the death, incapacity, bankruptcy, resignation, or ex-pulsion of a general partner does automatically dissolve the partnership in thesame way as it would in the case of a general partnership This automatic disso-lution can be extremely inconvenient if the limited partnership is conducting afar-f lung enterprise with many limited partners Thus, in most cases the part-ners agree in advance in their limited partnership agreement that upon such adissolution the limited partnership will continue under the management of asubstitute general partner chosen by those general partners who remain Insuch a case, the entity continues until it is voted out of existence by its part-ners, in accordance with their agreement, or until the arrival of a terminationdate specified in its certificate

Limited Liability Companies

The laws of the several states generally impose dissolution on an LLC upon theoccurrence of a list of events similar to those which result in the dissolution of

a limited partnership However, these laws usually allow the remaining bers to vote to continue the LLC’s existence notwithstanding an event of dis-solution Under such laws, the LLC may effectively have perpetual life in thesame manner as corporations

mem-TR ANSFER ABILITY OF INTER EST

To a large extent, transferability of an owner’s interest in the business is lar to the continuity of life issue

simi-Sole Proprietorships

A sole proprietor has no interest to transfer because he and the business areone and the same, and thus he must be content to transfer each of the assets ofthe business individually—an administrative nightmare at best and possibly

impractical in the case of nonassignable contracts, licenses, and governmentapprovals.

Partnerships

To discuss transferability in the context of a general partnership, one mustkeep in mind the difference between ownership of partnership assets as ten-ants in partnership and ownership of an individual’s partnership interest Apartner has no right to transfer partnership assets except as may be authorized

by vote in accordance with the partnership agreement and in furtherance ofthe partnership business However, a partner may transfer her partnership in-terest, and it may be attached by individual creditors pursuant to a chargingorder This transfer does not make the transferee a partner in the business, be-cause partnerships can be created only by agreement of all parties Rather, itsets up the rather awkward situation in which the original partner remains, buthis or her economic interest is, at least temporarily, in the hands of another Insuch cases, the Uniform Partnership Act gives the remaining partners the right

to dissolve the partnership by expelling the transferor partner

Corporations

No such complications attend the transfer of one’s interest in a corporation.Stockholders simply sell or transfer their shares Since stockholders (solely asstockholders) have no day-to-day involvement in the operation of the business,the transferee becomes a full-f ledged stockholder upon the transfer Thismeans that if Bruce, Erika, and Michael decide to operate as a corporation,each risks waking up one day to find that he or she has a new “partner” if one

of the three has sold his or her shares To protect themselves against this tuality, most closely-held corporations include restrictions on stock transfer intheir charter, their bylaws, or in stockholder agreements These restrictions setforth some variation of a right of first refusal either for the corporation or theother stockholders whenever a transfer is proposed In addition, corporatestock, as well as most limited partnership interests and LLC membership inter-ests, is a security under the federal and state securities laws, and because thesecurities of these entities will not initially be registered under any of theselaws, their transfer is closely restricted

even-Limited Partnerships

Just as with general partnerships, the partners of limited partnerships maytransfer their partnership interests The rules regarding the transfer of the in-terests of the general partners are similar to those governing general partner-ships described earlier Limited partners may usually transfer their interests(subject to securities laws restrictions) without fear of dissolution, but transfer-ees normally do not become substituted limited partners without the consent

of the general partners

Limited Liability Companies

As previously mentioned, although a membership interest in an LLC may befreely transferable under applicable state law, most LLCs require the affirma-tive vote of at least a majority of the members or managers before a member’sinterest may be transferred Furthermore, membership interests in an LLCwill usually qualify as securities under relevant securities laws and will there-fore be subject to the restrictions on transfer imposed by such laws

CONTROL

Simply put, control in the context of a business entity means the power to makedecisions regarding all aspects of its operations But the implications of controlextend to many levels These include control of the equity or value of the busi-ness, control over distribution of profits, control over day-to-day and long-termpolicy making, and control over distribution of cash f low Each of these isdifferent from the others, and control over each can be allocated differentlyamong the owners and other principals of the entity This can be seen either ascomplexity or f lexibility, depending upon one’s perspective

Sole Proprietorships

No such debate over allocation exists for the sole proprietorship In that ness form, control over all these factors belongs exclusively to the sole propri-etor Nothing could be simpler or more straightforward

busi-Partnerships

Things are not so simple in the context of general partnerships It is essential toappreciate the difference between the partners’ relationships with each other(internal relationships) and the partnership’s relations with third parties (exter-nal relationships)

Internally, the partnership agreement governs the decision-making cess and sets forth the agreed division of equity, profits, and cash f lows Deci-sions made in the ordinary course of business are normally made by a majorityvote of the partners, whereas major decisions, such as changing the character

pro-of the partnership’s business, may require a unanimous vote Some ships may weight the voting in proportion to each partner’s partnership inter-est, while others delegate much of the decision-making power to an executivecommittee or a managing partner In the absence of an agreement, the Uni-form Partnership Act prescribes a vote of the majority of partners for most issues and unanimity for certain major decisions

partner-External relationships are largely governed by the law of agency; that is,each partner is treated as an agent of the partnership and, derivatively, of theother partners Any action that a partner appears to have authority to take will

be binding upon the partnership and the other partners, regardless of whethersuch action has been internally authorized (see Exhibit 8.1).

