CHAPTER 9
Business Organizations and Securities
Regulation
Chapter Goals
This chapter is intended to be a straightforward introduction to the legal principles governing the creation
and propagation of a business. Part One offers a brief survey of the basic business forms and the
advantages and disadvantages of each. The student should simply be encouraged to look at the law of
business organizations in a commonsense fashion with a view to understanding how the law can be a
useful tool in building a sound foundation for a business. Of course, the student must also understand that
the law proscribes certain kinds of conduct that might otherwise facilitate one’s profit-seeking goals.
Part Two addresses securities regulation. Initially the student must understand the broad character of the
term “security” and, hence, the expansive grasp of the security laws. Presumably the instructor will want
to assist the student in exploring the broad goals of the 1933 and 1934 Acts, while giving some attention
to the staggering corporate failures of recent years and Congress reaction in the passage of the
Sarbanes-Oxley Act. In our view, the mechanics of securities regulation should take a distinct back seat in
favor of the larger policy questions including, e.g., whether government regulation could have made a
difference in recent events and what our future course should be.
Chapter Learning Objectives
After completing this chapter, students will be able to:
1. Describe the advantages and disadvantages of corporations, partnerships, and limited liability
companies.
2. Identify and explain the business judgment rule.
3. Explain the relationship between limited liability and the doctrine of “piercing the corporate veil.”
4. Compare and contrast C corporations and S corporations.
5. Define and describe common stock, preferred stock, and debt.
6. Identify the main concerns of corporate governance.
7. Identify some of the goals of the shareholder rights movement.
8. Define the term initial public offering (IPO).
9. Describe the securities registration process.
10. Compare and contrast the regulatory roles of the 1933 and 1934 federal securities acts.
11. Explain the due diligence defense.
12. Describe the fraud-on-the-market theory of reliance and explain its importance.
13. Define insider trading.
14. Contrast the classical fiduciary theory of insider trading with the misappropriation theory.
15. Describe the tender offer process and some defenses against it.
Chapter Outline
I. Introduction
Against a backdrop of the worst financial crisis since the Great Depression of the 1930s, this chapter
provides a brief introduction to some of the fundamental laws governing business
From the outset one needs to recognize the overlapping coverage of state and federal regulation of
business. Historically, state law governed most issues—such as the creation of business entities, the
powers and duties of management, and capital structure. Still today, the laws that regulate a partnership,
both among the partners and with outside parties, are state laws; as are the laws that permit the creation
of corporations, those under which limited liability companies (LLCs) have been allowed to form and those
permitting numerous other business forms. The owners of a corporation are called stockholders or
shareholders because the ownership interests are called shares of stock. Part One of this chapter will
discuss the key characteristics under state law of the most common business entity forms.
The first decade of the 21st century has been scarred by two systemic failures involving corporate actors
and the capital markets. The first is commonly referenced by the 2001 collapse of Enron and the second
was the financial crisis that struck in the fall of 2008. In each case, Congress responded with significant
legislation that, in part, imposes additional requirements on the management of publicly held corporations
(corporations with publicly traded shares). These federal laws are the Sarbanes–Oxley Act of 2002 (SOX)
and the Dodd–Frank Act of 2010. Part Two of this chapter will discuss corporate governance issues
specific to public corporations, including the relevant provisions of these two federal laws.
Part Three will take a closer look at how businesses are financed—particularly their access to capital
beyond the resources of the initial founders. Although state law plays a role here, federal regulation
dominates. Part Three of this chapter will focus on federal regulation of the securities markets, including
relevant changes following the two financial crises of the last decade.
Delaware Seeks Exclusive Jurisdiction
Delaware generates over a third of its total state revenue from taxes and fees related to corporate
domicile, each corporation paying up to $180,000 annually. In 2013, over 80 percent of all IPOs were by
entities incorporated in that state. In June 2013, that body upheld a bylaw restricting shareholder lawsuits
to the Delaware courts. Approximately 300 corporations now have this bylaw, with many more expected if
the ruling stands on appeal.
