Management Chapter 19 Clark And Lanham Failed Disclose The Existence

Chapter Nineteen

Forms of Business Organizations

A MANAGER’S DILEMMA: PUTTING IT INTO PRACTICE

When Is a Partner Not a Partner?

Issue Presented: May a general partnership expel a whistle-blowing partner merely for

reporting in good faith the suspicious conduct of another partner? Is it ethical to do so?

Should it matter whether the allegations of misconduct were true or not?

The Texas Supreme Court ruled that Butler & Binion did not breach any fiduciary duty

it owed to Bohatch. Bohatch v. Butler, 977 S.W.2d 543 (Tex. 1998). It recognized that the

relationship between partners “is fiduciary in character, and imposes upon all participants the

obligation of loyalty . . . and the utmost good faith, fairness, and honesty in their dealings with

each other.” Nonetheless, partners have no obligation to remain partners: “[A]t the heart of the

partnership concept is the principle that partners may choose with whom they wish to be

associated.”

The majority opinion of the Texas Supreme Court indicated that it did not matter

whether Bohatch was correct about the overbilling: “Such charges, whether true or not, may

have a profound affect on the personal confidence and trust essential to the partner

relationship.”

There must be some circumstances when expulsion for reporting an ethical

violation is culpable and other circumstances where it is not. . . . Here, the report

of unethical conduct, though made in good faith, was incorrect. That fact is

significant to me because I think a law firm can always expel a partner for bad

judgment, whether it relates to the representation of clients or the relationships

The dissent went a step further and argued that expulsion was a breach of

fiduciary duty even if the allegations turned out to be incorrect as long as

Bohatch acted in good faith: “Partners violate their fiduciary duty to one

As one considers the role the Texas law firm Vinson & Elkins played in Enron’s demise,

the public policy concerns raised by the dissenting opinion assume added importance. Even if a

partner disagreed with the advice Vinson & Elkins gave Enron concerning the tax treatment of

QUESTIONS AND CASE PROBLEMS

Question 1

Issue Presented: When is a defect in incorporation substantial enough to cause the entity to

lose corporate status?

(a) The lawyers for the bank can make several arguments to support the contention that

a valid corporation never existed. If this is the case, then the enterprise is a general partnership.

In a general partnership, each member is personally liable for the enterprise’s debts.

(b) The founders will first argue that a de jure corporation exists. They may succeed in

this argument if a court determines that the defects discussed above are relatively insignificant

and that the incorporation requirements have been substantially complied with. The

typographical error may be deemed to be insignificant, but it is probable that the fact that the

incorporator did not appoint the directors is not an insignificant error.

Question 2

Issues Presented: (a) When is it proper to pierce the corporate veil in an effort to reach the

personal assets of a shareholder? (b) How can an owner/manager of a small corporation

ensure that the corporate veil will not be pierced?

(a) A basic principle of corporate law in the United States is that the shareholders of a

corporation are not liable for the obligations of the corporation beyond the capital they invest in

exchange for their shares. Shareholders may be held personally liable, however, when the facts

of the case merit “piercing the corporate veil.” The most common reasons for piercing the

Shareholders may become personally liable for corporate obligations when a corporation

misrepresents the nature of its activities, its ability to perform, its financial condition, or its

financial structure. This does not appear to be the case here. At best, the parents can argue that

it assumed that the pool was operated at a funding level commensurate with its risks. This

argument is better relegated to the undercapitalization concept discussed below.

When a corporation is formed without enough capital to meet the basic needs of its

Here, the parents will argue that In Over Our Heads was substantially undercapitalized

for the activities in which it was engaged. It is probable that a court would decide that $10,000

was not a sufficient capital reserve in this business in the absence of liability insurance. Given

the obvious risk of injury or drowning at a pool, this undercapitalization may be perceived as

evidence of intentional bad faith.

(b) An owner/manager can follow several simple guidelines to minimize the chance that

the corporate veil would be pierced. First, he or she must ensure that the enterprise is

Second, the owner should also avoid any commingled bank accounts and respect all

corporate formalities. Even though courts generally allow more informality in a smaller

corporation, it is wise not to provide those who might seek to pierce the corporate veil with any

ammunition to do so.

Question 3

Issue Presented: What facts must be shown to establish a de facto merger?

In Lutriario v. A World of Pets & Supplies, Ltd., 26 Misc. 3d 1219(A), 2010 WL 424966

(N.Y.City Civ.Ct. 2010), the Civil Court of the City of New York, Richmond County, ruled that

there was a de facto merger of A World of Pets into A World of Pups, and that the latter was

The second exception is commonly known as the de-facto merger exception. According

to the court:

The hallmarks of a de facto merger are the “continuity of ownership; cessation of

ordinary business and dissolution of the [predecessor] as soon as possible;

assumption by the successor of the liabilities ordinarily necessary for the

The court cited the following evidence in support of its finding of a de facto merger:

[T]here is a continuity of ownership between A World of Pets and A World of

Pups, as Nodelman is the owner of both. There also appears to be a continuity of

Question 4

Issue Presented: May shareholders contract with each other to keep each other as directors

and officers of the company?

In McQuade v. Stoneham, 189 N.E. 234 (N.Y. 1934), the court held that shareholders may

contractually agree to vote for each other as directors, but may not contractually place limits on

Question 5

Issue Presented: Is a member of a limited liability company who entered into an oral

agreement for services personally liable if the existence of the LLC was not disclosed at the

time services were requested or performed?

