Business Law II, Accounting 456 Study Guide, Copyright Helen M.

Roe 2010

I. Relationship of Principal and Agent

Agency is a relationship between two persons whereby the agent is authorized to act
For and on behalf of the principal.

A. Creation of agency and scope of purpose

1. Whatever business activity a person may accomplish personally he may do

Through an agent. E.g. power of attorney.

A principal may not appoint an agent to perform act which are so personal
That their performance may not be delegated to another. E.g. contracts
For personal services.

2. An agency is a consensual relationship that may arise by contract between the

Principal and agent, estoppel or ratification.

3. Whether the principal has the capacity to act through an agent depends on the
Capacity of the principal to do the act himself. The incapacity of the agent
To bind himself through a contract does not disqualify him from making a
Binding contract on the principal. E.g. newspaper boy, Girl Scouts cookies

B. Classification of agencies

1. Disclosed principal

Third person has notice that the agent is acting for the principal and knows
The principal’s identity. May be liable.

2. Partially disclosed principal

Third person has notice that the agent acts or may act for another but does not
Know the principal’s identity. Liable.

3. Undisclosed principal

Third person has no notice that the agent is acting for a principal. Liable.

C. Types of authority

1. General: The agent can transact all business of the principal or all business of
A particular kind at a particular place.
 2. Special: The agent acts only in a particular transaction. E.g. real estate broker.

3. Subagent: The agent is employed by an agent with the knowledge and the
Consent of the principal.

D. Other legal relations

1. Master-Servant: work is of a ministerial nature and the servant has little

Authority

2. Independent contractor: Hiring principal has no right of control. E.g. UL

E. Duties of an agent to a principal

1. Obedience

2. Diligence

3. Inform

4. Account see F.1.c. below

5. Fiduciary: This arises out of a relationship of trust and confidence.

a. The agent cannot represent the principal in a transaction in which the agent
Has a personal interest. e.g. conflict of interest

b. The agent owes full disclosure. e.g. self dealing. Agent owes undivided
loyalty.

c. The agent cannot use for his own benefit information obtained in the course
Of his agency.

d. The agent cannot make a secret profit. E.g. real estate agent. Agent must
account for financial benefits.

F. Duties of a principal to an agent

1. Contract duties

a. By contracting to employ an agent the principal does not promise the agent
an opportunity to work. E.g. sales rep

b. The principal has a duty to render the agent a true account of money.
e.g. commissions.

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 c. The principal is under a duty to indemnify and reimburse the agent for
Authorized payments made by an agent on behalf of the principal.
e.g. travel expenses, contracts: put in engagement letter. See E.4. above

d. If no specific rate of compensation is set, then the principal must pay a

Reasonable rate of compensation.

2. Tort duties

a. Principal must provide reasonably safe conditions of employment.

Common law duties are maintenance, inspection and repair of premises.

b. Workers compensation: an employee is injured and the injury arises out

Of his employment. This is sole compensation from the employer.

G. Termination of Agency

1. Acts of the parties

a. Mutual agreement

b. Fulfillment of the purpose, e. g. real estate closing

c. Revocation of authority, P fires A

d. Renunciation of Agency, A fires P

2. Operation of law

a. Bankruptcy of P or A

b. Death of P or A

c. Incapacity of P or A

d. Loss or destruction of the subject matter

e. Loss of qualification of P or A

f. Disloyalty of A

g. Change of law

h. Outbreak of war

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 3. Irrevocable agencies

These occur when the agency is coupled with an interest.

e.g. a factor advances funds on behalf of the principal in the garment industry

II. Relation of principal and agent to third parties

A. Relation between the principal and the third party

1. Contract liability of the principal

The principal is liable for the authorized acts of the agent. The principal is not
Liable for the unauthorized acts unless he ratifies them.

2. Types of authority

a. Actual authority

It depends on the consent manifested from the principal to the agent

whether express or implied.

1) Actual express authority is embodied in language instructing

The agent. This is written or oral. E.g. Board of Directors resolution
To an officer on signing authority.

2) Actual implied authority is inferred from the words or conduct from the
Principal to the agent. E.g. business trip includes expenses for travel.

b. Apparent authority

1. This arises out of words or conduct of a disclosed principal manifested

to
a third person where the third person is reasonably induced to believe
that actual authority exists.