Part One—Business Entities and Their Defining Characteristics
One of the most significant decisions facing the founders of a business is the choice of a legal entity to
house the business.
The three traditional business forms are corporations, partnerships, and sole proprietorship. Partnerships
and sole proprietorships are default forms. Strictly speaking, a sole proprietorship is not a business entity
at all—the law treats the business and the individual as the same legal person.
An LLC is often referred to as a hybrid because it was specifically designed to combine various desired
characteristics of corporations with others of partnerships. Another hybrid form is known as a subchapter
S corporation, (also called sub-S or S corporations).
Each of these forms will be evaluated below according to the following considerations:
Formation and nontax costs: The method of and costs related to bringing a business form into
existence.
Management structure: The degree to which control is centralized in a hierarchical structure or is
dispersed among owners.
Limited liability: The extent to which business owners are personally liable for business
obligations.
Transferability of ownership interests: Whether the business owners can transfer their interests
without state law restrictions.
Duration of existence: The events, including those impacting the business owners, which will end
the business entity’s existence.
Taxes: The way each business form affects the income tax treatment of the business and its
owners.
Capital structure: The impact of the business form on the organization’s ability to access
additional capital.
I. Corporations
Although only 19 percent of all business entities are C corporations, they account for 67 percent of all
business revenue. Together, C and S corporations represent 64 percent of all business entities and
account for 87 percent of all business revenue. There are two very different corporate realities: the public
corporation and the closely held corporation (a corporation with relatively few shareholders, the stock of
which has no readily available market).
Corporate Constitutional Rights?
Under state law, corporations are legal persons. Over the years, the Supreme Court has held that
corporations are sometimes entitled to constitutional protections7 and at other times not so entitled. The
issue arose again in Citizens United v. Federal Election Com’n, 130 S.Ct. 876 (2010), in which the Court,
over a strong dissent, enunciated a wide-reaching principle that “the Government may not suppress
political speech on the basis of the speaker’s corporate identity.”
A. Formation and Nontax Costs
To create a corporation, a promoter or incorporator files articles of incorporation with the state
government. A modest fee is typically charged.
Once the articles are filed the corporation comes into existence. An organizational meeting will then be
held at which the initial members of the board of directors will be appointed by the incorporators
(unless they were already designated in the articles). Among other things, it will appoint officers and
adopt bylaws. Bylaws contain key policies and procedures, such as how meeting quorums will be
determined and the percentage of shareholders that must approve major corporate actions like
mergers.
Corporations are separate accounting entities and need to establish books of account. The cost of
their accounting systems, however, generally reflects their scale of operation, rather than the decision
to operate in corporate form.
Selection and Protection of the Corporate Name
Articles of incorporation are filed in the name of the soon-to-be corporation. States require corporate
names to be distinguishable from names already registered, so it is a good thing to check the state’s
database in advance for the desired name and reserve it prior to filing the articles. Other steps an
entrepreneur should consider include: trademark issues, domain name, fictitious name, and doing
business in other states.
B. Management Structure
One strength of the corporate form, an attribute that has allowed it to become a very effective engine
of economic growth, is its ability to separate ownership from management. All corporate powers are
exercised by or under the authority of the board for and on behalf of the shareholders. To actually run
the company, boards appoint officers, often a CEO (chief executive officer) or president, secretary,
CFO (chief financial officer) or treasurer, and several vice presidents. This hierarchy is referred to as a
centralized management structure.