The Supreme Court of Colorado ruled that Clark and Lanham were personally liable for

the monies owed by P.I.I. Water, Waste & Land, Inc. v. Lanham, 955 P.2d 997 (Colo. 1998). It

rejected Lanham’s assertion that Westec was put on notice that it was dealing with a limited

liability company because the business card contained the letters “P.I.I.” and Section 7-80-208 of

the LLC Act provides that the filing of the articles of organization serves as constructive notice

of a company’s status as an LLC. The court explained:

In light of the partially disclosed principal doctrine, the county court’s

determination that Clark and Lanham failed to disclose the existence as well as

the identity of the limited liability company they represented is dispositive under

third parties into the belief that the agent would bear personal financial

responsibility under any contract, when in fact, recovery would be limited to the

assets of a limited liability company not known to the third party at the time the

[S]ection 7-80-208 places third parties on constructive notice that a fully

identified company—that is, identified by a name such as “Preferred Income

Investors, LLC,” or the like—is a limited liability company provided that its

articles of organization have been filed with the secretary of state. Section 7-80-

208 is of little force, however, in determining whether a limited liability

company’s agent is personally liable on the theory that the agent has failed to

disclose the identity of the company.

The undisclosed principal theory is a rule of law and applies regardless of a

defendant’s intent to engage in wrongful conduct; however, the doctrine of

piercing the corporate veil is based in equity so that a failure to disclose must

coexist with wrongful conduct or improper purpose or intent for the latter theory

to apply and render personal liability.

From Lanham and Clark’s perspective, this dispute could have been easily avoided by

letting Westec know the status of P.I.I. as a limited liability company. If Lanham’s business card

Question 6

Issues Presented: (a) What types of business organizations are available to entrepreneurs? (b)

What are the advantages and disadvantages of each alternative? (c) Which one should

Jameson choose?

(a) The classic film Treasure of the Sierra Madre provides a vivid example of how a good

idea can go bad without the proper organizational form. In that film, three men set out on a

gold mining venture without rules about who was in charge or about admitting new members

In deciding which entity to choose, it is common and helpful to ask the extent to which

business entities possess the following:

(1) Separation and specialization of function among participants;

(2) Centralized control of the entity by a limited subset of participants;

The archetypal corporation possesses each of these characteristics. In contrast, an

archetypical general partnership assumes the absence of each of these features. The other forms

are a hybrid of these two archetypes. To determine which entity form is appropriate requires

consideration of the tax laws pertinent to each participant, the state in which the entity will do

(b) In making this decision, it is necessary to consider the following advantages and

disadvantages of various forms of business organization:

C Corporation

Advantages

1. Liability limited to the assets of the corporation.

Disadvantages

1. The C corporation is taxed as a separate entity. Start-up losses will not flow through

S Corporation

Advantages

1. Liability limited to the assets of the corporation.

Disadvantages

1. S corporations can have only once class have stock (but they can have differences in

2. Although the start-up losses flow through to the shareholders, the passive loss rules

3. S corporations are not eligible for QSBS.

Limited Partnership

Advantages

1. LPs have flow through of income and loss. Special allocations are permitted and so

Disadvantages

1. A partner cannot participate in control without being a general partner and thus

taking on unlimited liability (this can be addressed in part by Limited Liability

Limited Liability Company

Advantages

Same as limited partnerships. In addition:

3. There is flexibility in management and in the allocation of profits and losses.

Disadvantages

1. The law governing LLCs is still developing.

2. It may be easier to pierce the veil of an LLC than a corporation.

(c) While there is no “correct” answer with respect to what Jameson should do, he

would be well advised to form the business as an S corporation, assuming the investors meet

the eligibility requirements:

1. Jameson transfers to the Echo chip to the corporation in return for voting common

stock (tax free under IRC Section 351).

2. Investors purchase nonvoting common stock for cash.

Question 7

Issue Presented: Is the acquired company’s failure to meet analyst earnings expectations a

“Material Adverse Effect” excusing an acquirer from consummating a merger?

In IBP v. Tyson, 789 A.2d 14 (Del. Ch. 2001), the Delaware Court of Chancery concluded

that IBP had not suffered a Material Adverse Effect and ordered Tyson to proceed with the

the contractual language must be read in the larger context in which the parties

were transacting. To a short-term speculator, the failure of a company to meet

analysts’ projected earnings for a quarter could be highly material. Such a failure

is less important to an acquiror who seeks to purchase the company as part of a

The court concluded that

even where a Material Adverse Effect condition is as broadly written as the one

in the Merger Agreement, that provision is best read as a backstop protecting the

this issue.

Question 8

Issue Presented: Can a member of an LLC be held liable for harm caused by lead-based paint

pursuant to a housing code provision that imposes liability on any individual who “owns,

holds, or controls” the title to the property?

In Allen v. Dackman, 991 A.2d 1216 (Md. 2010), the Maryland Supreme Court held that

the lower court erred when it granted summary judgment in favor of Dackman. The court held

that Dackman could be held liable for the plaintiffs’ injuries because a reasonable trier of fact

The Code defined an “owner” as “any person, firm, corporation . . . who . . . owns,

holds, or controls the whole or any part of the freehold or leasehold title to any dwelling or

Respondent [Dackman] stated in his deposition that he was responsible for

running the day-to-day affairs of Hard Assets during the time period when Hard

Assets both acquired and sold 3143 Elmora Avenue. Respondent also executed

the deed certification when Hard Assets acquired the property, signed the

complaint seeking to remove Petitioners from the property, and signed the deed

when Hard Assets sold the property.

In summary the court stated:

The Housing Code was enacted to protect the safety and well-being of occupants

of dwellings. This intent was effectuated by imposing upon owners and

operators of dwellings a duty to keep those dwellings in a safe condition.