2. Upon termination of the agency, actual authority ceases but apparent

authority may continue to third persons until the third person receives
actual or constructive notice of the termination. (E.g. third party
has extended credit.) Actual notice is by
letter, fax, telephone conversation, telegram, email or meeting.
Constructive notice is an ad in a newspaper of general circulation

3. Ratification

a. It is the confirmation by a principal of a prior unauthorized act by another who

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 is or purports to be his agent.

b. Principal must manifest an intent to ratify with knowledge of all material facts
concerning the transaction.

c. Ratification must occur before a third party gives notice of withdrawal.

B. Tort liability of the principal

1. The principal is liable for authorized acts of the agent to commit tortious acts
With respect to the person or property of another.

2. The principal is liable for the unauthorized acts of the agent committed within
The scope of the agent’s employment. RESPONDEAT SUPERIOR.

III. Partnerships

A. Definition

A partnership is an association of two or more persons to carry on as co-owners of a

business for profit.

1. Association: It is a voluntary collection, uniting, coming together for a certain

purpose. E.g. CPA firm, law firm.

2. Two or more persons: can be individuals, partnerships, corporations or other

Associations.

3. Carry on a business: can be a trade, occupation or profession.

4. Co-owners of a business: not just joint tenancy, not just tenancy in common, nor
just an investment. RUPA 202 (c) (1)

5. Sharing in gross receipts is not enough. RUPA 202 (c) (2)

RUPA (c) (3) provides that a person who receives a share of the profits is
presumed to be a partner unless the profits were received for payment of a
debt, wages, rent, an annuity, consideration for the sale of the goodwill of a
business or as interest on a loan.

B. Partnership Name

The firm name must not be the name of another entity. If it uses a name other than
the name of the partners it must file under the assumed name statute so that parties

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 will know who they are dealing with and know who to serve with summons.

C. Legal Entity

This is a unit with the capacity of possessing legal rights and being subject to legal
duties. The assets of the firm are treated as a business unit and they are separate from
the assets of the partners. A partnership entity is distinct from its partners. Under
RUPA a partnership can sue and be sued in the name of the partnership.

D. Legal Aggregate

The debts of the partnership are ultimately the debts of the partners (unless LLP).
The IRS treats the partnership as an aggregate and the partnership files an
information tax return.

E. Partnership agreement

It need not be in writing. However, a contract to form a partnership to continue for a

period longer than one year is within the statute of frauds and must be in writing.
Among other items, it should contain the following:

1. Name and purpose of the partnership

2. Capital requirements

3. Accounting procedures such as bearing profits and losses

4. Identity of firm property

5. Management of the partnership

6. Dissolution and continuation

7. Partners are not entitled to salaries.

F. Partnership property

1. Property acquired by a partnership is property of the partnership and not the

partners individually. RUPA 203. E.g. Partners acquire a building.

2. Property is partnership property when it is acquired in the name of the partner-

Ship. RUPA 204 (a).

3. Property is partnership property when it is acquired in the name of one or more

partners in their capacity as partners in the partnership, if the name of the

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 partnership is indicated in the instrument transferring title to the property. RUPA
204 (a)(2).

4. Generally, property is presumed to be partnership property if purchased with

partnership assets, even if not acquired in the name of the partnership or in the
name of the partner. RUPA 204 (c).

5. If property is acquired in the name of a partner without an indication in the

instrument of an individual’s capacity as a partner or the existence of a partnership
and without use of partnership funds, then the property is presumed to be the
partner’s separate property. RUPA 204 (d).

G. Duties among Partners

1. Fiduciary duty of loyalty

a. A partner has the duty not to appropriate partnership benefits without the consent
of the partners, to refrain from self-dealing and to refrain from competing with
the partnership. RUPA 404(a)

b. The duty of loyalty is limited:

1) to account to the partnership in the conduct and winding up of the

partnership.

2) to refrain from dealing with the partnership in partnership business or in

winding up on behalf of a party with an adverse interest.

3) to refrain from competing with the partnership. RUPA 404 (b)

c. The duty not to compete ends on dissociation. RUPA 603 (b) (2)

d. A partner has the duty of good faith and fair dealing. RUPA 404 (d)

2. Duty of obedience

This applies to the partnership contract and any partner who violates it is
liable individually to the partners for loss.

3. Duty of care

It is limited to refraining from grossly negligent or reckless conduct,

intentional misconduct or knowingly violating the law. RUPA 404 (c)

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H. Rights among partners

1. Right to share in distributions

A distribution is a transfer of money or other partnership property from

the partnership to a partner in the partner’s capacity as a partner.
RUPA 101 (3). It includes:

a. Right to share in profits and unless otherwise agreed, partners share

profits equally. Losses follow profits.

b. Right to return of capital

A partner does not have the right to receive a distribution of the

capital contribution in his account before a partner’s withdrawal or
liquidation of the partnership.

c. Right to repayment of advances.