Both directors and officers have fiduciary duties to the corporation. A fiduciary is a person who acts on
behalf of another (beneficiary) and is required to do so with great integrity. The duty of loyalty requires
a fiduciary to act in the best interests of the beneficiary. Directors and officers also owe the corporation
a duty of due care, which requires that they act in good faith toward the corporation and in the manner
a reasonably prudent person would employ under the same circumstances. [For an inside look at
issues confronting board members today, see http://boardmember.com]
Business Judgment Rule
The judicial system has developed the business judgment rule, which posits a powerful
presumption… that a decision made by a loyal and informed board will not be overturned… unless it
cannot be “attributed to any rational business purpose.” [The] shareholder… challenging a board
decision [must] rebut the… presumption [by] providing evidence that directors… breached any one
of the triads of their fiduciary duty–good faith, loyalty or due care…. If a shareholder… fails to meet
this… burden, the… rule attaches to protect… officers and directors and the decisions they make,
and our courts will not second-guess these business judgments.
Legal Briefcase: Schlensky v. Wrigley, 237 N.E.2d 776 (Ill. App. Ct. 1968)
Director, Officer, Employee Liability
Wrigley involved a shareholder derivative suit. That action is initiated when the corporation is being
harmed or defrauded and neither the board nor the senior executives will take action to protect it.
The suit is brought by a minority shareholder, but any recovery inures to the corporation.
When an employee or director commits a tort or crime while conducting corporate business, both
that person and the corporation are liable for the consequences. The legal doctrine that makes the
employer liable for an employee’s acts is respondeat superior.
Because officers and directors are ultimately responsible for corporate acts and because
corporations are frequently sued, these persons face a high risk of becoming involved in costly
litigation. Most corporations, therefore, indemnify (pay for or reimburse) these individuals for the
costs incurred to defend such suits.
C. Limited Liability
Corporations can own property, be sued, take on debts, and otherwise act as separate entities. One of
the great advantages of this status is that the owners of the corporation are generally not responsible
for the corporation’s obligations.
The liability of shareholders is limited to the loss of their investment in the corporation, which is the
essence of limited liability and perhaps the most cherished characteristic of the corporate form.
However, for closely held corporations, this feature can be severely restricted because lenders are
well aware of limited liability and usually require the principal shareholders to guarantees the
corporation’s debts.
Closely held corporations also face the loss of limited liability through application of the doctrine known
as piercing the corporate veil. This doctrine usually has two elements:
Misuse of the corporate form
An unjust result if limited liability is allowed to stand
Legal Briefcase: Charles E. Wolfe v. United States 612 F. Supp. 605 (D. Mont. 1985) aff’d 798
F.2d 1241 (9th Cir 1986)
D. Transferability of Ownership Interests
Federal securities laws impose broad restrictions on the transfer of stock. Beyond these (and
analogous state) laws, no statutory restrictions are generally imposed on stock transfers. A common
contractual restriction in closely held corporations is a buy-sell agreement which, at a minimum, forces
a shareholder to offer his or her stock to the corporation or other shareholders before selling it to a
third party.
E. Duration of Existence
In general, a corporation has indefinite duration. Nothing that transpires in the lives of the stockholders
automatically affects the corporation’s existence.
The termination of a corporation, however, can occur—either voluntarily or involuntarily. Voluntary
termination requires a vote by the shareholders, who might do so if business prospects are no longer
favorable. On termination the corporation is liquidated, which involves first satisfying all creditors and
then distributing any remaining assets to the shareholders. Articles of dissolution are then filed,
officially ending the corporation’s existence.
Involuntary terminations are caused by the action of a court or of the state corporation regulator. A
common reason for the state to terminate a corporation is for failure to pay annual fees or make
required annual filings.
F. Taxes
Taxation transfers about one-quarter of the United States’ economic output to the government.
Virtually everyone wants to minimize tax payments, hopefully by legal tax avoidance (careful planning
within the law), not by illegal tax evasion (committing fraud to lower taxes).
Because the corporation is a separate legal entity, it is subject to taxation in its own right. This leads to
what many would say is the corporation’s greatest disadvantage, double taxation. In the United States,
a corporation pays tax on its income. When it later distributes its after-tax income to its shareholders
as dividends, the shareholders are taxed on that amount as well, hence, “double taxation.” Note,
however, that dividends are not mandatory. They are paid only after the board declares them, which it
is generally not required to do and which it legally cannot do if the corporation’s solvency (cash flow
and net worth) is insufficient.
