978-1285860381 Chapter 31 Solution Manual Part 2

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General Partnerships

Few people now affirmatively elect to form a partnership because so many other options are available.

Even professionals such as lawyers and accountants now have other choices. As we will see in the

next chapter, many partnerships are created accidentally by people unfamiliar with partnership law. In

addition, entrepreneurs who unsuccessfully attempt to form another type of entity, may find that they

are general partners instead. For example, if two people intend to form, say, a limited liability company

and fail to satisfy the state’s filing requirements, they will find themselves in a general partnership, a

potentially ugly realization if their business is sued and they, as partners, are personally liable.

Question: Why would anyone choose to form a partnership?

Answer: There was a time when lawyers and accountants had no other choice. Now in most states

Limited Liability Partnerships

A limited liability partnership (LLP) is a general partnership in which the partners are not liable for the

debts of the partnership. However, partners must file a statement of qualification with state officials

and the LLP must file an annual report.

Additional Case: Apcar v. Gaus1

Facts. Smith & West, LLP had two partners: Michael L. Gaus and John C. West. The partnership

registered in Texas as a limited liability partnership. The Texas statute requires LLPs to renew their

registrations each year, but Smith & West never did so. Four years after its initial registration, the

partnership entered into a lease with MF Partners (which subsequently assigned the lease to Apcar).

Three years into the lease, Smith & West stopped paying rent and abandoned the premises. Apcar filed

suit against the two partners individually and against the partnership. Gaus, West, and Apcar each filed

a motion for summary judgment. The trial court granted Gaus and West’s motions while denying

Apcar’s.

Issue: Were Gaus and West personally liable for payments due under Smith & West’s lease?

Holding: Judgment for Gaus and West reversed, case remanded for further proceedings. Under Texas

law, an LLP must renew its registration each year, or its LLP status expires. Smith & West did not

renew their application before the expiration date, therefore, its status as a limited liability partnership

expired one year after the initial filing. Smith & West entered into the lease three years after this

expiration. Therefore, Gaus and West are not protected from individual liability for the lease

obligations.

Question: Smith & West registered as an LLP once. Why does it matter that it didn’t continue to

renew its registration?

Professional Corporations

For many years, professional corporations (PCs) were the only option for professionals who sought to

avoid the unlimited liability of a partnership. Now, LLCs and LLPs are generally more favorable than

professional corporations because they offer limited liability but are not taxable entities. However,

changing from a professional corporation to an LLP or LLC has its own tax complications. The IRS

may consider it to be a sale of the assets of the professional corporation, causing the organization to

incur a substantial tax liability for capital gains.

1 2005 Tex. App. LEXIS 379 Court of Appeals of Texas, 2005

Joint Ventures

A joint venture is a partnership for a limited purpose. Large companies who undertake a limited

project together often use them. The text gives the example on p.778 of the joint venture between Imax

Corp. and cinema operators, whereby Imax would supply its big screens for a share of the box office

revenue. If students completed the joint venture research assignment, ask them to present their results.

General Questions:

What advantages does a joint venture provide to its partners?

What difficulties does it create?

Franchises

Franchises are increasingly common, being popular with down-sized executives, women bumping up

against the glass ceiling, employees tired of the corporate rat race, and people who simply aspire to

owning their own business.

Case: National Franchisee Association v. Burger King Corporation2

Facts: The Burger King Corporation (BKC) would not allow franchisees to have it their way. Instead,

BKC forced them to sell the double-cheeseburger (DCB) and, later, the Buck Double (the DCB minus

one slice of cheese) for no more than $1.00. Franchisees alleged that, because this price was below

their cost, they were losing money on every double cheeseburger they sold. The National Franchisee

Association (NFA), to which 75% of BKC’s individual franchisees belonged, filed suit alleging that (1)

BKC did not have the right to set maximum prices; and (2) that even if BKC had such a right, it had

violated its obligation under the franchise agreement to act in good faith.

The court dismissed the first claim because the franchise agreement unambiguously permitted BKC to

set whatever prices it wanted. But the court allowed the NFA to proceed with the second claim. BKC

filed a motion to dismiss.

Issue: Was BKC acting in good faith when it forced franchisees to sell items below cost?

Excerpts from Judge Moore’s Decision: The motive of BKC in exercising its discretion to set prices

under the contract is key. [B]ad faith involves a subterfuge or evasion of contractual duties. [T]here are

at least two ways a plaintiff can go about raising a claim of bad faith. Plaintiffs can allege facts

identifying defendant’s improper ulterior motive(s). For example, if a franchisee had evidence that a

franchisor had a secret agenda to take over the franchise and operate it as a company-owned business,

and was deliberately setting prices to weaken the targeted franchisee, such a plaintiff could raise a

claim of bad faith by alleging the existence of that plan.

It is more likely, however, that plaintiffs will lack direct evidence of dishonesty. In these cases,

plaintiffs must allege some facts tending to show that no reasonable person could have thought that the

steps taken by the defendant were a reasonable means of carrying out the contract’s defined purposes.

If no reasonable person would have exercised discretion as defendant had, the natural inference is that

defendant must have had some hidden improper motive.

