238 Planning and Forecasting be binding upon the partnership and the other partners, regardless of whether such 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 enforced against the partnership, even if Jean and George had voted against it. Such would not be the case, however, if Jennifer had signed a purchase and sale agreement 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 in- duce a potential client to breach its consulting contract with a competitor, the partnership would be liable for interference with contractual relations, even if the other two partners were not aware of Jean’s actions. Such might not be the case, however, if Jean decided to dynamite the competition’s offices, because such an act could be judged to be outside the normal scope of her duties as a partner. These obligations to third parties can even extend past the dissolution of the partnership if an individual partner has not given adequate notice that he or she is no longer associated with the others. Thus, a former partner can be held liable for legal fees incurred by the other former partners, if he has not notified the partnership’s counsel about leaving the firm. It should also be noted that agency law reaches into the internal relation- ships of partners. The law imposes upon partners the same obligations of fidu- ciary loyalty, noncompetition, and accountability as it does upon agents with respect to their principals. Corporations There can be much flexibility and complexity in the allocation of control in the partnership form, but not nearly so much as in the corporate form. Many EXHIBIT 8.1 Principal and agent. Principal Agent Agent Principal Outsider Governed by: Agreement and Fiduciary Principles Express, Apparent Authority, and Scope of Employment Choosing a Business Form 239 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 in those states which have specific (but rarely used) close corporation statutes governing corporations with very few stakeholders, the decision-making func- tion of stockholders is exercised only derivatively. Under most corporate statutes, a stockholder vote is required only with respect to four basic types of decisions: 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 what information is normally included in the charter. A name change, a change in purpose (given the broad purpose of clauses now generally employed), and an increase in authorized shares (given the large amounts of stock normally left on the shelf ) are neither frequent nor usually significant decisions. Certainly, a sale 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 the long-term policy decisions for the corporation. Thus, the right to elect the board is significant but indirectly so. Day-to-day operation of the corporation’s business 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 power from other aspects of control and allocate it differently. Assume Bruce and Erika (our hotel developers) were willing to give Michael a larger piece of the equity of their operation to reflect his contribution of the land but wished to divide their voting rights equally. They could authorize a class of nonvoting common stock and issue, for example, 1,000 shares of voting stock to each of themselves and an additional 1,000 shares of nonvoting stock to Michael. As a result, each would have one-third of the voting control, but Michael would have one-half of the equity interest. Alternatively, Michael could be issued a block of preferred stock repre- senting the value of the land. This would guarantee him a fair return on his investment before any dividends could be declared to the three of them as holders of the common stock. As a holder of preferred stock, Michael would also receive a liquidation preference upon dissolution or sale of the business, in the amount of the value of his investment, but any additional value created by the efforts of the group would be reflected in the increasing value of the com- mon shares. The previous information illustrates how one can separate and allocate decision-making control differently from that of the equity in the business, as well as from the distribution of profits. Distribution of cash flow can, of 240 Planning and Forecasting course, be accomplished totally separately from the ownership of securities, through salaries based upon the relative efforts of the parties, rent payments for assets leased to the entity by the principals, or interest on loans to the corporation. Stockholders exercise what voting power they have at meetings of the stockholders, held at least annually but more frequently if necessary. Each stockholder 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 of the 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, although the Securities and Exchange Commission requires 30 days’ notice for publicly traded corporations. No action may be taken at a meeting unless a majority of voting shares is represented (known as a quorum). This results in the aggres- sive solicitation of proxy votes in most corporations with widespread stock ownership. 