Business Associations (Main Deck)* Flashcards

Question

FORMATION OF A LIMITED LIABILITY PARTNERSHIP (State the Rule)

Answer 1

**Rule:** A limited liability partnership is formed by filing with the Secretary of State a Registration that includes: 1) The name of the partnership, 2) The address of its principal office, 3) The name and address of the agent designated to receive service of process, 4) A brief statement of the business in which the partnership engages, 5) A statement that the partnership is registering as a limited liability partnership, AND 6) Any other matters the partners deem importantto include. **Note:** 1) The name of a registered limited liability partnership must contain the words "Limited Liability Partnership" or "Registered Limited Liability Partnership," or the initials "LLP" or "RLLP' must be included as the last letters of its name. 2) In California, only accountants, lawyers, and architects may form limited liability partnerships, and all partners must be licensed in the profession.

Answer 2

**Rule:** The defining characteristics of a general partnership include: 1) Each partner has unlimited personal liability for all obligations of the partnership, a) **Note:** The amount or percentage of each partner's financial contribution is irrelevant to determining her liability for the debts or obligations of a general partnership. 2) All partners have equal authority over the management ofthe enterprise, a) Note: This can be altered through agreement. 3) Matters are generally determined by majority vote, AND a) **Note:** This can be altered through agreement. 4) Profits and losses are shared equally among partners. a) **Note:** This can be altered through agreement.

Answer 3

**Uniform Partnership Act (UPA):** 1) **Tort Obligations:** Partners have joint and several liability. 2) **Contract Obligations:** Partners have joint liability, but not several liability. **Revised Uniform Partnership Act (RUPA):** 1) Partners are held jointly and severally liable for all partnership obligations. 2) A partner's personal assets can be reached by a creditor only if a judgment has been obtained against the partner in his personal capacity, AND a) The assets of the partnership have been exhausted, b) The partner has agreed that the creditor need not exhaust partnership assets, c) A court grants the creditor permission to levy the personal assets ofthe partner, d) A legal obligation exists that permits attaching the partner's personal assets. OR e) The partnership has filed for bankruptcy. **Note:** In a partnership, every partner is deemed an agent of the partnership. Thus, the acts of a partner performed on behalf of the partnership and within the scope of its business are binding upon all co-partners.

Answer 4

**Rule**: The defining characteristics of a limited partnership include: 1) **Management and control:** a) General partners are responsible forthe management ofthe business and may also contribute capital. b) Limited partners invest capital in the partnership and share in the profits ofthe partnership, but do not participate in the management of the business. 2) **Liability**: a) General partners may be held personally liable for the obligations of the partnership. b) Each limited partner's liability is limited to the amount ofthe capital she invested in the partnership. **Note: **A limited partnership must have at least one general partner who can be held personally liable for the partnership's obligations. However, the general partner may be a corporation or an LLC, thereby protecting individuals from unlimited personal liability.

Answer 5

**Rule:** In a limited liability partnership (LLP), a debt or obligation incurred by the partnership is solely the obligation ofthe partnership. Partners will not be held personally liable for: 1) The partnership's debts (beyond the amount ofthe partner's investment into the partnership), OR 2) The tortious conduct of other partners (i.e., no vicarious liability). **Note:** Limited liability partners share management and control functions in a manner similar to general partners.

Answer 6

Shared characteristics of general, limited and limited liability partnerships include: 1) Partnerships are taxed at only one level (each individual partner), thereby avoiding the double taxation experienced at the corporate level, a) **Note**: Double taxation refers to the taxation of a corporation on its earnings, and the subsequent taxation of employees/shareholders on their earnings from the corporation. 2) Profits are shared equally among all partners unless altered through agreement ofthe partners, 3) Partners owe fiduciary duties to the partnership and to one another. a) General partners always owe fiduciary duties to other partners and to the partnership. b) Limited partners historically did not owe the same level of fiduciary duties as did general partners. However, under the modern statute (Re-RULPA) and recent case law, limited partners may owe fiduciary duties if they exert any influence or control over the partnership.

Answer 7

**Rule:** In a partnership, partners owe one another and the organization: 1) A duty of care, a) **Note:** Partners must not engage in grossly negligent or reckless conduct, intentional misconduct, or a knowing violation ofthe law. 2) A duty of loyalty, AND a) **Note:** Partners cannot serve their own interest at the expense ofthe partnership, engage in secret profit, or compete with the partnership. 3) A duty of good faith and fair dealing.

Answer 8

**Rule:** A partnership may be dissolved by: 1) Act of the partners, 2) Operation of law, OR 3) Judicial decree.

Answer 9

**Rule**: A partnership may be dissolved by: 1) Expiration of the time or termination of the purpose stated in the partnership agreement, 2) Withdrawal of a partner, 3) Expulsion of a partner, OR 4) Mutual agreement of all partners. **Note:** Under the UPA, the expulsion of a partner results in the dissolution of the partnership followed immediately by the formation of a new partnership with the remaining partners.

Answer 10

**Rule:** A partnership will be dissolved by operation of law if: 1) A partner dies, 2) A partner becomes bankrupt, 3) The partnership becomes bankrupt, OR 4) A supervening event has made the partnership's purpose illegal.

Answer 11

**Rule:** A partnership may be dissolved by judicial decree when: 1) A partner is determined by the court to be insane, 2) A partner is found guilty of conduct that prejudices her ability to act as a partner, OR 3) The partnership can be carried on only at a loss.

Answer 12

**Rule:** Upon dissolution of a partnership, the partnership's assets are liquidated and distributed in the following order to satisfy the partnership's obligations: 1) Creditors (excluding partners who are also creditors), 2) Creditor-partners, 3) Capital contributors, 4) Profits.