The argument that corporations are necessarily disadvantageous because of double taxation can be
misleading, however. There are a variety of circumstances in which employing the corporate form
yields clear tax advantages, especially for smaller closely held corporations. An example results from
corporations being the only form of business that comprehensively permits tax-deductible fringe
benefits.
The Hybrid S Corporation: Limited Liability without Double Taxation
In 1958, Congress amended the Internal Revenue Code to establish a separate tax status for some
corporations, now known as S corporations. An S corporation’s income is taxed only once—to the
shareholders on their personal returns—much like partnerships. Also like partnerships, an S
corporation is limited in the deductibility of some fringe benefits.
Not all corporations can elect to be taxed as an S corporation. S Corporations may issue only one
class of stock and may have no more than 100 shareholders, which in general may be individuals only.
Keep in mind that “S” status is relevant only for federal (and some state) tax purposes. In all other
respects the legal characteristics of S corporations are like all other corporations.
G. Capital Structure
Businesses often need access to capital to finance their activities. Capital is of two types: debt and
equity. The providers of both debt and equity capital hold claims against the corporation’s assets.
However, creditors’ claims are always satisfied before equity holders’ claims
Equity capital (stock) has a long-term horizon. Although any given shareholder may intend to hold the
stock for only a short period, the stock itself is generally expected to exist for the full life of the
corporation. Three property rights are associated with stock ownership: the right to participate in
earnings (that is, dividends), the right to participate in assets upon liquidation, and the right to
participate in control. There are two principal classes of stock: preferred and common. Where only one
class exists, it is common stock. Common stockholders share all three property rights in proportion to
their holdings.
Preferred stock is associated with “preferences,” which relate to distributions. Preferred stockholders
are paid their required annual dividend in full before any dividends are distributed to the common
stockholders. After the creditors are satisfied, the preferred stockholders receive the next round of
distributions up to their stock’s liquidation value (also called redemption value)—typically a few percent
over the stock’s par value.
The cost of these two preferences is the loss of the right to participate in control. Having no vote,
preferred stockholders cannot elect directors to protect their interests. To help ensure that its holders
regularly receive dividends, nearly all preferred stock is cumulative. This means that if a preferred
stock dividend is missed, then before the common stockholders get any dividends, the preferred stock
arrearage (all dividends not paid in any prior year) must be made up.
Debt capital may be short or long-term. Companies that provide motherboards to Dell are a source of
short-term debt capital. They expect to be paid fairly quickly, although not at the moment of delivery.
The long-term debt of a closely held corporation is likely to come from a commercial lender who takes
a security interest in specified property of the corporation. Just as a public corporation may sell its
stock to the public, large corporations may sell units of debt, called bonds, to the public.
Corporations carefully manage their capital structures (the balance between debt and equity). Further,
the capital structure must be managed to ensure that debt covenants are not breached. A debt
covenant is a term in the lending contract that makes the debt immediately payable should the
condition specified not be satisfied (such as exceeding a specified debt/equity ratio.) On the other
hand, if the ratio is too low, opportunities for positive financial leverage (employing funds at a rate of
return that exceeds the interest rate on the borrowed funds) may be forfeited.
II. Partnerships
This section discusses traditional, general partnerships. A partnership is two or more persons (partners)
who carry on a business as co-owners. Whereas corporate ownership interests are called stock or
shares, the equity interest of a partner is called a partnership interest.
Partnerships are mutual agencies. Every partner is an agent of the partnership with the capacity to bind
the partnership when acting within the scope of the partnership’s business. Each partner has the right to
examine all partnership records and to demand a formal determination by a court of the value of the
partner’s interest (an accounting).
What is the Law in your State?
There are significant differences between UPA (Uniform Partnership Act), and RUPA (revised form of the
UPA). Which is the law in your state?
