Accountant’s Legal Liability & Business Entities Guide

Posted on Sep 8, 2024 in Law & Jurisprudence

BLLS 800 Quiz #2 Study Guide

Accountant’s Legal Liability

Sources of Liability

An accountant may be liable due to:

  1. Contract: The agreement between the client and accountant is subject to contract law, and all contract rules apply.
    • Material breach: No fee
    • Substantial performance: Reduced fee
  2. Tort: A wrongful act resulting in injury to another person, property, or reputation. The injured party is entitled to compensation. The most common torts for accountants are:
    • Negligence
    • Fraud
  3. Criminal: Mostly federal laws (e.g., knowingly certifying false documents, altering records, forgery, preparing fraudulent tax returns). Penalties can include fines up to $250,000 and 3 years’ imprisonment for individuals.

Relevant Laws

Laws to be aware of:

  1. Common Law: Accountants’ contracts are governed by common law since they involve personal services.
  2. Securities Law: Primarily at the federal level.
  3. Code of Professional Conduct: AICPA, state boards of accountancy.

Accountants have traditionally been liable for civil damages but are increasingly held criminally liable.

Negligence & Fraud

Negligence: Requires four elements: 1. Duty; 2. Breach; 3. Cause; 4. Damage. Courts typically adopt one of three standards:

  1. Primary Benefit: Ultramares test
  2. Foreseen Users or Foreseen Class of Users
  3. Foreseeable Users: Anyone the accountant could reasonably foresee

Fraud: Requires six elements:

  1. False representation or omission
  2. Of fact
  3. That is material
  4. Made knowingly or with intent to deceive (scienter)
  5. Justifiably relied upon
  6. Causes damage/injury

Federal Securities Laws

Securities Act of 1933, Section 11

Accountants have civil liability if they prepare or certify financial statements for inclusion in a registration statement containing:

  1. A false statement or omission of a material fact
  2. Liability extends to those acquiring the security without knowledge of the untruth or omission
  3. Due diligence: An accountant will not be liable if they can prove their “due diligence.”

Securities Exchange Act of 1934, Section 18

Accountants are subject to civil liability if they make or cause to be made any false or misleading statement with respect to any material fact in any application, report, document, or registration filed with the SEC under the 1934 Act.

  1. Liability extends to any purchaser or seller who relied upon that statement without knowing that it was false or misleading.

Rule 10b-5: Applies to both oral and written misstatements or omissions of material fact and to all securities. Liability is imposed only when the accountant acted with scienter or intentional or knowing conduct.

Private Securities Reform Act of 1995

If an auditor becomes aware of an illegal act, they must:

  1. Determine if it occurred and its possible effect on the financial statements
  2. Inform the board of directors and audit committee of the illegal act
  3. If the illegal act has a material effect on the financial statements and no remedial action is taken, report conclusions to the board and have them notify the SEC and request a copy of such notice
  4. If the auditor does not receive such notice, either resign or send the report to the SEC

Sarbanes-Oxley Act of 2002

In addition to the above, to make auditors more independent, the Act prohibits auditors from performing the following non-audit tasks for their public clients:

  1. Bookkeeping
  2. Financial information systems design and implementation
  3. Fairness opinions
  4. Management or human resources functions
  5. Actuarial services
  6. The lead and audit partner must change every 5 years

The Act establishes a 5-member Public Company Accounting Oversight Board (the Board) to ensure informative, accurate, and independent audit reports of public companies.

Work Papers & Accountant-Client Privilege

Work Papers

Accountants are required to keep work papers to document their work, including procedures and tests performed. They belong to the accountant, and they may not disclose them unless:

  1. The client requests them
  2. There is a court order

Accountant-Client Privilege

No accountant-client privilege exists in common law or federal law. It is only allowed by: a) some states; b) the IRS for federal tax matters. However, an accountant should keep the client’s information confidential unless forced by:

  1. The client’s request
  2. AICPA/GAAP/GAAS guidelines
  3. A court order

Contrast this with the attorney-client privilege, which holds all information shared by a client with their attorney to be held in strict confidence – followed everywhere.

Negotiable Instruments

UCC Article 3: Negotiable Instruments

Negotiability:

  • Negotiable means transferable.
  • It is a legal concept that makes written instruments more freely transferable.
  • Without Article 3, the law of assignments would apply, which states the assignee stands in the shoes of their assignor.
  • Article 3 gives greater rights to the holder (HDC) than an assignee.
  • Article 3 and the HDC concept enable merchants to sell their contracts more readily and keep their capital working.
  • It reduces forgery, increases the efficiency of the payment system, and promotes greater liquidity.

Article 3 on Negotiable Instruments:

  1. Covers: Checks, promissory notes, drafts, certificates of deposit

Types of Negotiable Instruments

Four types of negotiable instruments:

  1. Draft: Three parties. The drawer orders the drawee to pay a fixed amount to the payee. Two types:
    • Time – payable at a future date
    • Sight – payable on demand
  2. Check: Three parties. A draft where the drawee is a bank or lending institution.
    • Cashier’s check: A check where both the drawer and drawee are the bank
  3. Promissory Note: Two parties. The maker promises to pay a stated sum of money to the payee. Two types:
    • Time note – payable at a stated future date
    • Demand note – payable on demand
  4. Certificate of Deposit: Two parties. A written acknowledgment by a bank of receipt of money that it promises to repay. The maker (bank) promises to pay a second party, the payee who is named on the CD.