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 directors will be elected by the holders of a majority of the voting shares. Thus, in the earlier 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 prevent this result, prior to investing Michael could insist upon a cumulative voting provision 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 to the number of directors to be elected. By using all their votes to support a sin- gle candidate, individuals with a significant minority interest can guarantee themselves 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 stock and elect two directors. Michael, the sole owner of the 1,000 outstanding shares of class B stock, would elect a third director. Of course, the board also acts 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 written consent, where each stockholder indicates his approval of a written resolution by signing it. This eliminates the need for a meeting and is very effective in corporations with only a few stockholders (such as our hotel operation). Unlike the rules governing stockholders’ meetings, however, in most states unanimity is required to adopt resolutions by written consent. This apparently reflects the belief that a minority stockholder is owed an opportunity to sway the majority with his arguments. A few states, notably Delaware, permit written consents of a majority, apparently reacting to the dominance of proxy voting at most meet- ings of large corporations, where the most eloquent of minority arguments would fall upon deaf ears (and proxy cards). Choosing a Business Form 241 Directors At the directors’ level, absent a special provision in the corporation’s charter, all decisions are made by majority vote. Typically, directors concentrate on long-term and significant decisions, leaving day-to-day management to the offi- cers of the corporation. Decisions are made at regularly scheduled directors’ meetings or at a special meeting if there is need to respond to a specific situa- tion. Under most corporate laws, no notice need be given for regular meetings, and only very short notice need be given for special meetings (24 to 48 hours). The notice must be sent to all directors and must contain the date, time, and place of the meeting but, unlike stockholders’ notices, need not contain the purpose of the meeting. It is assumed that directors are much more involved in the business of the corporation and do not need to be warned about possible agenda items or given long notice periods. At the meeting itself, no business can be conducted in the absence of a quorum, which, unless increased by a charter or bylaw provision, is a majority of the directors then in office. Reflecting recent advances in technology, many corporate statutes allow directors to attend meetings by conference call or teleconference as long as all directors are able to hear and speak to each other at all times during the meeting. Individual telephone calls to each director will not suffice. Unlike stockholders, directors cannot vote by proxy, because each director owes to the corporation his or her individual judgment on items com- ing before the board. The board of directors can also act by written consent, but, even in Delaware, such consent must be unanimous, in recognition that the board is fundamentally a deliberative body. Boards of directors, especially in publicly held corporations with larger boards, frequently delegate some of their powers to executive committees, or other committees formed for defined purposes. However, most corporate statutes prohibit boards from delegating certain fundamental powers, such as the declaration of dividends, the recommendation of charter amendments, or sale of the company. The executive committee can, however, be a powerful or- ganizational tool to streamline board operations and increase efficiency and responsiveness. Although directors are not agents of the corporation—in that they cannot bind the corporation to contract or tort liability through their individual ac- tions—they are subject to many of the obligations of agents discussed in the context of partnerships, such as fiduciary loyalty. Directors are bound by the so-called corporate opportunity doctrine, which prohibits them from taking personal advantage of any business opportunity that may come their way, if the opportunity would reasonably be expected to interest the corporation. In such an event, the director must disclose the opportunity to the corporation, which normally must consider it and vote not to take advantage before the director may act on her or his own behalf. Unlike stockholders, who under most circumstances can vote their shares totally in their own self-interest, directors must use their best business judg- ment and act in the corporation’s best interest when making decisions for the 242 Planning and Forecasting corporation. At the very least, the director must keep informed regarding the corporation’s operations, although he or she may in most circumstances rely on the input of experts hired by the corporation, such as its attorneys and accoun- tants. Thus, when the widow of a corporation’s founder accepted a seat on the board as a symbolic gesture of respect to her late husband, she found herself li- able to minority stockholders for the misbehavior of her fellow board members. Nonparticipation in the misdeeds was not enough to exempt her from liability; she had failed to keep herself informed and exercise independent judgment. Directors may also find themselves sued personally by minority stock- holders or creditors of the corporation for declaration of dividends or other distributions to stockholders that render the corporation insolvent or for other decisions of the board that have injured the corporation. Notwithstanding such lawsuits, however, directors are not guarantors of the success of the corpora- tion’s endeavors; they are required only to have used their best independent “business judgment” in making their decisions. When individual directors can- not be totally disinterested (such as the corporate opportunity issue or when the corporation is being asked to contract with a director or an entity in which a director has an interest), the interested director is required to disclose her or his interest and is disqualified from voting. In many states, the director’s pres- ence will not even count for the maintenance of a quorum. Apart from the question of the interested