Thus, if Jennifer purchases a subscription to the Harvard Business

Re-view for the partnership, and such an action is perceived to be within the

ordi-nary course of the partnership’s business, that obligation can be enforcedagainst the partnership, even if Jean and George had voted against it Suchwould not be the case, however, if Jennifer had signed a purchase and saleagreement for an office building in the name of the partnership, because rea-sonable third parties would be expected to know that such a purchase was not

in the ordinary course of business

These rules extend to tort liability, as well If Jean were wrongfully to duce a potential client to breach its consulting contract with a competitor, thepartnership would be liable for interference with contractual relations, even ifthe other two partners were not aware of Jean’s actions Such might not be thecase, however, if Jean decided to dynamite the competition’s offices, becausesuch an act could be judged to be outside the normal scope of her duties as

It should also be noted that agency law reaches into the internal ships of partners The law imposes upon partners the same obligations of fidu-ciary loyalty, noncompetition, and accountability as it does upon agents withrespect to their principals

by:

Agreement and Fiduciary Principles

Express, Apparent Authority, and

Scope of Employment

aspects of the corporate form have been designed specifically for the purpose

of splitting off individual aspects of control and allocating them differently

Stockholders

At its simplest, a corporation is controlled by its stockholders Yet, except inthose states which have specific (but rarely used) close corporation statutesgoverning corporations with very few stakeholders, the decision-making func-tion of stockholders is exercised only derivatively Under most corporatestatutes, a stockholder vote is required only with respect to four basic types ofdecisions: an amendment to the charter, a sale of the company, a dissolution

of the company, and an election of the board of directors

Charter amendments may sound significant, until one remembers whatinformation is normally included in the charter A name change, a change inpurpose (given the broad purpose of clauses now generally employed), and anincrease in authorized shares (given the large amounts of stock normally left

on the shelf ) are neither frequent nor usually significant decisions Certainly, asale of the company is significant, but it normally can occur only after the rec-ommendation of the board and will happen only once, if at all The same can

be said of the decision to dissolve It is the board of directors that makes all thelong-term policy decisions for the corporation Thus, the right to elect theboard is significant but indirectly so Day-to-day operation of the corporation’sbusiness is accomplished by its officers, who are normally elected by the board,not the stockholders

Even given the relative unimportance of voting power for stockholders,the corporation provides many opportunities to differentiate voting powerfrom other aspects of control and allocate it differently Assume Bruce andErika (our hotel developers) were willing to give Michael a larger piece of theequity of their operation to ref lect his contribution of the land but wished todivide their voting rights equally They could authorize a class of nonvotingcommon stock and issue, for example, 1,000 shares of voting stock to each ofthemselves and an additional 1,000 shares of nonvoting stock to Michael As aresult, each would have one-third of the voting control, but Michael would haveone-half of the equity interest

Alternatively, Michael could be issued a block of preferred stock senting the value of the land This would guarantee him a fair return on hisinvestment before any dividends could be declared to the three of them asholders of the common stock As a holder of preferred stock, Michael wouldalso receive a liquidation preference upon dissolution or sale of the business, inthe amount of the value of his investment, but any additional value created bythe efforts of the group would be ref lected in the increasing value of the com-mon shares

repre-The previous information illustrates how one can separate and allocatedecision-making control differently from that of the equity in the business, aswell as from the distribution of profits Distribution of cash f low can, of

course, be accomplished totally separately from the ownership of securities,through salaries based upon the relative efforts of the parties, rent paymentsfor assets leased to the entity by the principals, or interest on loans to thecorporation.

Stockholders exercise what voting power they have at meetings of thestockholders, held at least annually but more frequently if necessary Eachstockholder of record, on a future date chosen by the party calling the meet-ing, is given a notice of the meeting containing the date, time, and purpose ofthe meeting Such notice must be sent at least 7 to 10 days prior to the date

of the meeting depending upon the individual state’s corporate law, althoughthe Securities and Exchange Commission requires 30 days’ notice for publiclytraded corporations No action may be taken at a meeting unless a majority ofvoting shares is represented (known as a quorum) This results in the aggres-sive solicitation of proxy votes in most corporations with widespread stockownership Unless otherwise provided (as for a sale or dissolution of the com-pany, for which most states require a two-thirds vote of all shares), a resolution

is carried by a majority vote of those shares represented at the meeting

The preceding rules require the conclusion that the board of directorswill be elected by the holders of a majority of the voting shares Thus, in theearlier scenario, even though Bruce and Erika may have given Michael one-third of the voting shares of common stock, as long as they continue to vote together, Bruce and Erika will be able to elect the entire board To preventthis result, prior to investing Michael could insist upon a cumulative votingprovision in the charter (under those states’ corporate laws that allow it).Under this system, each share of stock is entitled to a number of votes equal tothe number of directors to be elected By using all their votes to support a sin-gle candidate, individuals with a significant minority interest can guaranteethemselves representation on the board

More directly (and in states which do not allow cumulative voting),Michael could insist upon two different classes of voting stock, differing only

in voting rights Bruce and Erika would each own 1,000 shares of class A stockand elect two directors Michael, the sole owner of the 1,000 outstandingshares of class B stock, would elect a third director Of course, the board alsoacts by majority, so Bruce and Erika’s directors could dominate board deci-sions in any case, but at least Michael would have access to the deliberations

In the absence of a meeting, stockholders may vote by unanimous writtenconsent, where each stockholder indicates his approval of a written resolution

by signing it This eliminates the need for a meeting and is very effective incorporations with only a few stockholders (such as our hotel operation) Unlikethe rules governing stockholders’ meetings, however, in most states unanimity

is required to adopt resolutions by written consent This apparently ref lects thebelief that a minority stockholder is owed an opportunity to sway the majoritywith his arguments A few states, notably Delaware, permit written consents of

a majority, apparently reacting to the dominance of proxy voting at most ings of large corporations, where the most eloquent of minority argumentswould fall upon deaf ears (and proxy cards)