Requirements for a Negotiable Instrument

To be a negotiable instrument, an instrument must have nine elements:

  1. Be in writing
  2. Be signed
  3. Contain a promise or order to pay
  4. Be unconditional
  5. Be for a fixed amount
  6. Be of money
  7. Contain no other promise or instruction
  8. Be payable on demand or at a definite time
  9. Be payable to order or bearer

Transfer of Negotiable Instruments

Holder

A holder is a person who is in possession of an instrument drawn, issued, or indorsed to them or their order or to bearer or in blank. Only a negotiable instrument can result in a transferee being a holder.

Negotiation

Negotiation is the transfer of possession (voluntary or involuntary) by a person other than the issuer of a negotiable instrument in such a manner that the transferee becomes a holder. To negotiate: 1) delivery – bearer paper; 2) delivery and signature – order paper.

Shelter Rule

To qualify as a holder, a person must have possession of an instrument that runs to them. If the transferor was a holder in due course (HDC), the transferee acquires the rights of an HDC, which rights they in turn may transfer. However, if the transferee committed fraud, they cannot be an HDC.

General Rule

The person best able (or most likely) to detect or defeat the wrongdoer is liable.

Imposter Rule

The issuer is liable. Reason: The issuer is best able to control the correct payee. However, if the person paying the instrument (e.g., the bank) fails to exercise ordinary care, it too may be held liable under comparative negligence. The bank should also be careful before paying the check.

Fictitious Payee Rule

The issuer is liable. Reason: The issuer (often the employer) is in the best position to prevent the issuance of checks to a fictitious payee (often the work of an unscrupulous employee). However, if the payor bank (drawee) is negligent and does not exercise ordinary care, it too may be liable. Comparative negligence applies.

Indorsements

An indorsement is a signature. Rules:

  • The indorser undertakes certain obligations by signing.
  • A forged or unauthorized signature breaks the chain of title to the instrument.
  • An indorsement affects subsequent indorsements.

Types:

  1. Blank: Just sign the name without adding anything – becomes bearer paper: payable on demand.
  2. Special: “Pay to ____” – will only be paid to that person; their signature is needed for negotiation.
  3. Restrictive: E.g., “for deposit only”; pay to trustee; restricts how funds may be applied.
  4. Qualified (without recourse) or unqualified (indorser is liable in case of dishonor):

An indorsement must be written on the instrument or on a paper called an allonge, affixed to the instrument. It must be in ink of an appropriate color, such as blue or black.

Holder in Due Course (HDC)

Requirements for an HDC

Requirements under Section 3-302:

  1. Be a holder of a negotiable instrument
  2. Take it for value; completed promise; not a gift
  3. Take it in good faith; honesty in fact and the observance of commercial standards of fair dealing
  4. Take it without notice of: overdue, dishonor (NSF), unauthorized signatures, alteration, knowledge of anyone having any defense or claim to it; time paper is due on the stated date; demand paper within a reasonable time after the due date; checks within 90 days of the date
  5. Take it without any reason to question its authenticity due to: forgery, alteration, incompleteness, any irregularity

Shelter Rule

If the transferor is an HDC, so is the transferee.

  1. If the transferee was a party to fraud or illegality affecting the instrument, they cannot be an HDC.

Defenses

A defense protects a person from liability on an instrument, while a claim to an instrument asserts ownership of it. E.g., Good is fraudulently induced to issue a check to Bad. Good has a claim of ownership of the check as well as a defense to Bad’s demand for payment.

Defenses available against all parties, including HDCs, are called real defenses. Examples include:

  1. Infancy – being a minor
  2. Incapacity – duress, undue influence, illegality
  3. Fraud, unauthorized signature, fraudulent alteration
  4. Discharge in bankruptcy
  5. Other discharge

Contract defenses that may be asserted against an HDC are called personal defenses. An HDC is not subject to personal defenses.

Limitation upon HDC (Exception)

In consumer credit contracts, the transferee does not get the rights of an HDC; the transferor remains liable. Reason: The seller (transferor) must honor warranties to the buyer.

Bank Transactions

UCC Article 4: Bank Deposits & Collections

Check Clearing Timeframes

  • By the next day: Cash deposits, wire transfers, government checks, up to $100 of other checks, checks drawn on the same bank
  • Within one intervening business day: Local checks
  • Within four intervening business days: Non-local checks

Check Clearing Process

  1. Same bank: Handled internally; depository and payor banks are one and the same
  2. Different banks: Use an intermediary – two options:
    • Use one of 12 Federal Reserve Banks
    • Use a clearinghouse: An association of banks whose members settle accounts with each other daily

Depository and Payor Banks

  1. Depository bank: The bank into which the payee deposits the check
  2. Payor bank: The bank that actually pays the check, i.e., the drawee on the check

How Checks are Paid

The payor or drawee bank pays the payee as long as three conditions are met:

  1. There are sufficient funds
  2. The drawer’s order has not been countermanded
  3. No signs of dishonor or fraud

Countermanding Orders (Stop Orders)

  1. Oral stop order: Binding for 14 days
  2. Written stop order: Binding on the bank for 6 months; may be renewed in writing
  3. Stale check: A bank is not obligated to pay a check over 6 months old

If a bank pays over a valid stop order, it is liable.