director, much of the modern debate on the role of the corporate director has focused around which con- stituencies a director may take into account when exercising his or her best business judgment. The traditional view has been that the director’s only con- cern is to maximize return on the investment of the stockholders. More re- cently, especially in the context of hostile takeovers, directors have been allowed to take into account the effect of their decisions on other constituen- cies, such as suppliers, neighboring communities, customers, and employees. In an early case on this subject, the board of directors of the corporation which owned Wrigley Field and the Chicago Cubs baseball team was judged to have appropriately considered the effect on its neighbors and on the game of baseball in voting to forgo the extra revenue that it would probably have earned if it had installed lights for night games. When the stockholders believe the directors have not been exercising their best independent business judgment in a particular instance, the normal procedure is to make a demand on the directors to correct the decision either by reversing it or by reimbursing the corporation from their personal funds. Should the board refuse (as it most likely will), the stockholders then bring a derivative suit against the board on behalf of the corporation. They are, in ef- fect, taking over the board’s authority to decide whether such a suit should be brought in the corporation’s name. The board’s vote not to institute the suit is not likely to be upheld on the basis of the business judgment rule, since the board members are clearly interested in the outcome of the vote. As a result, the well-informed board will delegate the power to make such a decision to an independent litigation committee, usually composed of directors who were not Choosing a Business Form 243 involved in the original decision. The decision of such a committee is much more likely to be upheld in a court of law, although the decision is not immune from judicial review. A more detailed discussion on the board of directors is contained in Chapter 15, “The Board of Directors.” Officers The third level of decision making in the normal corporation is that of the officers, who take on the day-to-day operational responsibilities. Officers are elected by the board and consist, at a minimum, of a president, a treasurer, and a secretary or clerk (keeper of the corporate records). Many corporations elect additional officers such as vice presidents, assistant treasurers, CEOs, and the like. Thus, the decision-making control of the corporation is exercised on three very different levels. Where each decision properly belongs may not be entirely obvious in every situation. The decision to go into a new line of busi- ness would normally be considered a board decision. Yet if by some chance the decision requires an amendment of the corporate charter, a vote of stockhold- ers may be necessary. On the contrary, if the decision is merely to add a twelfth variety of relish to the corporation’s already varied line of condiments, the decision may be properly left to a vice president of marketing. Often persons who have been exposed to the preceding analysis of the corporate-control function conclude that the corporate form is too complex for any but the largest and most complicated publicly held companies. This is a gross overreaction. For example, if Phil, our software entrepreneur, should de- cide that the corporate form is appropriate for his business, it is very likely that he will be the corporation’s 100% stockholder. As such, he will elect himself the sole director and his board will then elect him as the president, treasurer, and secretary of the corporation. Joint meetings of the stockholders and direc- tors of the corporation may be held in the shower adjacent to Phil’s bathroom on alternate Monday mornings. Limited Partnerships As you might expect, the allocation of control in a limited partnership reflects its origin as a hybrid of the general partnership and the corporation. Simply put, virtually all management authority is vested in the general partners. Like outside stockholders in a corporation, the limited partners normally have little or no authority. Third parties cannot rely on any apparent authority of a limited partner because that partner’s name will not appear, as a general partner’s name may, on the limited partnership’s certificate on the public record. General partners exercise their authority in the same way as they do in a general partnership. Voting control is allocated internally as set forth in the partnership agreement, but each general partner has the apparent authority to 244 Planning and Forecasting bind the partnership to unauthorized contracts and torts to the same extent as the partners in a general partnership. Limited partners will normally have voting power over a very small list of fundamental business events, such as amending the partnership agreement and certificate, admitting new general partners, changing the basic business pur- poses of the partnership, or dissolving the partnership. These are similar to the decisions that must be put to a stockholders’ vote in a corporation. The Revised Uniform Limited Partnership Act, now accepted by most states, has widened the range of decisions in which a limited partner may participate without los- ing his or her status as a limited partner. However, this range is still deter- mined by the language of the agreement and certificate for each individual partnership. Limited Liability Companies An LLC which chooses not to appoint managers is operated much like a gen- eral partnership. The operating agreement sets forth the percentages of mem- bership