Answer 13

**Rule**: In the absence of an agreement otherwise: 1) Each partner is repaid the amount he contributed, 2) Any profits are shared equally among the partners (per capita), AND 3) Losses are shared equally among the partners (per capita).

Answer 14

**Definition:** A limited liability company (LLC) is a business organization that combines characteristics of corporations and partnerships. It is designed primarily to limit the liability of its members. **Note**: 1) An LLC is a distinct legal entity and may carry out its business functions in the same manner as a corporation. 2) An LLC provides liability protection similar to that which shareholders receive in a corporation, but avoids the double taxation that corporations experience by allowing the owners of the LLC to be taxed personally (as in a partnership).

Answer 15

**Rule:** An LLC is formed by filing Articles of Organization with the Secretary of State that include: 1) The name of the LLC, 2) The purpose of the LLC, 3) The name and address of the agent for service of process, AND 4) Whether the LLC will be managed by members or by non-member managers. **Note:** 1) The name of the LLC must contain language demonstrating that the business entity is an LLC (e.g., "Limited Liability Company" or a "LLC"). 2) If the LLC is formed for a term, the articles must contain the time at which the LLC is to dissolve.

Answer 16

**Rule:** An LLC must be adequatelyfunded through capitalcontribution by its members. If an LLC is under-capitalized for the type of business in which it is engaged, a court may ignore the liability protection of the LLC and hold the individual members personally liable.

Answer 17

**Rule:** An LLC is treated like a partnership for tax purposes unless the LLC chooses to be taxed like a corporation. Thus, members of an LLC are taxed on their share of the LLC's profit (i.e., pass-through taxation). **Note**: California imposes an annual franchise tax on LLCs, but otherwise taxes members only on their share of the LLC's profits.

Answer 18

**Rule:** The distribution of income and losses among the members is determined by the Articles of Organization. If the articles do not determine the distribution, the default rules of the state in which the LLC is formed will apply. **Note:** 1) Income and losses may be distributed in two ways: in proportion to the amount of investment or equally divided among the members. 2) In California, income and losses will be allocated in proportion to the amount of capital investment by each member if the articles are silent on the matter.

Answer 19

**Rule:** The Articles of Organization determine whether the LLC will be member-managed or manager-managed. If the articles do not contain a statement vesting management authority in members or managers, the default rules of the state in which the LCC is formed will apply. **Note:** In California, LLCs will be member-managed if the articles are silent on the matter.

Answer 20

**Rule:** Generally, the Articles of Organization determine how decisions are made. In the absence of instruction by the articles, the method by which decisions are made depends upon how the LLC is managed: 1) **If member-managed:** Decisions are made through a majority vote of the members. Each member's vote is weighted in proportion to the member's capital contribution. 2) **If manager-managed:** Decisions are made through a majority vote of the managers. Each manager's vote is weighted equally.

Answer 21

**Rule:** The members and managers of an LLC will not be held personally liable for any debts, obligations or liabilities of the LLC simply by virtue of being a member or manager of the LLC. **Note:** Members and managers remain personally liable for any torts they commit in the course of performance of their duties for the LLC.

Answer 22

**Rule:** Generally, a member may assign her interest in an LLC, in whole or in part, as long as the assigning member obtains the consent of the majority interest of the non-assigning members. **Note:** 1) A member may assign the right to distribution of income from the LLC freely and without the consent of the other members. 2) Assigning the right to distribution does not assign one's management rights.

Answer 23

**Rule**: An LLC can be dissolved by: 1) Agreement of all members to end the LLC, 2) The incapacity, death, resignation or bankruptcy of a member (unless the remaining members vote to continue the LLC), 3) An order by a court or administrative agency dissolving the LLC, OR 4) The expiration of the stated term (if the LLC is a term LLC).

Answer 24

**Definition:** A corporation is a fictitious legal entity created in accordance with statutory requirements. **Note:** Defining characteristics of a corporation include: 1) Limited liability of shareholders (generally liable only for the amount of their capital contributions), 2) Free transferability of shares, 3) Perpetual existence (unless otherwise noted in the corporation's articles), 4) Centralized management (i.e., board of directors).

Answer 25

**Definition:** Corporation by estoppel results from a court decree stating that an unincorporated organization will be treated as a corporation. **Rule:** Estoppel may require that an organization be treated as a corporation in two situations: 1) A person or entity that treats an organization as a corporation, regardless of that organization's effort to incorporate, may be estopped from later claiming the entity is not a corporation. 2) An organization that holds itself out as a corporation may later be estopped from denying liability as such if sued by a plaintiff who treated the organization as a corporation in reliance on the organization's representation. **Note:** Corporation by estoppel is applied only in contractual (not tort) disputes.

Answer 26

**Definition:** A de facto corporation is that which may arise if an attempt to create a corporation fails. **Rule:** A de facto corporation will be created if: 1) A statute establishes the requirements for the creation of a legal corporation, 2) A good faith effort to comply with the statute has been made, AND 3) An agent of the corporation acted on the corporation's behalf. **Note:** If a de facto corporation is created, the entity will be treated as a corporation for all purposes.

Answer 27

**Definition**: A de jure corporation is created when the incorporator complies with all statutory requirements and the corporation is granted a state charter. **Rule:** The incorporator must file Articles of Incorporation with the Secretary of State: 1) The Articles of Incorporation must contain: a) The name of the corporation, b) The name and address of the corporation's authorized agent and all incorporators, AND c) The number of shares the corporation may issue. 2) The Articles of Incorporation often (but are not required to) contain: a) A statement of purpose, AND/OR b) A statement of duration.