Death of Drawer or Change of Authority

  1. Death: The bank is not liable if it is unaware of the drawer’s death; even if aware, the bank may pay checks for 10 days after death
  2. Change in authority: The drawer has a duty to inform the bank

Customer’s Duties under Article 4

  • Must promptly examine bank statements: If an unauthorized transaction occurs, the bank must be notified immediately.
    • Time limits: 30 days after getting the bank statement; if notified and the drawer was not negligent, then the bank bears the loss
    • After 1 year: The bank is not liable, even for forgeries
    • 3-year limit for unauthorized indorsements: After that, the bank is not liable
  • Rule: The customer should notify the bank promptly to avoid loss. Balance your checkbook and credit card statements as soon as you get them.
  • Negligence: If the bank exercised ordinary care in paying items, it will not be liable. If it did not, and the bank’s failure substantially contributed to the loss, the loss is allocated between the customer and bank based on comparative negligence.

Bank’s Duties

  1. Provide regular statements showing: Number of the item, amount, date of payment; it may be electronic or paper; it may be monthly
  2. Needs to send statements only; no duty on the bank’s part to ensure receipt of statements

Electronic Funds Transfers (EFTs) & Credit Cards

EFT Regulations

The law requires financial institutions to provide:

  • Written documentation of each transfer from an electronic terminal – a receipt
  • Periodic statement: Like a monthly statement similar to a bank statement
  • Preauthorized transfer: Must be authorized in writing by the customer in advance, and a copy given to the customer when made; the customer gets notice of the wire transfer

Unauthorized EFT Transactions

Notify the credit card company immediately when unauthorized transactions occur.

  • 2-day window: The customer’s loss is limited to $50
  • 60-day window: The customer has 60 days in total to notify the credit card company of the loss; the customer’s liability is limited to $500
  • After 60 days: The customer is liable for the entire loss

Employment Law & Agency

Employment Law

Categories of Employment Law

  • Labor-Management laws: Subject to negotiation between management and labor
  • Anti-Discrimination: Based on race, sex, religion, age, disability, pregnancy, sexual harassment
  • Employee Protection & Safe Work Environment: Unemployment benefits and a safe workplace

Labor Laws

  1. Norris-La Guardia Act of 1932: Labor will have full freedom to form unions; prohibits “yellow dog contracts”
  2. National Labor Relations Act or Wagner Act of 1935: NLRB established
    • “Right to form, join labor organizations, to bargain collectively…”
    • Unlawful for employers to: 1. Discriminate against union members; 2. Refuse to bargain in good faith with union representatives
  3. Labor Management Relations Act (LMRA) or Taft-Hartley Act of 1947: Declared some union activities to be unlawful, namely:
    • Coercing an employee to join a union
    • Forcing an employer to discharge a non-union employee
    • Levying excessive union dues
    • Causing an employer to pay for work not performed
    • Organizing a strike in a company that has no dispute with its own union

A union shop contract permits an employer to hire non-union workers who have to join the union. Most states permit union shops. A right-to-work state may prohibit union shops.

Discrimination Laws

The principal sources of anti-discrimination laws in the US are:

  1. Title VII of the Civil Rights Act of 1964: Prohibits employment discrimination on the basis of race, color, sex, religion, or national origin. The definition of religion includes all aspects of religious observance and practice, and the statute provides that an employer must make reasonable efforts to accommodate an employee’s religious beliefs.
  2. The Civil Rights Act of 1961
  3. The Americans with Disabilities Act (ADA) of 1990: Cannot discriminate against disabled employees. Businesses must have ramps and wheelchair-accessible restrooms and elevators.
  4. Equal Pay Act: Must pay the same for “substantially equal” work.
  5. Pregnancy Discrimination Act: Extends the benefits of Title VII to pregnant women. An employer cannot refuse to hire a pregnant woman, fire her, or force her to take maternity leave unless the employer can establish a bona fide occupational qualification defense. E.g., a. seniority or merit system; b. ability test; c. performance-based compensation; d. bona fide occupational qualification; e. business necessity.
  6. Sexual Harassment: The employer will be held liable if it does not take reasonable action when it knows or should have known of the harassment. If the perpetrator holds a supervisory position over the victim, the employer may be liable without knowledge or reason to know.
  7. Age Discrimination: Cannot discriminate in hiring, firing, or salary for employees who are 40+

Limits on remedies exist, except for racial discrimination: Unlimited damages + punitive awards are allowed.