A partner who makes an advance beyond his agreed capital contribution is

entitled to reimbursement from the partnership. RUPA 401 (d).
(advance=loan) The partnership must indemnify the partner. RUPA 401 (c).
A loan from a partner is treated the same as a loan from a person who is not
A partner. RUPA 404 (f).

d. Right to compensation

No partner is entitled to payment for services performed for the partnership.

RUPA 401 (h). No partner is entitled to a salary.

2. Right to participate in management

Each partner has equal rights in management RUPA 401 (f)

a. Majority of the partners consent on ordinary decisions.

b. All of the partners are required to consent on extraordinary matters.

RUPA 401 (j) e.g. new partner, new business, relocation.

3. Right to choose associates (other partners)

A person may become a partner only with the consent of all of the partners.
RUPA 401(i)

4. Enforcement rights:

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 a. A partner has the right to information and to inspect the books. RUPA 403 (b)
A partnership must disclose to a partner, without demand, information regarding
partnership business. RUPA 403 (c) (1)

b. A partner may maintain a direct suit against a partner or partnership for legal or
equitable relief with or without an accounting. RUPA 405 (b)

I. Partner’s rights in specific partnership property.

A partner may use or possess partnership property only on behalf of the

partnership. RUPA 401 (g) NO TENANCY IN PARTNERSHIP. Partnership
property is owned by the partnership entity and not by the individual partners.

J. Partner’s interest in the partnership

1. It is all of a partner’s interests in the partnership including the partner’s transferable

interest and all management and other rights. RUPA 101 (9)

2. A partner’s transferable interest is a partner’s right to share profits and losses of the
partnership and to receive distributions. It is treated as personal property. RUPA
502

3. Transfer of a partner’s transferable interest (usually by assignment) is permissible

and does not cause a partner’s dissociation or the dissolution and winding up of the
firm. The transferee is not entitled to participate in management of the firm or to
have access to the firm’s books, etc. RUPA 503 (a) The transferee of the interest
has the right to receive distributions that the transferring partner would receive prior
to dissolution. RUPA 503 (b)

4. A partner’s transferable interest is subject to that partner’s creditors who may get
a charging order against it. RUPA 504 (a)

IV. Operation and Dissolution of General Partnerships

A. Contracts of a Partnership

Partners are jointly and severally liable for the contracts of a

partnership: all of the partners may be sued jointly in one action or in
separate actions, leading to separate judgments which may be maintained
against each of them. RUPA 306 (a)

A judgment creditor of the partnership must exhaust partnership assets

before enforcing against the separate assets of a partner. RUPA 307 (d)

1. Authority to bind the partnership

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 a. Actual express authority: This is written or oral in the partnership
contract or in additional contracts among the partners. RUPA 401 (j)
Items that are not binding on the partnership
are a guaranty, sale of partnership property
not in the normal course of business, payment of a partner’s debts
out of partnership assets.

b. Actual implied authority: This is reasonably deduced from the nature

of the partnership business, the partnership contract, and the relationship
of the partners. E.g. hire and fire employees,
purchase items for business, receive obligations due the partnership, bring
actions to enforce claims of the partnership.

c . Apparent authority: This is an act of a partner for apparently carrying

on the ordinary partnership business so long as a third party has no
notice of lack of actual authority. RUPA 301 (l) e.g. indorse checks,
warrant goods, enter into advertising contracts.

2. Partnership by estoppel

It imposes partnership duties and liabilities on a non partner who represents or

consents to a representation that he is a partner. RUPA 308 (a)

B. Torts and Crimes of a partnership

1. A partnership is liable for loss or injury that any partner causes by any act or
omission, or other actionable conduct, while acting within the ordinary course
of partnership business or with the authority of the partnership. RUPA 305 (a)
e.g. negligence, fraud, defamation, breach of fiduciary duty or breach of
trust.

2. If a partnership is liable, each partner has unlimited personal liability. RUPA 306.

3. A partner can be liable to a third party and must indemnify the partnership if a
a partner commits a tort or a breach of trust. RUPA 405 (a).

4. A partner is not liable for crimes of partners unless he authorized or participated in

them.

C. Liability of incoming partner

1. Antecedent debts: liability of incoming partner is limited to capital contribution.

2. Subsequent debts: liability of incoming partner is unlimited.

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V. Dissociation

A. General

1. Dissociation occurs when a partner ceases to be associated in the carrying on

of the business. E.g. “buyout”. (Dissolution is when a partnership winds up and
terminates.