Answer 28

**Promoter**: The person or persons who take the steps necessary to procure financing and capital for the corporation. **Incorporator:** The person (often the promoter) who incorporates the entity by filing the Articles of Incorporation with the Secretary of State. **Directors**: The elected or appointed persons who make up the board of directors and who manage the affairs of the corporation through the appointment of officers. **Officers**: The persons who are responsible for the daily operations of the corporation. **Shareholders**: The holders of shares in the corporation.

Answer 29

**Definition**: The Articles of Incorporation are a contract between the corporation and the state, as well as between the corporation and its shareholders. The articles state the business purpose of the corporation and provide the primary rules for management of the corporation.

Answer 30

**Definition:** Ultra vires acts are acts beyond the scope ofthe business purpose stated in the corporation's Articles of Incorporation. **Rule**: If a corporation engages in an activity that is outside the scope of its stated business purpose, then: 1) Shareholders may bring suit to enjoin the activity, 2) The corporation may bring suit against the directors or officers for exceeding their authority, AND/OR 3) The state Attorney General may bring suit to dissolve the corporation.

Answer 31

**Rule**: Generally, a promoter remains personally liable to third parties for contracts the promoter enters into on behalf of the organization before it is incorporated. **Exception**: A promoter's liability may be extinguished if: 1) An agreement substituting the corporation for the promoter is made (i.e., a novation), OR 2) The pre-incorporation contract entered into by the promoter expressly states that the promoter will not be held liable for a breach arising from the contract.

Answer 32

**Rule:** A corporation cannot be held liable until formed. Once formed, the corporation may be held liable for contracts entered into by the promoter if: 1) The board of directors ratifies the contract, OR 2) The corporation accepts the benefits of the contract.

Answer 33

**Rule**: Promoters owe a duty of loyalty to the corporation and may not act for their own benefit in dealings with the corporation. **Exception**: A promoter may profit from his dealings with the corporation if: 1) All material facts of the transaction are fully disclosed to all parties AND 2) The board of directors ratifies the transaction

Answer 34

**Definition:** Piercing the corporate veil refers to the method by which creditors are able to reach the personal assets of shareholders, or the assets of sister or parent corporations, by removing the liability protection offered by the corporate structure. **Rule:** To pierce the corporate veil, the claimant must establish: 1) A unity of interests and ownership (i.e., alter ego), AND 2) That maintaining the corporate facade would facilitate fraud or injustice. **Note:** The claimant's inability to collect on his claim if the veil is not pierced is generally not a sufficient showing of injustice to pierce the veil.

Answer 35

**Rule**: To determine whether a unity of interests and ownership exists, courts will look to: 1) The extent to which corporate formalities have been disregarded, 2) Whether the corporation is grossly undercapitalized, 3) Whether the corporation's assets are intermingled with those ofthe officers or directors, or those of a sister or parent corporation, 4) Whether the officers or directors treat the corporation's assets as their own, 5) Whether parent, subsidiary or sister corporations share directors, officers, or employees, AND 6) Whether parent, subsidiary or sister corporations maintain completely separate operations.

Answer 36

**Vertical Piercing:** Vertical piercing allows a corporation's claimants to reach the assets of dominant shareholders. **Horizontal Piercing:** Horizontal piercing allows a corporation's claimants to reach the assets of sister corporations. **Reverse Piercing:** Reverse piercing allows a dominant shareholder's claimants to reach the assets of a corporation.

Answer 37

1) Duty of Due Care 2) Duty of Loyalty 3) Duty Not to Commit Waste **Note:** The duty of good faith is implied in the duty of due care and the duty of loyalty.

Answer 38

**Definition:** The Business Judgment Rule (BJR) creates a strong presumption in favor ofthe legitimacy ofthe board's decisions when managing a corporation's affairs and frees the board from liability for business decisions made in good faith. **Rule:** Courts generally will not question directors' decisions made in the course of managing the corporation. **Exception:** The BJR will not protect decisions made by the board of directors if: 1) The decisions were not made in good faith and with the belief that the decision was in the corporation's best interest, 2) The directors failed to obtain sufficient information or conduct a sufficient investigation before making the decision, 3) The directors violated their duty of due care or loyalty, OR 4) The directors' failure to act was grossly negligent. **Note:** Under the BJR, the board of directors may: 1) Delegate decision-making power to committees, 2) Rely on special investigations of committees, AND/OR 3) Rely on the professional judgment of qualified advisers.

Answer 39

**Rule:** Directors owe a degree of care to the corporation that a business person of ordinary prudence would exercise in the same position. The duty of due care requires that directors: 1) Act in good faith and in a manner they reasonably believe to be in the best interest of the corporation, 2) Reasonably inform themselves before making decisions, AND 3) Monitor and remain informed about the operations of the corporation.

Answer 40

**Rule**: Directors owe a duty of loyalty to the corporation and may not serve their own interest at the expense or to the detriment of the corporation, or engage inactivities which create a conflict of interest with the corporation.

Answer 41

**Rule:** A director may not engage in transactions in which the director has a conflict of interest with the corporation. **Note:** A conflict of interest arises when a director, in her capacity as such, engages in a transaction in which she or a family member has a personal financial interest.

Answer 42

**Rule:** A director may not appropriate an opportunity in which the corporation has a foreseeable interest without first presenting the opportunity to the corporation. To determine if a corporate opportunity exists, courts look to whether: 1) The corporation has a contractual or expectancy interest in the opportunity, 2) The opportunity is in the same line of business as the corporation, 3) The corporation has the resources to pursue the opportunity, AND 4) The director learned ofthe opportunity through his role as a director. **Note:** If a director presents the opportunity to an informed and disinterested board of directors and a majority of the board votes to reject the opportunity, the director is free to pursue the opportunity.