Sexual Harassment

An employer is liable when:

  1. An employee commits sexual harassment, and the employer does not take reasonable action when it knows or should have known of the harassment
  2. If the perpetrator holds a supervisory position over the victim, the employer may be liable without knowledge or reason to know
  3. Extends to same-sex incidents

Age Discrimination in Employment Act of 1967 (ADEA)

Prohibits:

  1. Discrimination in hiring, firing, or compensating employees over 40: Employers with fewer than 20 employees are exempt
  2. Mandatory retirement for most employees, no matter their age: Exception for bona fide executives

Americans with Disabilities Act (ADA) of 1990

Prohibits employers from discriminating against anyone with a disability in:

  1. Hiring, discharge, compensation, advancement, training, etc.
  2. Businesses must make special accommodations such as installing ramps, wheelchair-accessible restrooms, and doors

Vietnam Veterans Readjustment Act

Requires firms with $10,000+ in federal contracts to take affirmative action regarding handicapped Vietnam veterans.

Employee Protection

Employee Status under Common Law

  1. An employee could be dismissed for “no cause or for cause morally wrong”
  2. Either party could terminate the work arrangement

Employee Job Protection under Federal and State Laws

  1. An employee cannot be fired for filing workers’ compensation claims
  2. Contract protection: Some courts have held employee dismissals unlawful when the employee had detrimentally relied on the employer’s promise of work for a reasonable time: Promissory estoppel
  3. It is best to fire for cause; document the reason for firing

Social Security and Unemployment Benefits

  • FUTA provides for unemployment benefits to employees who have been laid off due to a lack of work – not fired
  • The employer contributes one-half of all Social Security payments for the employee
  • Unemployment insurance (UI) is funded by employer taxes: Federal taxes pay for administrative costs, while state contributions pay actual benefits

Fair Labor Standards Act (FLSA)

  • Under 14 prohibited from all non-farm work except newspaper delivery and acting
  • 16-17-year-olds may work in non-hazardous jobs; 18+ may work anywhere
  • Provides for a minimum wage; 1 ½ time for overtime (more than 40 hours/week); professionals, managers, and outside salespersons are exempt

Safe Work Environment

Job Safety

The Occupational Safety and Health Act (administered by OSHA) imposes on employers:

  • A duty to provide a work environment “free from recognized hazards that are causing or likely to cause death or serious physical harm to employees”

Workers’ Compensation

  • For injury while working
  • Under common law: Employers argued that the employee assumed voluntary risk by working on the job; employees had contributory negligence
  • All states have workers’ compensation: Provides recovery under strict liability: The employee does not have to prove negligence
  • The only requirement is that the employee be injured, and the injury arises out of and in the course of their employment

Fair Labor Standards Act (FLSA)

  • Under 14 prohibited from all non-farm work except newspaper delivery and acting
  • 16-17-year-olds may work in non-hazardous jobs; 18+ may work anywhere

Family and Medical Leave Act

Requires employers with 50+ employees to grant up to 12 weeks of leave in a year for birth, adoption, or care of a spouse, child, or parent. May be paid or unpaid.

Partnerships

Factors to Consider in Forming a Business Entity

  1. Ease of formation – very important: Sole proprietorship is easiest
  2. Taxation: Partnerships, LLCs, grantor trusts are pass-throughs; corporations, MLPs are separate taxable entities
  3. Liability: Sole proprietors and general partners have unlimited liability; shareholders and members have limited liability
  4. Management & control: General partners, members of LLCs, and sole proprietors may have full control; limited partners, some members may not
  5. Transferability of ownership: Corporations and LLCs allow free transferability; partnerships and LLPs do not

Common Business Entities

  1. Sole proprietorship: Not a separate legal entity; Schedule C; unlimited liability for the owner; ends when the sole proprietor dies
  2. Partnership: An association of two or more persons to carry on as co-owners a business for profit
  3. Limited partnership: Unincorporated business association consisting of one general and one limited partner; file a Certificate of Limited Partnership with the state
  4. LLC: An unincorporated business association that provides limited liability to all its members
  5. LLP: A general partnership that limits its partners’ liabilities; state filing required; laws similar to general partnerships
  6. LLLP: A limited partnership in which the general partner’s liability has been limited to the same extent as an LLP
  7. Corporation: A separate legal entity with limited liability for its owners

Tests of a Partnership

  • Co-ownership of property: Alone will not create a partnership; e.g., a joint bank account, stock ownership are not partnerships
    • Need co-ownership of the business
    • Need active involvement
    • Need a pattern and some continuity
  • Sharing of revenues, expenses: Alone will not create a partnership
    • Brokers sharing commissions are not partners
    • Two accountants sharing office expenses are not partners
    • Sharing of profits is prima facie evidence of a partnership

Duties of Partners

  1. Fiduciary: Finest loyalty; refrain from self-dealing; not appropriate benefits
  2. Obedience & care: To partners and the partnership
  3. Ownership: Best stated in the partnership agreement
    • Transferable portion: Share of profits and losses
    • Non-transferable portion: Management portion
  4. Creditor’s rights: Governed by statutes and common law; classes if permitted by the partnership agreement
  5. Distribution:
    • Share of profits: Follow the agreement; unequal distribution allowed
    • Return of loan; advance to partner
    • Compensation for services
    • Indemnification: Reimburse partner for expenses and indemnify for liability
  6. Accounting: An equitable proceeding for a comprehensive settlement of partnership affairs

Operation of General Partnerships

All partners are:

  • General partners
  • May run the business
  • Have unlimited liability: Jointly and severally liable
  • Respondeat superior applies to partners in a partnership

Dissolution & Winding Up

  1. Inform parties
  2. Pay creditors
  3. Pay partners

Limited Partnerships

Definition of Limited Partnership (LP)

A partnership formed under state law having at least one general and one limited partner.

