Business Associations/Corporations Outline

Corporations; Professor Bullard; Fall 2013

I. Corporations Questions[1]

A. Sample Exam Questions

Donahue Question

1. The 85-year old founder of Family Inc. owns 80 of its 100 shares. The remaining 20 shares are owned by the descendants of the founder’s original partner. The founder has three children, two of whom are CEO and CFO. The founder recognizes that he can no longer participate actively in running the business and is willing to retire (i.e., work only 4 – 5 days each month) and give up his shares, but he wants: (1) the company to continue to be family-controlled, (2) each child to be treated the same, and (3) to receive, one way or another, $6 million. Family Inc. is worth $10 million and it has $3 million in cash (which is included in the $10 million). It generates $2 million annually in net income. The children refuse to pay a penny of their own money for the founder’s shares. What would you advise the family to do and why? (500 words)

a. NOTE – THIS QUESTION WAS COMPLETELY DIFFERENT ON THE FALL 2013 EXAM.

My Answer

1. We know this is a closed corporation b/c there are a small number of SHs, no ready market for the stock, and substantial majority SH participation in management. In Donahue, the majority shareholder’s children of a closed corporation sold some of his shares to the corporation, but refused to extend that same offer to Donahue, the minority shareholder. The Court held (and thus the legal standard for this fact pattern is) that when a closed corporation reacquires its shares from a controlling shareholder, that shareholder must have acted with the utmost good faith and loyalty to the other shareholders. And to meet this test, the shareholder must offer each stockholder and equal opportunity to the company. The Court reasoned that without such a standard, minority shareholders could be “freezed out.”

2. I recommend each child receive 21 of Founder’s shares. That way, they are on equal footing with each other, still have more than the Partner, and purchasing the minimum amount is ideal since they don’t want to pay out of pocket. This also prevents the family losing control if one sibling decides to side with Partner’s descendants (like Harry was afraid of in Donahue).

3. In terms of transferring the shares to the Founder’s children, there are a couple methods. I think the ideal method would be temporarily increasing dividends. That way, Partner’s dividends also increase and Founder’s children can purchase the shares without spending their own money. Another option would be increasing the children’s salaries, but there is a risk of an excessive salary claim since Partner’s salary will not be increased.

4. For the 17 leftover shares, the company can either reacquire them or sell them to someone else. However, because of the standard set in Donahue, if the company repurchases the 17 shares, it must also offer Partner the same option. When the closely held corporation reacquires its own stock, the purchase is subject to the additional requirements of good faith and a duty of loyalty owed by all shareholders to the other shareholders. Here, the standard would be met if the same offer was made to the Partner’s descendants. In the event of requisition of shares, the minority shareholders may be trapped in a disadvantageous situation because shares are not as liquid or easily transferred in a closely held corporation, but if Partner’s descendants are offered a way out, that is no longer a problem. Also, if the corporation bought the leftover shares, it would essentially reabsorb them, which would make the remaining shares more valuable. That said, the Founder could just sell the 17 leftover shares to someone else if it does not want to risk Partner’s descendants’ accepting the corporation’s offer to sell their shares back into it.

5. Founder also wants to receive $6 million somehow or another. I recommend that because he will work with the corporation a few times a month on a consultancy basis, his salary for that position be $1 million a year. And since Founder is 85 years old. I would also recommend the consultancy contract be limited to 6 years. He would receive his $6 million and it would only take 6 years, which is important because of his age. To ensure his wife is taken care of if Founder dies, I would recommend the corporation purchase a life insurance policy payable to his wife so she does not go without if he dies before the consultancy contract ends.

Form of Organization Question

David, Joe, and Liz want to start up DLJ’s Taco Stand Based on the following facts, what form of organization would you recommend and why (including why forms not recommended were not recommended)?

1. The business requires $100,000 start up capital. David plans on working full time managing the business and will contribute $10,000 in capital and take a 20% equity interest. Joe will keep the books, and handle tax, administrative, and financial matters on an as-needed basis. Joe will contribute $10,000 in capital and take a 20% equity interest. After one year, Joe will be paid as an hourly consultant for services in excess of 10 hours per month. David and Joe will each own an option to buy another 10% of the business for $20,000 during the first 3 years. Liz will receive the remaining 60% equity interest in return for her $80,000 investment. She will not participate in managing the enterprise, but wants to have a say in and veto power over fundamental decisions. She expects a 10% to 20% return on her investment. (Source – Joseph Shade, Business Associations, 41-42 (2006)) (16 minutes/points)

a. NOTE – THIS QUESTION WAS NOT ON THE FALL 2013 EXAM.

My Answer

1. The three most important elements to consider when recommending a form of organization to your client are limited liability, tax, simplicity and cost, and flexibility. It’s also important to advise your clients to obtain insurance and include an indemnification clause in their operating agreement. For this fact pattern, I would recommend a LLC form for the following reasons.

2. I would not recommend a general partnership.

a. This form offers unlimited liability. Not only are you responsible for your actions personally, but your partners are too. You’re jointly and severally liable. You don’t want to be liable for someone else’s actions.

3. I would not recommend a limited partnership.

a. This form only provides limited liability for limited partners, which are required to be passive. The general partners take the most risk since they are not passive. Also, because David will manage the business, Joe will keep the books, and Liz wants to be apart of some decision making, none of them will be passive, limited partners, exposing all three to unlimited liability.

4. I would not recommend a limited liability partnership.

a. LLPs only off a partial shield in some states. It is also a new entity, so it has quirks. Also, some states require the business be for professionals only and the Taco Stand is not a professional organization.

5. I would not recommend a corporation.

a. A corporation has complete limited liability, but it’s ruled out because of double taxation, which means profits are taxed at the corporate level and any distributions (dividends) The Taco Stand would pay more in taxes and make less money. Corporate statues are also stricter and more formalistic, making this form less flexible and more costly. There are mandatory rules that don’t apply to other forms. For example, there is an automatic voting requirements statute, but LLCs get to decide that in their operating agreement.

6. I would not recommend a S corporation.

a. S corporations have limited liability, but also have formal rules and are less flexible and more costly (similar to an ordinary corporation). More importantly, S corporations require one class of sock, meaning the members will have the same pro rata share of distribution. Each gets their percentage of the shares upon liquidation of the company. Liz would lose money because she invested $80k, but only has a 60% stake in the company. Joe and David each have 20% shares and $10k co