Answer 43

**Rule:** The remedies available for misappropriation of a corporate opportunity include: 1) Awarding damages measured by profits gained by the director, 2) Awarding damages measured by profits lost to the corporation, OR 3) Declaring a constructive trust over the profits for the benefit of the corporation.

Answer 44

**Rule:** A director has a duty not to compete with the corporation. **Note:** Competing with the corporation creates a conflict of interest.

Answer 45

**Rule:** The board of directors has a duty not to commit corporate waste. Under this duty: 1) Directors may donate corporate funds to charity, as long as the donation is not excessive or given in bad faith, 2) Directors may not intentionally refrain from generating profit for the corporation. a) **Note:** Though directors are under no affirmative duty to generate profit, they may not actively decide to not generate profit for the corporation. **Note:** Corporate waste occurs when the corporation enters into a deal or transaction that is so inequitable that no business person of ordinary, sound judgment could conclude that the corporation had received adequate consideration.

Answer 46

**Rule:** Directors are jointly and severally liable for harm caused to the corporation by a breach of their duties.

Answer 47

**Rule**: A corporation, through its bylaws, may limit directors' personal liability to the corporation or its shareholders for actions taken in their capacity as directors. **Exception:** A corporation may not limit directors' personal liability for: 1) Wrongful procurement of financial gain, 2) Intentional harms inflicted on the corporation or its interests, OR 3) An intentional violation of the law.

Answer 48

**Rule:** Directors will not be held liable for engaging in acts that may otherwise constitute a breach of their duties if: 1) The transaction is shown to be fundamentally fair to the corporation, 2) The corporation takes subsequent action to demonstrate the actions were reasonable, 3) A majority of disinterested shareholders approved the transaction after full disclosure, OR 4) A majority of disinterested board members approved the transaction after full disclosure.

Answer 49

**Rule:** Initially, the plaintiff bringing suit for breach of a fiduciary duty must present evidence sufficient to overcome the presumption of legitimacy provided by the Business Judgment Rule. If the plaintiff makes this showing, the burden shifts to the director defendant, who must prove her action was cleansed (e.g. a majority of disinterested directors voted to approve her action).

Answer 50

**Rule:** If a director is sued for actions taken or decisions made in her role as director and prevails in the lawsuit, the corporation must reimburse the director for the costs of litigation.

Answer 51

**Rule**: If a director is sued for actions taken or decisions made in his role as director and does not prevail, the corporation may reimburse him for the costs of litigation if: 1) The director acted in good faith. 2) He believed he was acting in the best interests ofthe corporation. AND 3) His decisions or actions were not illegal.

Answer 52

**Rule**: A corporation may not reimburse a director who does not prevail in a lawsuit against her for actions taken or decisions made in her role as director if: 1) The director is found liable to the corporation, OR 2) The director improperly benefited from the decision or action for which she is being sued.

Answer 53

**Rule:** Directors are elected by shareholders at the shareholder meeting.

Answer 54

**Rule**: Directors may be removed by a vote of the shareholders, or they may resign upon notice to the board.

Answer 55

**Rule:** The board of directors must hold regularly scheduled meetings as determined in the corporation's articles or bylaws. **Note:** Notice is not required for regularly scheduled meetings of the board.

Answer 56

**Rule**: Notice is required for specially scheduled meetings and must be given to all directors at least 2 days before the special meeting. **Note:** 1) Notice must include the date, time and place ofthe meeting. 2) Special meetings are generally held to discuss out-of-the-ordinary business matters, such as a potential merger, sale of assets or amendment of the articles.

Answer 57

**Rule:** Unless otherwise specified in the corporation's articles or bylaws, a board meeting may not be held without a majority of the directors present. **Note:** 1) Even if otherwise stated in the articles or bylaws, at least one-third ofthe board's directors must be present to meet quorum. 2) Quorum is required for special and regular board meetings.

Answer 58

**Rule**: Once quorum has been established, a board may act by a majority vote ofthe directors present. **Note:** Quorum is measured at the time the board votes. If directors leave and attendance is reduced to below quorum before a vote, quorum will be lost.

Answer 59

**Rule:** Officers owe the same duties of care and loyalty as directors and are liable to the corporation for violation of their fiduciary duties in the same manner as directors. **Note:** Though the Business Judgment Rule does not explicitly protect the decision-making of officers, case law suggests that officers are entitled to the same protection under the BJR as directors because officers owe the same fiduciary duties as directors and are responsible for the day-to-day management of the corporation.

Answer 60

**Mandatory Indemnification**: If an officer wins in a suit brought against him for violation of fiduciary duties in his role as an officer of the corporation, the corporation must reimburse the officer for the costs of litigation. **Permissive Indemnification**: If an officer is sued for actions taken or decisions made in his role as officer and does not prevail, the corporation may reimburse him for the costs of litigation if: 1) He acted in good faith, 2) He believed he was acting in the best interests of the corporation, AND 3) His decisions or actions were not illegal. **Prohibited Indemnification**: A corporation may not reimburse an officer who does not prevail in a lawsuit for actions taken or decisions made as an officer if the officer: 1) Is found liable to the corporation, OR 2) Improperly benefited from the decision or action for which he is being sued.

Answer 61

**Rule:** Officers are selected by: 1) Election or appointment by the board of directors, OR 2) Officers authorized by the corporation's bylaws or the board of directors to select other officers.