Characteristics of LPs

  • The name must include the words “limited partnership”
  • “Foreign” in states other than the one in which it was formed
  • The general partner controls and manages and has unlimited liability
  • A limited partner will have the liability of a general partner if they manage
  • Admission of new partners requires the written consent of all partners
  • A general partner may withdraw at any time; a limited partner needs to give 6 months’ notice
  • A partner may assign their partnership interests, which are personal property
  • Profit and loss are distributed according to the partnership agreement; if none, according to partners’ capital contributions
  • Dissolution & winding up: Order of asset distribution: 1. Creditors; 2. Partners as creditors; 3. Partners as a return of their contributions; 4. Partners according to the partnership agreement

Limited Liability Company (LLC)

A non-corporate business organization that:

  1. Provides limited liability to all members
  2. Permits all members to manage the business

An LLC may be:

  1. Member-managed: All members may manage
  2. Manager-managed: Only managers manage

LLC Documents

  1. Certificate of Organization: In the state formed; foreign in other states
  2. Operating Agreement: Contract among members governing the operations of the LLC

LLPs & LLLPs

LLP

It is a general partnership that, by making the appropriate state filing, limits the liability of its partners’ obligations. Most states follow the “full shield statute” that provides limited liability for all debts and obligations of the LLP.

  • Does not apply to an individual partner who committed a wrongful act; or
  • Anyone who supervised the person who committed the wrongful act

LLLP

An LLLP is a limited partnership in which the general partner’s liability has been limited to the same extent as in an LLP. New laws provide that a limited partner (in an LP, LLP, or LLLP) cannot be held liable for the partnership debts even if they participate in the management and control of the entity.

Corporations

Characteristics of Corporations

  1. Separate legal entity: Distinct from owners; stock transfers do not affect the corporation; title to property is in the corporation’s name
  2. Created by a state: Incorporation statutes of the state; not federal
  3. Limited liability: For its shareholders: Limited to the amount invested
  4. Transferability of shares: Free transferability unless otherwise agreed upon
  5. Perpetual existence: May terminate, dissolve, or merge
  6. Centralized management: The owners elect a Board of Directors to manage the business of the corporation

Classifications of Corporations

  1. Public or Private: A public corporation administers a city, county, town, school district, or conducts public business like TVA, FDIC. A private corporation is founded and owned by private parties. May be for-profit or not-for-profit. A non-profit corporation must use its profit for the charitable, educational, or scientific purpose for which the corporation was organized.
  2. Domestic or Foreign: Domestic in the state of incorporation; foreign in other states. Incorporated abroad – alien. Doing business in a state subjects it to the state’s laws, litigation, and tax. “Safe Harbors.”
  3. Public or Closely Held:
    1. Public: Shares are owned by a large number of people and widely traded on a national securities exchange
    2. Closely held: Owners are a small number of persons, often family and friends
  4. Other types:
    1. S corporation: 1. Limit of 100 shareholders; 2. No non-resident shareholders; 3. One class of stock; 4. Domestic
    2. Personal Service Corporation: Professional services; e.g., doctors, lawyers, accountants

Promoter & Problems in Corporations

Promoter

A person who brings about the “birth” of a corporation; a fiduciary; files and signs articles of incorporation. Is liable for pre-incorporation acts.

Bylaws

The rules that govern a corporation’s internal management; desirable, but not required.

Problems in Corporations

  1. De Jure: Substantial compliance with requirements; fully valid
  2. De Facto: Failed to comply with state statutory requirements; still okay
  3. Corporation by estoppel: If you deal with a defective corporation, you cannot deny its existence
  4. Piercing the corporate veil: The corporate shield will be disregarded, and individuals held personally liable when it is used to:
    • Commit wrongdoing; protect fraud
    • Commingle funds; use corporate assets for private use
    • Engage in thin capitalization
  5. Ultra Vires: Any act not within the scope of corporate authority; largely abandoned
  6. Respondeat superior: The corporation is liable for the acts of its employees and agents in the course of furthering the corporation’s business

Corporate Securities

Blue Sky Laws

State laws prohibiting fraud in the sale of securities.

UCC Article 8 Investment Securities

Statutory laws for the transfer of securities.

Debt Securities (Bonds)

A corporation promises to repay principal at a stated time with stated interest.