[T]he magnitude of the injury claimed by plaintiff is of central importance. [A]n inference of bad faith

may arise when the defendant exercises discretion in such a manner as to effectively destroy whatever

benefits the plaintiff could have reasonably expected under the contract. The logic is that the measure

with such severe results could not have been within the contemplation of the parties.

[N]one of the facts alleged by plaintiffs are sufficient to support a claim of bad faith. Plaintiffs rely

principally on their allegation that franchisees could not produce and sell DCB or Buck Doubles at a

cost less than $1.00, and therefore that franchisees suffer a loss on each of these items sold. There are a

variety of legitimate reasons why a firm selling multiple products may choose to set the price of a

2 2010 U.S. Dist. LEXIS 123065 United States District Court for the Southern District of Florida, 2010

single product below cost. Among other things, such a strategy might help build goodwill and customer

loyalty, hold or shift customer traffic away from competitors, or serve as loss leaders to generate

increased sales on other higher margin products.

The issue is not whether such a strategy was wise or ultimately successful or mistaken. In the absence

of some other evidence of improper motive, the question is whether it was so irrational and capricious

that no reasonable person would have made such a decision. There is nothing about the pricing decision

that suggests BKC was doing anything other than seeking to promote the performance of its

franchisees. Nothing about this action suggests bad faith.

[T]o the extent plaintiffs seek to raise a claim of bad faith by pointing to the injuries allegedly caused

them by BKC’s decision, plaintiffs must allege that the damage to their overall business was so severe

as to deprive them of their reasonable expectations under the contract. Plaintiffs come nowhere close to

alleging such an impact. Significantly, nowhere do plaintiffs claim that their overall business has been

appreciably impaired. Nor do they allege that their overall businesses are no longer profitable or that

their competitive positions or economic viability going forward are threatened.

For the foregoing reasons, it is ORDERED AND ADJUDGED that Defendant’s Motion to Dismiss is

GRANTED.

Note: The franchisees agreed to dismiss the lawsuit and entered into an agreement giving the

franchisees more input on the price of items on its value menu and on how long special deals run.

Question: Were BKC’s action done in bad faith?

Additional Case: Kieland v. Rocky Mountain Chocolate Factory3

Facts: Rocky Mountain is a franchisor of stores that sell chocolate and other candies. Kristine and

Scott Kieland’s Rocky Mountain store failed four years after they purchased it. Kathleen and Stanford

Evavold’s franchise was not as profitable as they thought it would be. Rocky Mountain had given both

the Kielands and the Evavolds a uniform franchise offering circular (UFOC) before they signed their

franchise agreements.

Rocky Mountain required that its franchisees purchase a point of sale cash register system (POS

system). At the time the Kieland’s signed their agreement the POS system was $3,000 per register

with an annual maintenance fee of $773. Their agreement stated, “We may require you to upgrade or

update your POS Systems. No contractual limitation exists on the frequency or cost of this

obligation.”

Shortly after signing their agreement, the Kielands learned that they would have to purchase a new

POS System (referred to as AIM) for $20,000 per register with an annual maintenance fee of almost

$2,000.

Stanford Evavold e-mailed a pro forma budget to Kraig Carlson, a Rocky Mountain salesperson.

The email stated, “I don’t believe you can state if these (numbers) appear reasonable, but maybe you

can tell me if it is a “rainy day” or a “sunny day”. Carlson responded that the numbers “did not raise

any issues with him.” Based on this, the Evavold’s signed another agreement that stated “The

Franchisee acknowledges and agrees that no representations have been made to it by the Franchisor

regarding projected sales volumes, market potential, revenues, or profits of the Franchisee’s Store.”

The Kielands and the Evavolds sued Rocky Mountain for violating the Minnesota Franchise Act by

failing to disclose the cost of the new AIM system and by approving Evavold’s earnings estimate. Had

they known all the relevant facts, the Kielands and the Evavolds would not have purchased a Rocky

Mountain franchise. Rocky Mountain filed a motion for summary judgment.

Issue: Did Rocky Mountain violate Minnesota franchise law?

Holding: No, Rocky Mountain’s motion for summary judgment is granted. According to the court, the

Kieland’s claim that Rocky Mountain failed to disclose the cost of the new AIM system fails as a

3 2006 U.S. Dist. LEXIS 76057, United States District Court for the District of Minnesota, 2006.

matter of law. Pursuant to the UFOC singed by the Kielands, Rocky Mountain had the right to require

franchisees to “upgrade or update” the POS system. Although the expense of the AIM system was

approximately $13,000 more that the [old] system, and the maintenance fee was approximately $1,200

more, the UFOC authorized Rocky Mountain to require the Kielands to make such an upgrade.

Similarly, the Evavolds claim that Carlson gave them an earnings claim by replying to their email

that the numbers “did not raise any issues” fails as a matter of law. The UFOC signed by the Evavolds

clearly states that Rocky Mountain does not authorize its sales personnel to make any oral projections

regarding a franchisee’s potential success.

Question: If the purpose of the offering circular is to ensure that the franchisor discloses all relevant

facts, was that purpose achieved with the Rocky Mountain offering circular?