2. A partner has the power to dissociate (rightfully or wrongfully) at any time by

expressing his right to withdraw. RUPA 602(a)

3. However, a partner does not always have the right to dissociate. In this instance
the partner is liable to the partnership for damages caused by dissociation.
RUPA 602 ©

B. Wrongful dissociations

1. Dissociation is wrongful if it is a breach of an express provision of the partnership

contract. RUPA 602 (b)(1)

2. Dissociation is wrongful in the case of a partnership for a particular term before

the expiration of the term if:

a. The partner withdraws by express will (unless the withdrawal follows within
90 days after another partner’s dissociation by death, bankruptcy or wrongful
dissociation. RUPA 601 (6) through (10)

b. Partner is expelled by judicial determination. RUPA 601 (5)

c. Partner becomes a debtor in bankruptcy.

d. Partner is an entity (not an individual, trust or estate) who is expelled or

otherwise dissociated because its dissolution or termination was
willful. RUPA 602 (b)(iv)

C. Rightful dissociations

All of the dissociations other than those in RUPA 602(b) above are rightful
including the following:

1. The death of a partner in any partnership.

2. The withdrawal of a partner in a partnership at will (no term).

RUPA 101 (h): partners have not agreed to remain partners until the expiration of
a definite term.

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 3. An event occurs that was agreed to in the partnership contract causing
dissociation. e.g. government agency ceases to exist.

4. Court determines that a partner cannot perform his duties under a partnership
contract.

D. Effect of dissociation RUPA 603 (b)

1. Partner’s right to participate in the management and conduct of the business

terminates.

2. The partner’s duties terminate.

3. A partner’s duty of loyalty and duty of care continues only to matters occurring
before the partner’s dissociation.

VI. Dissolution

A. Causes of dissolution

1. Acts of the partners: In a partnership at will, a partner’s giving notice of intent to

withdraw is a cause of dissolution. A partner can force a liquidation.
RUPA 801 (1)

2. Acts of the partners: In a term partnership, dissolution can occur as follows:

a. Term expires

b. All partners agree to terminate

c. A dissolution will occur within 90 days after a partner’s dissociation by death,

or incapacity, bankruptcy, or wrongful dissociation if at least half of the
remaining partners agree to windup the partnership business. RUPA 801 (2)

3. In all partnerships, dissolution occurs upon an event in the partnership contract but
partners may continue the business. RUPA 801 (3)

4. Dissolution by operation of law occurs if an event occurs making it unlawful to do

business. RUPA 801 (4)

5. Dissolution by court order occurs:

a. Economic purpose of the partnership is likely to be unreasonably frustrated.

e.g. market contracted for typewriters.

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 b. Another partner is conducting partnership business which makes it not
reasonably practical to carry on the business. E.g. post merger.

c. It is not practicable to carry on the partnership in conformity with the

partnership contract. E.g. anti-trust firm.

6. On application of a transferee of a partner’s transferable interest a court may

dissolve the partnership if it is equitable to wind up partnership business in a
partnership at will or after the partnership term has expired. RUPA 801 (6)

B. Effects of dissolution

1. A partnership continues after dissolution only to wind up its business.

A partnership is terminated when the winding up is completed. RUPA
802(a)

2. After the dissolution but before the winding up, all of the partners, including
a dissociated partner (but not a wrongfully dissociated) may waive the right to
have the partnership’s business wound up and the partnership terminated.
The partnership resumes. RUPA 801 (b)

3. Upon dissolution, actual authority of a partner to act for the partnership

terminates except to wind up. RUPA 804 (1)

4. Upon dissolution, a partnership is bound by a partner’s act after dissolution

that would have bound the partnership before dissolution if the other party did
not have notice of the dissolution. RUPA 804 (2)

5. Partner’s liability: after dissolution a partner is liable to the other partners for
the partner’s share, if any, of partnership liability. RUPA 806 (a)

C. Winding Up

1. This is liquidation and includes completing business, collecting debts, auditing,

paying creditors and distributing the excess to the partners.

2. Partnership assets must first be applied to partners who are creditors and other
creditors. The surplus is applied to a liquidating distribution equal to the
partners’ rights to distribution. RUPA 807 (a)

3. Each partner is entitled to settlement of accounts. Profits and losses must be

charged, then a final liquidating distribution. A partner with a negative account
balance must contribute to the partnership the excess of charges over credits.
If a partner fails to contribute then all partners contribute in the proportion in
which they share partnership losses. The estate of a deceased partner is liable
for that partner’s obligation to contribute to the partnership. RUPA 807.