interests required to authorize various types of actions on the LLC’s behalf, with the percentage normally varying according to the importance of the act. Although the LLC is a relatively new phenomenon, courts can be ex- pected to deem members (in the absence of managers) to have apparent au- thority to bind the entity to contracts (regardless of whether they have been approved internally) and to expose the entity to tort liability for acts occurring within the scope of the entity’s business. An LLC that appoints managers is operated much like a limited partner- ship. The managers make most of the decisions on behalf of the entity, as do the general partners of a limited partnership. The members are treated much like limited partners and have voting rights only in rare circumstances involv- ing very significant events. It can be expected that apparent authority to act for the entity will be reserved by the courts to the managers, as only their names will appear on the Certificate of Organization. LIABILITY Possibly the factor that most concerns the entrepreneur is personal liability. If the company encounters catastrophic tort liability, finds itself in breach of a significant contract, or just plain can’t pay its bills, must the owner reach into her or his own personal assets to pay the remaining liability after the company’s assets have been exhausted? If so, potential entrepreneurs may well believe that the risk of losing everything is not worth the possibility of success, and their innovative potential will be diminished or lost to society. Most entrepreneurs are willing to take significant risk, however, if the amount of that risk can be limited to the amount they have chosen to invest in the venture. Choosing a Business Form 245 Sole Proprietorships With the sole proprietorship, the owner has essentially traded off limitation of risk in favor of simplicity of operation. Since there is no difference between the entity and its owner, all the liabilities and obligations of the business are also liabilities and obligations of its owner. Thus, all the owner’s personal assets are at risk. Failure of the business may well mean personal bankruptcy for the owner. Partnerships The result may be even worse within a general partnership. There, each owner is liable not only for personal mistakes but also for those of his or her partners. Each partner is jointly and severally liable for the debts of the partnership re- maining after its assets have been exhausted. This means that a creditor may choose to sue any individual partner for 100% of any liability. The partner may have a right to sue the other partners for their share of the debt, as set forth in the partnership agreement, but that is of no concern to a third party. If the other partners are bankrupt or have fled the jurisdiction, the targeted partner may end up holding the entire bag. If our three consultants operate as a partnership, Jennifer is 100% per- sonally liable not only for any contracts she may enter into but also for any con- tracts entered into by either Jean or George. What’s more, she is liable for those contracts, even if they were entered into in violation of the partnership agreement, because, as was demonstrated earlier, each partner has the appar- ent authority to bind the partnership to contracts in the ordinary course of the partnership’s business, regardless of the partners’ internal agreement. Worse, Jennifer is also 100% individually liable for any torts committed by either of her partners as long as they were committed within the scope of the partner- ship’s business. The only good news in all this is that neither the partnership nor Jennifer is liable for any debts or obligations of Jean or George incurred in their personal affairs. If George has incurred heavy gambling debts in Las Vegas, his creditors can affect the partnership only by obtaining a charging order against George’s partnership interest. Corporations Thus, we have the historical reason for the invention of the corporation. Un- like the sole proprietorship and partnership, the corporation is recognized as a legal entity separate from its owners. Its owners are thus not personally li- able for its debts; they are granted limited liability. If the corporation’s debts exhaust its assets, the stockholders have lost their investment, but they are not responsible for any further amounts. In practice, this may not be as at- tractive as it sounds, because sophisticated creditors, such as the corpora- tion’s bank, will likely demand personal guarantees from major stockholders. 246 Planning and Forecasting But the stockhold ers will normally escape personal liability for trade debt and, most important, for torts. This major benefit of incorporation does not come without some cost. Creditors may, on occasion, be able to “pierce the corporate veil” and assert personal liability against stockholders, using any one of three major arguments. First, to claim limited liability behind the corporate shield, stockholders must have adequately capitalized the corporation at or near its inception. There is no magic formula with which to calculate the amount necessary to achieve ade- quate capitalization, but the stockholders normally will be expected to invest enough money or property and obtain enough liability insurance to offset the kinds and amounts of liabilities normally encountered by a business in their in- dustry. Thus, the owner of a fleet of taxicabs did not escape liability by cancel- ing his liability insurance and forming a separate corporation for each cab. The court deemed each such corporation inadequately capitalized and, in a novel decision, pierced the corporate veil laterally by combining all the corporations into one for purposes of