A. Formation and Nontax Costs
Under RUPA a partnership is a separate legal entity, distinct from its partners. However, no filing with
the state is required to create it. Mere co-ownership of property, however, does not create a
partnership. One might expect the contract that creates and governs the partnership, the partnership
agreement, to very precisely specify the terms of that relationship. This may be true if the partnership
agreement is written. However, the vast majority are oral agreements. If disagreements arise over an
oral agreement, the partners may find it very difficult to establish conclusively what the original
agreement was.
Partnership agreements also tend to be expensive to draft because of the many opportunities for
customization, because state law provides only a general framework, and because the personal risks
of being a partner are so significant. Similarly, partnership accounting systems can be among the most
expensive of all the business forms because of the need to track the customized economic
arrangements.
B. Management Structure
By default, management in a partnership is not centralized. Absent an agreement to the contrary, each
partner has an equal right to participate in control on a one-partner, one-vote basis regardless of the
size of the partner’s ownership interest. In response some partnerships create a central management
structure by adding provisions to the partnership agreement in which the partners yield many of their
management rights to a subset of partners (perhaps only one—a managing partner).
Legal Briefcase: Veale v. Rose 657 S.W.2d 834 (Texas. Ct. of App. 1983)
C. Limited Liability
A partnership does not offer limited liability to its owners. The partners are personally liable for all of
the partnership’s obligations should it default. This is clearly the greatest disadvantage of the
partnership form. Under RUPA partners are jointly and severally liable for both contract obligations and
torts. If a wealthy partner pays the debt, that partner is entitled to recoup an appropriate share from the
other partners under the right of contribution.
Under the doctrine of respondeat superior, the partnership, and therefore the partners, are liable for
the torts of the partnership’s employees and for the unintentional torts of the partners.
D. Transferability of Ownership Interests
Because partnerships are mutual agencies, involve fiduciary relationships, and do not have limited
liability, without an express agreement to the contrary, the law does not allow a partner to transfer a
partnership interest to a third person without the unanimous consent of the other partners. A
partnership interest can be assigned, but the assignment entitles the assignee only to the distribution
rights of the assigning partner (assignor).
E. Duration of Existence
Under UPA, a partnership is automatically dissolved, or terminated, upon the death, incapacity,
bankruptcy, expulsion or withdrawal of any partner. To minimize the harm from such an automatic
dissolution, it is common practice to include a provision in the partnership agreement allowing a
partnership to be immediately reformed by the remaining partners.
Under RUPA, the only event that will automatically dissolve a partnership is a partner’s express
withdrawal. The remaining events will result in the disassociation of the affected partner, but will not
dissolve the partnership nor require the formation of a new partnership by the remaining partners.
E. Taxes
The greatest advantage of the partnership form is the extraordinary range of economic relationships
that can be crafted. Double taxation does not apply to partnerships because the Internal Revenue
Code does not treat them as separate taxable entities, whether or not the state has adopted RUPA.
There are two important negative tax consequences of a partnership:
Fringe benefits provided to partners are generally not business deductions (although fringes
provided to employees are).
All of a partner’s allocable share of ordinary income is subject to the self-employment tax (at an
effective rate of about 13 percent).
F. Capital Structure
The sole source of equity is the partners themselves, although new partners can be brought into the
partnership to infuse new equity capital into the business. Debt capital can be raised based on the
creditworthiness of the individual partners, as well as by offering assets to lenders as collateral for
loans.
G. Limited Liability Companies
Wide displeasure with the lack of a limited liability business form that had the flexible tax
characteristics of partnerships led the Wyoming legislature to create the limited liability company in
1977. By 1997, LLCs were available nationally and are now the fastest-growing business form in the
United States.
To create an LLC, the owners (although some states allow one-member LLCs), called members; file
articles of organization with the state, much as a corporation files articles of incorporation. The equity
interests are called members’ interests. An operating agreement, which can be oral or written but is
most likely to be written, will be prepared which sets forth information similar to that often found in
partnership agreements.