Answer 62

**Rule**: Officer duties and responsibilities are: 1) Determined by the corporation's bylaws, 2) Delegated by the board of directors, OR 3) Prescribed by any officer authorized by the bylaws or the board to prescribe the duties of other officers.

Answer 63

**Rule:** An officer may resign at any time by giving notice to the corporation, or may be removed with or without cause by: 1) The board of directors, OR 2) An officer authorized to remove other officers. **Note:** Officers can be authorized to remove other officers by the corporation's bylaws or by the board of directors.

Answer 64

**Definition:** Stocks are a form of securities that are issued (i.e.. sold) by the corporation as a method of raising capital. **Note:** Corporations also raise capital through borrowing capital (i.e.. acquiring debt) in the form of bonds. In the case of bankruptcy of the corporation, bondholders will be paid before shareholders.

Answer 65

**Rule:** The corporation maydecide how many shares of stock to issue, but the quantity of stock the corporation will make available to the public (authorized shares) must be listed in the corporation's Articles of Incorporation filed with the Secretary of State.

Answer 66

**Rule**: The corporation may decide what type of stock to issue and whether to offer different classes of shares. **Note:** 1) Though a corporation may determine the type of stock it will issue, at least one class or series of stock must be assigned: a) Unlimited voting rights, AND b) The right to receive payment upon dissolution ofthe corporation. 2) The type of stock the corporation will make available must be listed in the corporation's Articles of Incorporation.

Answer 67

**Rule**: An owner of stock (shareholder) has anownership interest in the corporation. The rights associated with ownership of stock depend upon the type of stock that is owned.

Answer 68

**Rule:** If a corporation issues only one class of stock (common shares), all shareholders hold equal rights. **Note:** Corporations may choose to offer only one class of shares, or may offer different classes of shares to which different rights, preferences, privileges, and restrictions are attached.

Answer 69

**Rule**: A corporation may, in its Articles of Incorporation, divide stock into multiple classes of shares or a series of shares within a class, with varying rights, preferences, privileges and restrictions assigned to each. Classes or series within a class of shares may be divided by: 1) Voting rights, 2) Rights of redemption, 3) Distribution rights, AND/OR 4) Preference (i.e., over other classes or series of stock). **Note:** If a corporation chooses to issue varying classes or series of stock, it must include in the Articles of Incorporation the number of shares per designated class and series as well as the rights and restrictions associated with each class/series.

Answer 70

**Rule**: All shares of any one class must have the same rights, preferences, privileges and restrictions, unless the class is divided into a series, in which case all shares of any one series must have the same rights, preferences, privileges and restrictions.

Answer 71

**Rule**: The corporation must receive consideration for issued shares. Consideration may consist of any tangible or intangible property or benefit to the corporation, including: 1) Cash, 2) Services performed, 3) Promissory notes, 4) Contracts for services to be performed. **Note:** 1) The board of directors determines whether the consideration received for the stock is adequate. 2) The board's determination of adequacy is accepted as conclusive for purposes of determining whether the shares are validly issued and fully paid.

Answer 72

**Definition**: A subscription agreement is an offer by an individual or entity to purchase shares of stock from an existing or yet-to-be formed corporation. **Rule:** Subscription agreements are subject to the following requirements: 1) Pre-incorporation agreements are irrevocable for 6 months unless otherwise stated. 2) If payment terms are not stated in the agreement, the board may determine the payment terms of a pre- incorporation subscription agreement. 3) The payment terms must be uniform across all shares unless otherwise stated. 4) Shares issued pursuant to pre-incorporation subscription agreements are paid in full when the corporation receives the consideration specified in the agreement (regardless of the current value of the stock). 5) If the subscriber defaults on payment for shares issued pursuant to a pre-incorporation subscription agreement, the corporation may: a) Collect on the default payment as it would collect on any other debt, OR b) Rescind the agreement and sell the shares if the debt is not paid within 20 days of a written demand for payment.

Answer 73

**Definition**: A controlling shareholder holds a majority of shares, or a sufficiently large percentage of shares to effectively direct the use of assets of the corporation.

Answer 74

**Rule**: A controlling shareholder owes a duty of loyalty to the corporation and will breach this duty if she uses her position to distribute corporate assets in a manner benefiting herself at the expense of the minority shareholders.

Answer 75

**Rule:** A controlling shareholder may sell a controlling share of the corporation at a premium. **Exception**: A controlling shareholder may not knowingly sell a controlling share of a corporation to looters and has a duty to investigate parties purchasing stock for a premium, especially in suspicious circumstances (e.g., an anonymous purchaser or a purchaser with a history of looting). **Note:** A looter is a party who intends to pillage the corporation's assets.

Answer 76

**Definition**: Quorum is based on the number of corporate shares issued and outstanding. **Rule**: The quorum required for shareholder voting is usually a majority of outstanding shares, unless otherwise specified in the corporation's articles or bylaws. **Note:** 1) Quorum does not require that the shareholder be present at the meeting, only that her shares be present (i.e., by proxy). 2) Once quorum is present, quorum cannot be broken by withdrawal of shares from the meeting.

Answer 77

**Rule:** Unless otherwise specified in the Articles of Incorporation, each share is entitled to one vote, and a plurality of votes will approve a proposal. **Note**: Other voting systems can be provided for in the articles or bylaws, including: 1) Weighted voting (usually dependent upon the class of stock), 2) Cumulative voting (for the election of directors), 3) Class voting (when a matter will affect only one class).

Answer 78

**Definition:** A proxy is a writing signed by a shareholder authorizing another shareholder to vote his shares. **Rule:** A shareholder may vote his shares in person or by proxy.