Answer: Not according to the Keilands and Evavolds. According to them, the circular did not state

Question: Why did Stanford Evavold ask the Rocky Mountain sales person his opinion about their

budget?

Answer: Probably because he was worried that his franchise was not making as much money as he

Question: What is wrong with that?

Answer: It may not be wrong to ask, but the court made it clear that it was wrong to rely on any

Suggested Additional Assignment

If your students obtained a copy of a franchise offering circular, this would be a good time to discuss it.

Question: In examining a franchise circular, what factors should a potential purchaser look at most

closely?

Answer: Three issues are of particular importance: (1) the financial terms, (2) the success of the

franchises, and (3) the relationship between the franchisor and its franchisees. A buyer should look at

the total cost of the initial investment and annual fees charged as well as any requirements that goods

Multiple Choice Questions

1. A sole proprietorship:

(a) Must file a tax return

(b) Requires no formal steps for its creation

(d) May sell stock

(e) Provides limited liability to the owner

2. CPA QUESTION Assuming all other requirements are met, a corporation may elect to be

treated as an S corporation under the Internal Revenue Code if it has:

(a) Both common and preferred stockholders

(b) A partnership as a stockholder

(d) The consent of a majority of the stockholders

3. A limited liability company:

(a) Is regulated by a well-established body of law

(b) Pays taxes on its income

(d) Must register with state authorities

(e) Protects the owners from personal liability for their own misdeeds

4. CPA QUESTION A joint venture is a(n):

(a) Association limited to no more than two persons in business for profit

(b) Enterprise of numerous co-owners in a nonprofit undertaking

(d) Association of persons engaged as co-owners in a single undertaking for profit

5. A limited liability partnership:

(a) Protects partners from liability for their own misdeeds

(b) Protects the partners from liability for the debts of the partnership

(d) Both (a) and (b)

(e) (a), (b), and (c) are all correct

Case Questions

1. Alan Dershowitz, a law professor famous for his prominent clients, joined with other lawyers to

open a kosher delicatessen, Maven’s Court. Dershowitz met with greater success at the bar than in

the kitchen—the deli failed after barely a year in business. One supplier sued for overdue bills.

What form of organization would have been the best choice for Maven’s Court?

Answer: A sole proprietorship would not have worked, because there was more than one owner. A

2. Mrs. Meadows opened a biscuit shop called The Biscuit Bakery. The business was not

incorporated. Whenever she ordered supplies, she was careful to sign the contract in the name of

the business, not personally: The Biscuit Bakery by Daisy Meadows. Unfortunately, she had no

money to pay her flour bill. When the vendor threatened to sue her, Mrs. Meadows told him that he

could only sue the business, because all the contracts were in the business’s name. Will Mrs.

Meadows lose her dough?

3. Kristine bought a Rocky Mountain Chocolate Factory franchise. Her franchise agreement required

her to purchase a cash register that cost $3,000, with an annual maintenance fee of $773. The

agreement also provided that Rocky Mountain could change to a more expensive system. Within a

few months after signing the agreement, Kristine learned that she would have to buy a new cash

new cash register? Did Rocky Mountain act in bad faith?

4. What is the difference between close corporations and S corporations?

Answer: State statutes authorize the creation of a corporation, but the IRS determines its tax

status. Thus, state law determines if an organization is a regular corporation or a close corporation.

5. If you were to look online for a description of a professional corporation, you might find websites

stressing that, in a PC, shareholders are still responsible for their own wrongdoing. For example:

“In some states, these professionals can form a corporation, but with the distinction that each

professional is still liable for his or her own wrongful professional actions.” Why is this statement

at best unnecessary and at worst misleading?

Discussion Questions

1. Leonard, an attorney, was negligent in his representation of Anthony. In settlement of Anthony’s

claim against him, Leonard signed a promissory note for $10,400 on behalf of his law firm, an LLC.

When the law firm did not pay, Anthony filed suit against Leonard personally for payment of the

note. Is a member personally liable for the debt of an LLC that was caused by his own negligence?

2. Think of a business concept that would be appropriate for each of: a sole proprietorship, a

corporation, and a limited liability company.

3. As you will see in Chapter 33, Facebook began life as a corporation, not an LLC. Why did the

founder, Mark Zuckerberg make that decision?

4. Corporations developed to encourage investors to contribute the capital needed to create

large-scale manufacturing enterprises. But LLCs are often start-ups or other small businesses. Why

do their members deserve limited liability? And is it fair that LLCs do not have to pay income

taxes?

5. ETHICS Frank Brown, who is African-American, tried to buy lunch at a McDonald’s at the

Dadeland Mall in Florida. The manager, Omar Zaveri, not only refused to serve Brown but verbally

abused him, used racial slurs and told all the other employees that he would fire them if they

served Brown. This McDonald’s was owned by a franchisee. Is McDonald’s liable to Brown?

Whether or not McDonald’s is technically liable, should it pay Brown anyway?

Answer: In this case, McDonald’s was found not liable. From the agency chapter, we remember

that the franchisor would be liable if it exercised control over the hiring in this franchise. It is not