liability. It is necessary to capitalize only for those liabilities normally encoun- tered by corporations in the industry. The word normally is key because the corporation obviously need not have resources adequate to handle any circum- stance no matter how unforeseeable. Also, adequate capitalization is necessary only at the outset. A corporation does not expose its stockholders to personal liability by incurring substantial losses and ultimately dissipating its initial capitalization. A second argument used by creditors to reach stockholders for personal li- ability is failure to respect the corporate form. This may occur in many ways. The stockholders may fail to indicate that they are doing business in the corpo- rate form by leaving the words “Inc.” or “Corp.” off their business cards and stationery, thus giving the impression that they are operating as a partnership. They may mingle the corporate assets in personal bank accounts or routinely use corporate assets for personal business. They may fail to respect corporate niceties such as holding annual meetings and filing the annual reports required by the state. After all, if the stockholders don’t take the corporate form seri- ously, why should their creditors? Creditors are entitled to adequate notice that they may not rely on the personal assets of the stockholders. Even Phil, the software entrepreneur imagined earlier holding stockholder’s and direc- tor’s meetings in his shower, would be well advised to record the minutes in a corporate record book. A third argument arises from a common mistake made by entrepreneurs. Fearful of the expense involved in forming a corporation, they wait until they are sure that the business will get off the ground before they spring for the at- torneys’ and filing fees. In the meantime, they may enter into contracts on be- half of the corporation and perhaps even commit a tort or two. Once the corporation is formed, they may even remember to have it expressly accept all liabilities incurred by the promoters on its behalf. Under simple agency law, however, one cannot act as an agent of a nonexistent principal. And a later Choosing a Business Form 247 as signment of one’s liabilities to a newly formed corporation does not act to re- lease the original obligor without the consent of the obligee. The best advice here is to form the corporation before incurring any liability on its behalf. Most entrepreneurs are surprised at how little it actually costs to get started. Limited Partnerships In keeping with its hybrid nature, a limited partnership borrows some of its as- pects from the corporation and some from the general partnership. In sum- mary, each general partner has unlimited joint and several liability for the debts and obligations of the limited partnership after exhaustion of the part- nership’s assets. In this respect, the rules are identical to those governing the partners in a general partnership. Limited partners are treated as stockholders in a corporation. They have risked their investment, but their personal assets are exempt from the creditors of the partnership. As you might expect, however, things aren’t quite as simple as they may initially appear. In limited partnerships, it is rather common for limited part- ners to make their investments in the form of a cash down payment and a promissory note for the rest, partly for reasons of cash flow and partly for pur- poses of tax planning. This arrangement is much less common in corporations because many corporate statutes do not permit it and because the tax advan- tages associated with this arrangement are generally not available in the corpo- rate form. Should the limited partnership’s business fail, limited partners will be expected, despite limited liability, to honor their commitments to make fu- ture contributions to capital. In addition, it is fundamental to the status of limited partners that they have acquired limited liability in exchange for foregoing virtually all manage- ment authority over the business. The corollary to that rule is that a limited partner who excessively involves her- or himself in management may forfeit limited liability and be treated, for the purposes of creditors, as a general part- ner, with unlimited personal liability. Mitigating this somewhat harsh rule, the Revised Uniform Limited Partnership Act increased the categories of activi- ties in which a limited partner may participate without crossing the line. Fur- thermore, and perhaps more fundamentally, in states that have adopted the Revised Act, the transgressing limited partner is now only personally liable to those creditors who were aware of the limited partner’s activities and detri- mentally relied upon his or her apparent status as a general partner. Limited Liability Companies One of the major benefits of employing the LLC form is that it shields all members and managers from personal liability for the debts of the business. However, even though the LLC is relatively new on the legal scene, courts can be expected to apply most of the same doctrines they use in piercing the corporate veil to pierce the veil of the LLC as well. Furthermore, it can be . the limited partnership after exhaustion of the part- nership’s assets. In this respect, the rules are identical to those governing the partners in a general partnership. Limited partners are. general partners. Like outside stockholders in a corporation, the limited partners normally have little or no authority. Third parties cannot rely on any apparent authority of a limited partner. limited partner because that partner’s name will not appear, as a general partner’s name may, on the limited partnership’s certificate on the public record. General partners exercise their authority