  1. Indenture: Agreement between the corporation and the bondholder
  2. Debenture: Unsecured bond with only the promise of the corporation behind it
  3. Secured bond: Secured or backed by collateral
  4. Income bond: Interest payment conditioned on corporate income
  5. Participating bond: Have a stated percentage of return regardless of the overall return, with additional payments dependent on earnings
  6. Convertible bond: May be exchanged, at the holder’s option, for other securities, e.g., stock
  7. Callable bond: Allow the corporation to call or redeem (pay off) before maturity at a specific price

Corporate Securities – Equity

  • Par value: The minimum price of stock; most are now no par
  • Paid-in capital = amount received in excess of par + other items
  • Treasury stock, preferred stock, participating stock, stock option, warrant, right, dividends
  • Formulas:
    • Net assets = total assets – total liabilities = stated capital + surplus
    • Stated capital = sale price of issued stock (including no par)
    • Surplus = capital surplus + earned surplus
    • Earned surplus = undistributed net profits + income + gains – losses (from the start)

Management Structure of Corporations

Board of Directors

  • Elected by shareholders; inside or outside directors; staggered terms
  • Quorum: Majority – norm; supermajority – protects minority interests
  • Voting & election: Straight vs. cumulative; staggered terms
  • Shareholder meetings: Annual & special; none required for closely held corporations
  • Officers: Appointed by the Board; president, clerk/secretary, treasurer
  • Role of the Board: Choose officers; decide on capital structure; declare dividends

Role of Shareholders

  • Elect the Board; amend articles of incorporation; sell most assets; approve mergers and acquisitions

Indemnification

A corporation may indemnify a director or officer for liability incurred if they acted in good faith in the best interests of the corporation.

Derivative Suit

: when dir or off usurp any corp opp. or harms the corp, a sh may sue him/her on behalf of the corp for breach of fiduciary duty.

Ch 36 – Fundamental changes

¨Changes requiring shareholder approval: charter amendments, mergers, consolidations, dissolution, sale or lease of substantially all assets, sale of corporation stock

¨Definitions:

¤Merger: a combination of two corps’ assets: A + B = A; the surviving corporation assumes all liabilities of the merged corporation

¤Consolidation: a combination of two corps’ assets but a new corp is created: A+B=C; A & B cease to exist

¤Conversion: procedures that permit a corp to become an LLC or LLP or partnership or vice versa

¤ Going private: a method is for corp or major SH to acquire shares through purchases in the open market or a tender offer for its shares

¤Buyout: a transaction in which mgt increases its ownership by eliminating its public shareholders

¤Leveraged Buyout [LBO]: often a buyout is financed with excessive borrowing, hence the term

¤Voluntary Dissolution: brought about by a decision of majority of shareholders; need to file articles of dissolution in Mass

¤Involuntary Dissolution: The Secy of State may do so for nonpayment of annual report fees; a court may dissolve a corp

Secured transactions

Why secured transactions?

“Neither a borrower nor a lender be” would severely restrict availability of goods and services

¨1. make debt easy to obtain and inexpensive: if creditors spend less to collect their debts, they charge lower interest rates when lending

¨2. minimize risk to lenders: less worry about collection if there is collateral

¨3. way for lenders to collect debts: reduce uncertainty in the collection process; reduce need to go to court; provide priority among parties upon default

¨UCC Article 9 is entitled “Secured Transactions”

Important definitions

¨1. Security Interest [SI]: a SI is an interest in personal property or fixtures which secures payment or performance of an obligation.

¨2. Security Agreement [SA]: a SA is an agreement that creates or provides for a security interest.

¨3. Collateral: is the property subject to a SI.

¨4. Secured Party [SP]: a SP is the person in whose favor a SI in the collateral is created. A secondary obligor is usually a guarantor or surety of the debt.

¨5. Purchase Money Security Interest [PMSI]: a PMSI is created in goods when a seller retains a SI in the goods sold on credit by a SA.

¨6. Chattel Paper: is a record that evidences a monetary obligation and a SI in or a lease of specific goods

¨7. Proceeds: include whatever is received upon the sale, lease, license, exchange, or other disposition of collateral.

¨8. Pledge: is the delivery of personal property to a creditor for a payment of debt. E.g. field warehousing, pawn broker.

Attachment & Perfection

¨Attachment: is the Code’s term to describe the creation of a SI that is enforceable against the debtor.  Attachment is essential to making a SI enforceable.  A SA attaches to the described collateral once the following three events have taken place:

¤1. the secured party has given value;

¤2. debtor has rights in the collateral;

¤3. there is an agreement between debtor and secured party

¨Pledge: delivery of personal property to a creditor as security for payment of a debt.  E.g. pawnshop; field warehousing.:

¤1. filing a financing statement

¤2. possession: the SP takes possession of the collateral

¤3. automatic: PMSI; automatic perfection occurs in consumer goods with a PMSI

¤4. temporarily as specified by the Code

Attachment & Perfection

¨Perfection: provides the greatest protection against third parties who have competing interests in the same collateral.  Perfection of a SI occurs when it has attached and when all the applicable steps required for perfection have been satisfied.  After perfection the SP is protected against creditors and transferees of the debtor.  A SI may be perfected in the following ways:

¤1. filing a financing statement: most common; filed in a central location in the state of debtor’s residence.  Good for 5 years; may renew.

¤2. possession: the SP takes possession of the collateral; e.g. pledge.

¤3. automatic: e.g. automatic perfection occurs in consumer goods with a PMSI

¤4. temporarily as specified by the Code

¨Certificate of Title: Many states have adopted CT statues for autos, trailers, mobile homes, boats, and farm tractors.  In these states Art 9 does not apply to these items. A CT is an official representation of ownership.  To perfect a security interest in these items in these states, the secured party should be noted on the face of the CT. Some keep the CT itself as security.  E.g. car with loan in Massachusetts.

