I. Incorporation Question:
A. Deciding Whether and Where to Incorporate (and why firms go to DE):
(in order of complexity)
Sole Proprietorship: an individual business owner who runs a small individually-owned business. That person gets all profits and is personally responsible for all actions (no limited liability). Very simple.
A basic business
General Partnership: control shared by two or more general partners; each partner gets share of profits; each partner is jointly and severally personally liable for all actions of partnership (no limited liability); partnership rules (profit distribution, management decisions) are mutable by contract (but default rule is equal distribution); flow-through taxation (all firm’s income and expenses are taxable to firm’s owners).
A basic business with multiple owners
Per capita profits and losses
Limited Partnership: have general and limited partners – general partners are jointly and severally liable for obligations, limited partners are not personally responsible for obligations of partnership. General partners are managers; limited partners are investors and are not involved in management (if they do, then they will be considered general partners). Must be created (pay filing fee, set up legally) through legal process; has flow-through taxation.
GPs run the business
Corp can be the GP
LPs enjoy limited liability
Often used for complex financial arrangements
i. Lose flow-through taxation if traded on an exchange
ii. Blackstone get LP status b/c its profits are “passive”
iii. REITs get LP status
iv. Hedge funds are structured to avoid securities regulation
Corporation: Does not begin automatically – must file legally. 5 basic + 2 add’l characteristics:
Limited Liability: shareholders not personally liable for corporate obligations; managers also have limited liability so long as they are acting on the corporation’s behalf and are within their authority.
i. Defensive asset partitioning: Keeps personal liability from infecting corp and vice versa. Combined with legal personality, the cost of capital is reduced since the personal creditors are in the best position to evaluate and monitor the personal assets of the individuals and the corporate creditors are in the best position to monitor the corporation’s assets.
ii. More efficient: since the creditors will in effect be monitoring the managers, which is more efficient than the SHs monitoring the managers since SHs are widely dispersed
iii. Small corps: Lenders usually require owners to personally guarantee loans
Free Transferability of Ownership Interests: shares of stock are freely transferable, thus creating markets for shares (unlike partnerships where transferability is limited by contract)
i. Small corps: Often restrict so that one must gain approval of other shareholders to sell out–most common restriction
Continuity of Interest/ Perpetual Life: the legal existence of a corporation is relatively secure against early termination b/c its existence is perpetual (unless shorter time period established in certificate of incorporation), unlike p-ships where the p-ship might dissolve if one partner died/becomes insolvent
i. Small corps: Sometimes have dissolution provisions in Certificate
Centralized Management: managed by or under the direction of a Board of Directors – SH has no right to participate in management
i. Signals authority clearly to third parties
ii. Characteristics of the Board of Directors:
1. separate from the operational managers of the corporation: two tier boards will have top corporate officers in the second tier, but not in first tier; single tier boards will have officers be a part of the board → officers execute business decisions, and the board hires these officers and monitors and ratifies decisions – this is a check on the quality of decision-making by officers
2. formally distinct from SHs: don’t have to go to SH for routine decisions, allows minority SH or employees access to decision-making
3. elected by the firm’s SH: ensures the board will remain responsive to owners’ interests
4. has multiple members: facilitates mutual monitoring and checks idiosyncratic decision-making (not always the rule for small/close corps)
iii. Small corps: Often run by the owners
Entity Status: corporation is a “legal personality” or “legal entity.” Can be sued or sue as a corporation (not individual SH); corporations have individual constitutional rights. This now applies to all but sole proprietorships.
i. A firm is a single contracting party that coordinates the activities of suppliers of inputs and of consumers of products and services – a party distinct from the individuals who own or manage the firm
ii. Separate patrimony: ability for firm to own property and pledge property to creditors
iii. Kraakman (Skeel favorite): legal personality consists of two main ingredients (and is a major characteristic of a corporation) –
1. Priority Rule (Asset Partitioning): the assets of the firm are pledged first to creditors as security for the firms’ debts; the creditors of the firm are kept separate from the creditors of the individual SHs (owners). This increases the ability for corporations to secure loans and credit. Also, lenders don’t want to worry about the SH assets – too complicated and diverse. Gives certainty to creditors of the corporation – the creditors only need to monitor the corporation and not the individual SH.