Answer 79

**Definition:** A proxy solicitation is a request to shareholders to agree to a mutual representation and a pooling of their votes. **Rule:** Proxy solicitations cannot make false or misleading statements and must provide full disclosure of all material facts of the proposals on which the shareholders will vote.

Answer 80

**Definition:** A voting trust is a written agreement between shareholders in which the parties transfer all of their shares to a trustee who votes and distributes dividends according to the terms of the voting trust instrument. **Rule:** The trust instrument and the names and contact information of all beneficiaries must be filed with the corporation.

Answer 81

**Definition:** A voting agreement is a written and signed agreement in which two or more shareholders agree to the manner in which they will vote their shares. **Rule:** The agreement is specifically enforceable, unless otherwise stated in the agreement.

Answer 82

**Definition:** A shareholder management agreement is an agreement entered into by a corporation's shareholders regarding various management issues, including the company structure, shareholder rights, valuation of shares, and election ofthe corporation's officers and directors. **Rule:** A shareholder management agreement must be unanimously approved at the time of its adoption and can be included in the corporation's articles or bylaws, but need not be filed to be valid.

Answer 83

**Rule:** Shareholders may offer proposals for a shareholder vote at the corporation's expense if: 1) The sponsor of the proposal meets minimum stock-ownership and time requirements (at least 1 percent or $2,000 in stock for more than 1 year), 2) The proposal identifies the sponsor and the sponsor's stake in the company, 3) The proposal is in resolution form, AND 4) The proposal is presented at the shareholder's meeting. **Note:** The board may prevent shareholder proposals from being voted on if: 1) The proposal presents an improper subject for a shareholder vote (e.g., ordinary business operations), 2) The proposal would require illegal action if passed, 3) The proposal is misleading or fraudulent, OR 4) The proposal relates to a matter that is beyond the corporation's power to effectuate.

Answer 84

**Rule**: A shareholder's right to vote is inviolate and should not be abridged. **Note:** 1) To determine if directors' actions were improperly taken for the purpose of abridging shareholder voting rights, courts look to: a) The primary purpose ofthe board's actions, AND b) Whether the board had a compelling justification for its action. 2) If the primary purpose was not to infringe shareholders' voting rights or if the board had a compelling justification for its decisions or actions, the directors will be protected by the Business Judgment Rule.

Answer 85

**Direct Action:** An action brought by shareholders for a breach of a fiduciary duty owed to the shareholders. **Derivative Action:** An action brought by shareholders for a breach of a fiduciary duty owed to the corporation. **Note:** Though the corporation is named as a defendant in both cases, damages awarded in a derivative action usually are awarded to the corporation, and damages in a direct action are awarded to the shareholders.

Answer 86

**Rule:** To institute a derivative action, a shareholder must: 1) Have been a shareholder at the time of the challenged action or decision or received his shares by inheritance or operation of law from one who was a shareholder at the time, 2) Represent the interests of the corporation, AND 3) Make a written demand on the corporation to remedy the harm. **Note:** 1) A derivative action cannot be filed until 90 days after the submission of the written demand unless irreparable harm will occur if 90 days pass. 2) The corporation may file a motion to dismiss the suit if a majority of the directors find in good faith and after a reasonable inquiry that the suit is not in the corporation's best interests.

Answer 87

**Rule:** Material alterations of the corporate structure require: 1) Approval by the board of directors, AND 2) Approval by a majority of shares entitled to vote.

Answer 88

**Rule**: Material changes to the corporate structure include: 1) Changes to the Articles of Incorporation, 2) Mergers, 3) Disposal of large amounts of corporate assets.

Answer 89

**Rule:** If a corporation approves a material change, dissenting shareholders may demand payment of the fair value of their shares.

Answer 90

1) **Amendment to articles:** Any shareholder whose interests will be materially and negatively affected by the amendment. 2) **Merger:** a) Any shareholder entitled to vote on a merger plan, AND b) The shareholders of a subsidiary if the subsidiary is being merged into a parent corporation. 3) **Disposal of corporate property**: Any shareholder who is entitled to vote on a proposed transfer of the corporation's property.

Answer 91

1) Voluntary Dissolution 2) Involuntary Dissolution

Answer 92

**Rule:** A corporation may voluntarily dissolve by: 1) A vote of shareholders holding shares representing 50 percent or more ofthe voting power, OR 2) Approval of the board of directors if the corporation: a) Has entered into bankruptcy, b) Has disposed of all of its assets and has not conducted business for five years, OR c) Has not issued any shares.

Answer 93

**Rule:** The following parties may bring an action for involuntary dissolution: 1) The state Attorney General, 2) Directors ofthe corporation (requires at least one-half of the board), 3) Anyone expressly authorized to do so in the Articles of Incorporation, 4) A shareholder or group of shareholders who together own at least one-third of: a) The total number of outstanding shares. b) The outstanding common shares. OR c) The equity of the corporation.

Answer 94

**Rule:** Directors, shareholders, or any other person authorized by the Articles of Incorporation may bring an action to dissolve a corporation if: 1) The corporation has abandoned its business for more than one year, 2) The corporation has an even number of directors who are equally divided and cannot agree as to the management of its affairs, and voting shareholders cannot elect a board consisting of an uneven number. 3) The directors' terms have expired and the shareholders are deadlocked, 4) Officers or directors ofthe corporation have been found guilty of persistent and pervasive fraud, mismanagement or abuse of authority, 5) The period for which the corporation was formed has terminated, OR 6) Liquidation is necessary to protect the interests ofthe complaining shareholders. a) **Note:** Dissolution to protect the interests of the complaining shareholders is available only for the dissolution of close corporations.