Perfection and Priority

¨Filing a Financing Statement: most common method of perfecting a SI.  It must include:

¤A. Name of debtor

¤B.  Name of SP

¤C.  Description of collateral

Debtor’s signature is no longer required. These are indexed by debtor’s name and kept in a central location by the Secretary of State.  They are good for 5 years.  May be renewed.

¨Priority Rule:  among competing parties

¤1. Attached over unattached SI:

¤2. Perfected over unperfected

¤3. Among perfected: the earlier of time prevails

If neither perfection or attachment, the creditors are general, unsecured creditors.

¨Default: the UCC does not define default, instead contract law between parties determine when default occurs.  Usually debtor has right of redemption [free the collateral of SI] by fulfilling all obligations – paying the debt + collection expenses.  Otherwise, the SP may take possession of collateral without a breach of peace.

Collateral; Repossession

¤Collateral: if collateral is sold, the proceeds are applied in the following order:

n1. expenses of retaking the collateral;

n2. paying the debt owed;

n3. paying any subordinate debt;

n4. paying an secured cosignor

Any surplus belongs to the debtor.  If debtor consents, the SP may keep the collateral.  However, with consumer goods, if debtor has paid 60%+ of the debt, the SP must sell the collateral.

¤ Breach of Peace: no definition in UCC or by law.  Defined by courts and vary from state to state.  Look to case law for guidance.  It may be:

n1. threat or use of violence; or

n2. mere entry without consent

Suretyship

Surety: A surety promises to pay the debt of another. E.g. mom guarantees college loan; contractor obtains performance bond; accused granted bail.

Suretyship: involves three [3] parties: debtor, creditor, surety. A surety promises to pay the debt or another, the debtor.  Two types of surety:

¤1. Absolute surety: creditor may hold surety liable as soon as debtor defaults without proceeding against the debtor

¤2. Conditional surety: [or guarantor of collection]: is liable only if creditor has exhausted legal remedies against debtor without success.

¤ Surety’s Rights:

n1. Exoneration: right to require debtor honor his debt and pay it when due.

n2. Reimbursement: when a surety pays a creditor upon default by debtor.

n3. Subrogation: surety steps in the shoes of the creditor upon full payment of debt

n4. Contribution: if multiple sureties and surety has paid more than her proportionate share of debt

Trusts

Definition: A trust is a fiduciary relationship in which one or more persons hold legal title to property for the benefit of another.

                  There are three parties in a trust

                  1. Grantor: aka Donor, Settlor, Trustor creates the trust and often gives the property [res ] the trust owns

                  2. Trustee: the person with the legal title who manages it for the benefit of the; legal title

                  3. Beneficiary: the person who gets the benefit from the trust; beneficial title

Trust created when trustor is alive [inter vivos] or when dead [testamentary].  A spendthrift trust enables Grantor to remove the trust res not only from the beneficiary’s control but also from the beneficiary’s creditors.

¨The trustee’s duties:

¤Carry out the purpose of the trust

¤Act with prudence and care – prudent person standard

¤Exercise a high degree of loyalty toward the beneficiary

¨A trust may be:

¤Revocable: Grantor may change, amend, alter, revoke the trust or its functions

¤Irrevocable: Grantor may not change: default provision

If the trustee acquires both the equitable and legal title to the trust res, the merger doctrine applies, and the trust terminates.

Estate

Estate: Whatever a decedent [dead person] leaves behind is her estate.

Probate: The legal process by which a decedent’s estate is settled or disposed of.

Non-probate assets:  They bypass the will.  Examples:

¤Jointly owned property: e.g. bank acct, JTROS, tenancy by the entirety

¤Pension and retirement funds: e.g. 401(k), IRA

¤Life insurance proceeds

¤Trust property

Intestate: When a person dies without a will, she is considered to have died intestate. Note: the State DOES NOT automatically get everything! Instead, intestate laws of the state govern disposition of the estate.

Some Concepts:

¤Widow’s statutory or forced share

¤Children: per stirpes: equal shares to each child with the share of any predeceased child divided equally among his children

¤Administrator: appointed by Probate Court to administer the Intestate Estate

Tax Estate: Not to be confused with [or equal to] the Decedent’s Probate Estate.  This is the amount of the estate that is subject to estate tax.

¤Usually consists of all property Decedent had “control” over at the time of death

¤May be subject to federal and state estate tax

¤Often subject of intense tax and estate planning

Wills

Will: A written instrument executed in accordance with legal formalities which disposes of a decedent’s property.  The person making the will is the testator/testatrix. Gifts made in a will are called devises [personal property] or bequests [real property].

¤Effective date of will: at testator’s death.  She may revoke/alter will prior to death.

¤Invalid will: one made under duress, undue influence, or fraud.

¤Basic requirements: 1. writing; 2. signed by testator; 3. attestation – witnesses may not have any interest under the will.