2. Liquidation Protection Rule: SH cannot liquidate their shares at will (an individual SH cannot force the corporation to dissolve → in partnership, one partner can force dissolution of the firm by becoming insolvent or death; creditors of the individual partner can also attack his interest in the firm), nor can personal creditors of an individual owner foreclose on owner’s share of firm assets (the creditor basically becomes owner of the shares of the stock of the former SH, but they remain one step removed and cannot demand the corporation pay them off – they can sell the stock and get dividends) (this not found in p-ships)
v Entity status was more important historically than even limited liability. Creditor (or death) of a shareholder (probably) can’t cause a corp to be liquidated. Creditor of a shareholder didn’t know and could’t control credit taken out by other shareholders
v Entity status is converse of limited liability since this protects the firm. The corporate assets would generally be worth less if they were liquidated individually, hence it is valuable to the firm for the firm to remain whole
3. Firms having both priority rule and liquidation protection are characterized as having strong form legal personality, as opposed to weak form found in p-ships (only priority rule). Strong form increases the creditworthiness of the firm.
Investor Ownership (another element in place of continuity of interest, added by Kraakman):
– Two key
is member-managed, but can also be manager-managed
§ Voting by Members: half statutes say vote per capita (one vote per member; like partnership default rule), other half says vote pro rata (by financial interest; like corporation default rule). Most statutes require majority vote, though some require unanimity for certain actions.
§ Agency Powers:
· Member-managed LLCs: apparent authority of member is comparable to apparent authority of a partner (each member can bind the LLC for things that apparently carry out the business of the LLC in a usual or ordinary way). Can be given actual authority by remaining members to act in not ordinary way (and can withdraw this authority).
· Manager-managed LLCs: rules comparable to corporations – only managers have apparent authority to bind firm. Members (like SHs) have no authority to bind.
§ Inspection of Books and Records: members entitled to access to these, but some statutes require a proper purpose
§ Fiduciary Duties: largely unspecified, but important provisions are specified: duty of care, etc…
· Big difference between LLCs and corps/p-ships: operating agreement permitted to waive all fiduciary duties
§ Derivative Actions: permits members to bring derivative actions on LLCs behalf based on breach of fiduciary duties
§ Distributions: distrib to members are made pro rata (like corp law) and not per capita (like part. law)
§ Members’ Interests: members have financial rights (right to receive distributions), and may have governance rights (to vote, participate in management). Can transfer financial rights by transferring interest in the LLC. Some statutes provide that member can transfer governance rights only with unanimous consent of the other members, others only require majority of financial interests or members, others allow transference without any approval if articles of organization or operating agreement so provide. Cannot assign governance rights if assign interest, but unsure if member retains this right. If member assigns interest in LLC as a pledge to secure debt, and not an outright sale, and if creditor gets judgment against member, then creditor gets charging order where they get member’s distributions.
§ Limited Liability: members and managers are not liable for LLC’s debts, obligations, and other liabilities, but courts will likely apply piercing the veil rules to LLCs
§ Disassociation (termination of member’s interest other than by voluntary sale): death, bankruptcy, or lawful expulsion results in disassociation. Some statutes say member has the power, if not the right, to withdraw at any time, or the right to withdraw unless otherwise stated in operating agreement.
§ Tax Structure: pass-through or double taxation (check the box provisions have essentially made the IRS not check and see whether an LLC is really a corporation)
o Why can’t a law firm become a full LLC? B/c the members couldn’t transfer their interest to anyone since it must be a lawyer → also lawyers cannot have LL from their own malpractice
Why isn’t every corporation an LLC? IRS is generous in tax treatment, but if you have publicly traded ownership interests, you get treated like a corporation – you