Answer 95

**Rule**: In California, the Attorney General may bring an action to dissolve a corporation if the corporation: 1) Commits a serious violation ofthe California Corporations Code. 2) Fraudulently abuses corporate privileges or powers. 3) Violates a law that calls for dissolution in the case of violation. OR 4) Fails to pay the Franchise Tax Board for 5 years.

Answer 96

**Rule:** Fraud in connection with tender offers is prohibited. Fraud will be found if: 1) The individual making the offer has non-public information, 2) The information is material to the corporation for which the offeror is making the tender offer, 3) The offeror knows, or should know, that the information came from the target corporation or the acquiring corporation, AND 4) The offeror sells or purchases (or causes the sale or purchase) securities ofthe target or acquiring corporation. **Note**: A tender offer is a public offer to purchase stock from shareholders at a specified price per share. The offered price per share is often much higher than the current market value of the stock, as such offers are usually made in an effort to gain a controlling interest in a corporation.

Answer 97

**Rule:** It is illegal for any person, in connection with the purchase or sale of any security, to: 1) Employ any device, scheme, or artifice to defraud, 2) Make any untrue statement of a material fact, or omit to state a material fact necessary to render a statement not misleading, OR 3) Engage in any act, practice, or course of business that operates or would operate as a fraud or deceit upon any person.

Answer 98

**Rule**: A violation of Rule 10b-5 may result in the wrongdoer being sued civilly, prosecuted in criminal court, or subjected to an SEC action for injunctive relief.

Answer 99

**Rule**: To establish the liability ofthe wrongdoer, the plaintiff must establish: 1) Fraudulent conduct, 2) Scienter, a) The defendant must have acted with the intent to deceive, manipulate, or defraud. 3) Materiality, a) Courts apply the Reasonable Investor Test to determine materiality (i.e., whether the information in question would likely be used by a reasonable investor as part of the basis of her investment decision). 4) Reliance, a) The plaintiff must have relied on the fraudulent information in buying or selling stock. 5) Damages, AND 6) Causation.

Answer 100

**Rule:** Individuals with insider information must not trade stock on the basis of material non-public information. Such individuals must either: 1) Disclose the information, OR 2) Abstain from trading stock in the company or industry for which they have the insider information.

Answer 101

**Statutory Insiders:** Fiduciaries of the corporation (e.g., officers and directors). **Constructive Insiders:** People who become fiduciaries to the corporation through the acquisition of inside information (e.g., accountants, lawyers, analysts).

Answer 102

**Tipper:** A tipper is an insider who tips off an outsider by giving him inside information. **Tippee:** A tippee is an outsider who is given inside information by an insider. **Rule:** Both the tipper and tippee may be held liable for insidertrading: 1) The tipperwill be held liable if the disclosure was made for any direct or indirect personal advantage. 2) The tippee will be liable for derivative breach of fiduciary duties if: a) The disclosure was made for any direct or indirect personal advantage, AND b) The tippee knows or should know ofthe tipper's breach of duty.

Answer 103

**Definition:** Section 16(b) of the Securities Exchange Acte stablishes reporting requirements and restrictions on profits from the sale and purchase of stock by officers, directors, and principal stockholders who own more than 10 percent of a corporation's stock.

Answer 104

**Reporting Requirements**: Directors, officers, and stockholders who own more than 10 percent of a corporation's stock are required to file a statement with the Securities and Exchange Commission of all stock owned in the corporation by that shareholder and the terms of the agreement through which the stock was purchased. **Profit Restrictions:** An officer, director, or shareholder with more than 10 percent of a corporation's stock may not make a profit from buying and then selling (or selling and then buying) the corporation's stock within a 6-month period. Any profit obtained from such transactions within a 6-month period will be returned to the corporation. **Note:** Suit must be brought by the corporation within 2 years of the transaction to recover the profit.

Answer 105

The Sarbanes-Oxley Act established a federal agency (the Public Company Accounting Oversight Board) to oversee the audit of public corporations that are subject to federal securities laws to in order to "protect the interests of investors and further the public interest in the preparation of informative, accurate, and independent audit reports." **Note:** The overriding concern in the passing of Sarbanes-Oxley was the prevention of financial-reporting fraud.

Answer 106

**Rule:** The Sarbanes-Oxley Act applies to corporations: 1) Whose stocks are traded on a national securities exchange. 2) That have more than 500 shareholders and $10 million in assets. OR 3) That have more than 300 investors (e.g.. through a combination of privately held stock and publicly issued bonds).

Answer 107

**Rule**: Under Sarbanes-Oxley, periodic financial reports must be submitted to the Securities and Exchange Commission that include: 1) Certification that the signing officers have reviewed the report, 2) Certification that the report does not contain any material false or misleading statements or omissions, 3) Certification that the report fairly presents the financial condition of the company, 4) Certification that the signing officers have evaluated the corporation's internal controls in the 90 days immediately preceding the filing, 5) A list of any deficiencies found in the internal controls of the corporation, 6) An explanation of any significant changes in internal controls, AND 7) Disclosure of any fraud that involves an employee of the company.

Answer 108

**Rule 1:** It is a crime punishable by fines and/or up to 20 years imprisonment for altering, destroying, mutilating, concealing, or falsifying documents or tangible objects with the intent to obstruct, impede or influence an investigation. **Rule 2:** It is a crime punishable by fines and/or up to 10 years imprisonment for any accountant who knowingly and willfully fails to retain records of audits for at least 5 years.