A will is revoked by:

¤Destruction or alteration: tearing or burning

¤Subsequent will: the last will controls; usually state that former wills are void

¤Marriage: generally revokes a will made prior to marriage

¤Divorce: or annulment revokes any disposition of property the will made to the former spouse

¤Ademption: removal or extinction of gift in will made by testator.

¨Noncupative will: is an unwritten oral declaration made before witnesses.  Few states allow them under limited circumstances, usually when the testator is in his last illness.

¤Soldiers in battle

¤Sailors at sea

¨Holographic Will: about one-half of all states allow a will entirely in the testator’s handwriting, even without a witness

Special Documents

¨Living Will: is not a will but more a health care  directive.  Individual declares that she does not wish to receive extraordinary medical treatment to preserve her life.

¨A codicil: is an amendment to a will and must be executed with the same formalities of the will.  If there are many changes, make a new will.

¨Power of Attorney: is a written authorization to represent someone else.  The person giving the power is the principal, grantor or donor.  The one getting the power is the agent or attorney-in-fact.

¨Durable Power of Attorney: A POA is ineffective when principal loses capacity.  The DPA continues even when the principal is incapacitated; usually due to injury or illness. Allows agent to make business and personal decisions on principal’s behalf without court appointment of guardian.

¨Springing Power: the DPA only takes effect after the incapacity of the principal.  Allowed in Massachusetts.

¨Health Care Proxy: is a health care power or attorney;  similar to a Living Will.  In Massachusetts this is called a Health Care Proxy.  The agent has the power to make health care and end-of-life decisions of the principal.  Usually given to the principal’s doctor.

Why Study Bankruptcies

Goals of Bankruptcy laws:

¨1. protect creditor rights; provide equitable distribution of debtor’s assets

¨2. grant debtor relief; petitioner gets a discharge

The US Constitution provides for bankuptcy protection.

First step in filing for bankruptcy. Petition – usually be debtor:

¨1. list all creditors and amounts owed

¨2. list all debtor’s properties

¨3. list exempt property

¨4. statement of debtor’s affairs

Individual debtors are required to get credit counseling prior to filing petition. Once filed, it results in an “automatic order of relief” which is a “stay” against all creditors.

Second, the court appoints a trustee who represents the debtor’s estate and is responsible for collecting, liquidating, and distributing the debtor’s estate.

Exempt Property- Individuals Only

¨1. Equity in home or burial plot: limit of $ 23K; max of $ 156K for homestead.

¨2. Automobile: limit of $ 3,675

¨3. Household goods: limit of $ 12,250 – max $ 575/item

¨4. Jewelry: limit $ 1,550

¨5. Other property: up to $ 11,500

¨6. Books and professional tools

¨7. Life insurance policies: owned by debtor

¨8. Benefits: social security, alimony & support payments, retirement funds including IRA, 401(K)

¨9. 529 plans: savings for child’s college education

Debtor has option of using either the federal or state exemptions, whichever is more generous.

Common Types of Bankruptcy

¨Chapter 7: or Complete Liquidation – about 70 % of all filings; available to all debtors.  A discharge under Ch 7 relieves the debtor of all dischargeable debts.  This involves:

¤1. terminating the business of the debtor

¤2. distributing his nonexempt assets;

¤3. discharging his dischargeable debts.

¨Chapter 11: or Reorganization – about1 % of all filings; available to all debtors. Allows debtor to submit feasible plan to reorganize [reduce or extend payment on debt] and use assets to generate income and operate.  Many Ch 11 end up as Ch 7.

¨Chapter 13: or Financing Plan – about 25 % of all filings; available to individuals only with unsecured debts [

¨A debtor in a Chapter 11 or 13 case is not discharged until all plan payments have been made.  Some Ch 11 or 13 end up as Ch 7.

Debts not discharged in bankruptcy

¨1. Certain taxes – income, real estate, payroll, sales taxes

¨2. Liabilities due to false premises, fraud, etc.

¨3. Domestic Support Obligations: alimony & child support

¨4. student loans

¨5. fines and penalties to the govt.

¨6. debts for personal injuries

¨7. debts for luxury goods [> $ 650/item]

¨8. any fraudulent transfer made within 2 years of petition; e.g. transfers to relatives and friends

¨9. most transfers made within 90 days of petition

¨10. debts not listed in the bankruptcy filing

¨11. violations of securities laws – Sarbanes-Oxley

Discharge

Once the Bankruptcy judge approves the petition, the debtor is discharged.  Upon discharge the bankruptcy estate is distributed in the following order

n1. secured creditors to the extent of their security

n2. creditors with priority in the order provided [see below]

n3. unsecured creditors

n4. other claims

Any surplus belongs to the debtor.  Unsecured claims are paid in order of priority as follows. 

n1. Domestic Support Obligations – alimony and child support

n2. Administrative expenses of debtor’s estate; filing and lawyer/accountant’s fees

n3. Unsecured claims arising in the course of debtor’s business

n4. Unsecured claims up to $ 12,475 for wages earned within 180 days of filing of petition

n5. Contributions to employee benefit plans

n6. Up to $ 2,775 for consumer deposits

n7.  Income, property, payroll and other taxes .

Each claimant within a priority class shares pro rata.