The management structure of LLCs is extremely flexible: the operating agreement generally specifies
whether it will be centrally managed by managers (manager-managed: often one or two of the
members) or member-managed (similar to a partnership).
LLCs are hybrids because, with regard to limited liability of the owners and the duration of existence,
they more closely resemble corporations. With regard to transferability of ownership interests and
access to equity capital, however, they more closely resemble partnerships.
Sole Proprietorships
Sole proprietorships business ventures undertaken by a single individual, are not entities—they have
no legal existence apart from the owner. However, the same characteristics used to evaluate other
business forms can be applied to them. A sole proprietorship comes into existence by the mere
decision of the proprietor to pursue a venture. Thus, it is the default business form for single owners.
This largely explains why the majority of all business endeavors are sole proprietorships, although
they generate only 4 percent of all business revenue—averaging a little over $50,000. No legal filings
or fees are required to establish a sole proprietorship. there is only one owner, centralization
of management automatically exists.
A proprietor may dispose of the proprietorship freely, but such a transfer can be accomplished only
through the transfer of the assets which underlie the business, not by a transfer of the “business” in its
own right.
A sole proprietorship is not a taxable entity. All of its revenues and expenses will be incorporated into
the personal tax return of the proprietor. The capital structure issues for a sole proprietorship are
similar to those of a partnership—without a change in business form, new equity can only come from
the sole proprietor. Any debt will be based on the creditworthiness of the proprietor and the property
the proprietor can offer as security.
III. Other Hybrid Forms
Limited Liability Partnerships
These were first enacted in Texas in 1991 at the instigation of a number of its major law firms, who
also sought relief from professional liability. Most states now have some form of an LLP. In spite of
the similarity of name and its creation in the shadow of LLCs, its closest analogue is a general
partnership, not an LLC. To bring an LLP into existence, a document, called a statement of
qualification in RUPA, is filed with the state.
As originally conceived and as is still true in some states, an LLP partner’s limited liability extended
only to the negligence or malpractice of other partners, while retaining full liability for all other
partnership obligations. RUPA, and many states, now provide full limited liability “whether arising in
contract, tort, or otherwise” to all partners “solely by reason of being” a partner.
Professional Limited Liability Companies (PLLCs) and Professional Limited Liability
Partnerships (PLLPs)
Some states that have established LLPs that confer full limited liability for partners have chosen to
prohibit their use by licensed professionals such as accountants, lawyers and doctors. As an
alternative, they have created entities (variously named depending on the state) that closely
resemble the original Texas LLP concept. They delegate regulation relating to malpractice to an
appropriate state-licensing body and/or set malpractice insurance standards for the protection of
the public.
Limited Partnerships
They are entities with two classes of owners: general partners and limited partners. General
partners have the same legal benefits and burdens as the partners of a general partnership. They
(often only one) are the sole managers of the entity. Limited partners invest in the entity by
contributing capital but do not participate in control (except to a limited extent analogous to
shareholders). Forty-nine states have adopted the Uniform Limited Partnership Act (ULPA) in one
of its three versions. Limited partnerships come into existence only upon filing a certificate of
limited partnership. However, like an S corporation shareholder, the ordinary income of the limited
partners is not subject to self-employment tax.
Limited Liability Limited Partnerships
State legislation establishing limited liability limited partnerships (LLLPs) is generally directed at
facilitating the acquisition of limited liability for the general partners of preexisting limited
partnerships.
Series Limited Liability Companies
The concept is to create a related set of entities (referred to as “series” or “cells”) through which the
liability risks of different real estate investments or businesses are kept separate even though only
one entity, the series LLC, is created under state law.
A. International Hybrids
Dozens of other business forms exist throughout the world. Using these criteria, managers operating
in a multinational environment should be able to evaluate form-of-business decisions under a variety
of regimes.