Answer 109

**Definition:** A close corporation is a corporation with 35 or fewer shareholders whose shares have no public market and in which shareholders may exercise control over the management of the corporation. **Note:** Defining characteristics of a close corporation include: 1) The formalities of director and shareholder meetings need not be followed, 2) Shareholder agreements may govern operations, management, and distribution of profits and losses, 3) Perpetual existence (unless otherwise noted in the corporation's articles), 4) Freedom from SEC regulation (because there is no market in the shares), AND 5) Any single shareholder in a close corporation may initiate an action in court to dissolve the corporation.

Answer 110

**Rule:** The incorporator must file with the Secretary of State Articles of Incorporation that contain: 1) The name of the corporation, 2) The name and address of the corporation's authorized agent and all incorporators, 3) The number of shares the corporation may issue, 4) A provision stating the corporation's classification as a close corporation, AND 5) The number of shareholders who may hold shares. **Note:** A close corporation's name must contain a designation that it is a corporate entity (e.g., "incorporated' or "close corporation").

Answer 111

**Rule:** A close corporation may only have the number of shareholders specified in the Articles of Incorporation, and never more than 35.

Answer 112

**Rule:** Close corporations are shareholder-managed. Shareholders in a close corporation may exercise management functions over the corporation by: 1) Shareholder voting agreements, 2) Classified stock, 3) Voting trusts, AND/OR 4) Restrictions on share transfer.

Answer 113

**Rule:** A close corporation'sfailure to observe corporateformalities (e.g., annual meetings of directors and shareholders) may not be considered whendetermining whether shareholders will be held personally liable for the corporation's obligations.

Answer 114

**Rule:** Shareholders in a close corporation have a duty to: 1) Further the interests of all shareholders. 2) Exercise reasonable care. 3) Not withhold relevant information from other shareholders. AND 4) Not use their position or information available to them to gain a special advantage over other shareholders

Answer 115

**Rule**: A close corporation may restrict the sale or transfer of shares through: 1) Right of first refusals, 2) Buy-sell agreements, 3) Buy-back rights, OR 4) First options.

Answer 116

**Rule**: A material change ofthe corporate structure of a close corporation requires: 1) A two-thirds vote of each class of shares (if the articles do not specify how many votes are required), OR 2) Approval by a number of votes specified in the articles (but never less than a majority of each class of shares). **Note:** Material changes to the corporate structure include: 1) Changes to the Articles of Incorporation, 2) Mergers, 3) Conversion to a general corporation.

Answer 117

**Rule:** A close corporation will be transformed into a general corporation if: 1) The shareholders vote to convert the close corporation into a general corporation, OR 2) The number of shareholders exceeds 35 or the number specified in the Articles of Incorporation.

Answer 118

**Definition:** A professional corporation is a corporation that is engaged in rendering licensed professional service. **Note:** 1) In California, those professionals that are prohibited from forming a general corporation for the purpose of practicing their profession must instead form a professional corporation if they wish to practice under a corporate structure. 2) Licensed professionals that typically form professional corporations include accountants, architects, attorneys, doctors, dentists and other medical professionals.

Answer 119

**Rule**: The incorporator must file Articles of Incorporation with the Secretary of State that contain: 1) The name of the corporation, 2) The name and address of the authorized agent and all incorporators, 3) The number of shares the corporation may issue, 4) A statement that the entity will be classified as a professional corporation, AND 5) The type of professional service that will be provided. **Note:** 1) In California, a professional corporation may engage in only one profession. 2) While the corporation may employ non-professionals, only licensed professionals can render professional service on behalf of the corporation. 3) A professional corporation's name must contain a designation that it is a corporate entity (e.g., Incorporated' or professional corporation').

Answer 120

**Rule:** Shares in a professional corporation may only be issued to licensed professionals engaged in the same professional practice as that ofthe professional corporation. **Exception:** The shares of medical and dental professional corporations may be owned by shareholders who are licensed in related fields as long as the total percentage of shares owned by the related-field shareholders does not exceed 49 percent of the total shares of the professional corporation.

Answer 121

**Rule 1:** If a professional corporation has only one shareholder: 1) The single shareholder will be the sole director and serve as both president and treasurer, AND 2) The remaining positions of vice president and secretary may be filled with non-licensed individuals. **Rule 2**: If a professional corporation has two shareholders: 1) Both shareholders will serve as directors, AND 2) The positions of president, vice- president, secretary and treasurer will be filled by the two shareholders. **Rule 3:** If a professional corporation has more than three shareholders: 1) There must be at least three directors, AND 2) All ofthe directors and officers must be licensed professionals.

Answer 122

**Rule:** Shareholders of professional corporations may only sell or transfer their shares to professionals licensed in the same field as that of the professional corporation. **Exception:** The shares of medical and dental professional corporations may be owned by shareholders who are licensed in related fields as long as the total percentage of shares owned by the related-field shareholders does not exceed 49 percent of the total shares of the professional corporation.

Answer 123

**Rule:** No shareholder may enter into a voting trust, proxy or voting arrangement with any other person unless that person is also a shareholder in the same professional corporation.

Answer 124

**Rule**: In the event that a shareholder dies or loses his professional license, that person's shares must be transferred to: 1) The professional corporation, 2) Another shareholder in the professional corporation, OR 3) A licensed professional in the same profession. **Note:** If the shares are not transferred within 90 days of the loss of a shareholder's license or 6 months of the death of a shareholder, the professional corporation will be suspended.

Answer 125

**Rule**: Shareholders in a professional corporation can be held personally liable for malpractice that they personally commit, but will not be held personally liable for: 1) The malpractice of other shareholders, OR 2) Tort liabilities of the professional corporation that do not stem from providing professional service (e.g., a client slipping on the wet floor of a law office).

Answer 126

**Rule**: A professional corporation follows the same rules that govern the dissolution of a general corporation.