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VII. Dissociation without dissolution

This may result in a buy out of a partner’s interest, not in a wind up.

A. Non-dissolving dissociations

1. Partnership at will: A partner will be dissociated without dissolution on a

partner’s death, bankruptcy, incapacity, expulsion. RUPA 601 & 801

2. Term partnership: A partnership will not dissolve if within 90 days after certain
causes of dissolution, less than half the partners express their will to wind up
partnership business (causes are death, bankruptcy, incapacity and partner’s
wrongful dissociation) RUPA 801

3. By agreement, partners may eliminate grounds for dissolution except if the

business was illegal, a court orders dissolution on application of a partner or
a court orders dissolution on application of a transferee of a partners’s
interest. RUPA 103

B. Continuation after dissocation

1. If a partner is dissociated without dissolution the partners have the right to

continue the business and creditors of the partnership remain creditors of the
partnership. The dissociated partner remains liable for obligation
incurred before he became dissociated. RUPA 703 (a)

2. A partnership must purchase a dissociated partner’s interest in the partnership

pursuant to RUPA 701. A partnership must indemnify a dissociated partner
against all partnership liabilities.

C. Dissociated partner’s power to bind the partnership.

1. A dissociated partner has no actual authority to bind the partnership.

RUPA 603 (b)(1)

2. A dissociated partner’s apparent authority continues for 2 years unless notice

of dissociation is given to third parties. RUPA 702

D. Dissociated partner’s liability to third parties.

1. A partner’s dissociation does not discharge a partner’s liability for the partner’s
obligations incurred before dissociation. RUPA 703 (a)

2. A dissociated partner is not liable for partnership obligations incurred more than 2
years after dissociation. RUPA 703 (b)

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VIII. Limited Partnerships and Limited Liability Companies

A. Limited Partnerships

1. It is formed by 2 or more persons with at least one general partner and one limited
partner. The state must have a limited partnership statute. LP101.

2. It is formed by filing a certificate with the Secretary of State in the state of its
Principal office. LP201

3. The name cannot be deceptively similar to the name of any corporation or limited
partnership. The name must say “limited partnership”. LP102

4. General partners have exclusive control. He has a fiduciary duty to general and
limited partners.

5. Limited partner liability is limited to their contribution (cash, property, services

rendered, etc.)

6. It can be dissolved by expiration of the time period, withdrawal of a general

partner or judicial dissolution. The limited partner does not have the power or
the right to dissolve the partnership.

B. Limited Liability Companies

1. It is a noncorporate business organization that provides limited liability to all of

Its members and permits them to participate in its management.

2. Formation

a. Articles of organization must be filed at a designated state office. Most LLCs

are perpetual and require annual reports.

b. The name contains the words “limited liability company” or “llc”.

c. Members must make a contribution of cash, property, services rendered.

promissory note, etc.

d. The operating agreement governs the affairs of the company and states the
rights and duties of the managers.

3. Rights of members

a. A member’s interest is personal property which consists of the financial

interest (right to distribution) and management interest (right to manage,

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 vote, obtain information and bring an enforcement action.

b. Profit and loss sharing is set forth in the operating agreement. If not stated
in the operating agreement, then the profits and losses are allocated on
the basis of members’ contributions. 405

c. Method of distributions is in accordance with the operating agreement.

If there is no operating agreement, then on the basis of members’ contributions.

d. Members are allowed to withdraw from the LLC and demand payment of their
interest on proper notice.

e. Management: Usually each member has equal rights in the management.

LLCs may also have managers who are non-members. If the LLC is member
managed then the members have actual and apparent authority to bind the LLC.
If the LLC is manager managed, the limited liability members have no actual
or apparent authority to bind the Limited Liability Company.

f. Voting rights are in the LLC statute or as modified in the operating agreement.

g. Derivative actions allow a member to bring an action on behalf of an LLC if the

managers or members have refused to bring an action.

h. As a general rule, a member is allowed to assign her financial interest in the LLC
and the assignee receives the member’s share of the distributions. (A judgment
creditor may get a charging order against the member’s interest. Assignment
does not dissolve the LLC.) The assignee may become a member of the LLC
under some circumstances.

4. Duties

a. In a manager-managed LLC, the managers have a duty of care of a prudent

person.

b. In a member-managed LLC, the members have the same duties of care and
loyalty as a manager-managed LLC.

5. Liabilities

No member or manager of an LLC shall be obligated personally for any debt,

obligation or liability of the LLC solely by being a member or acting as a
manager of the LLC. However, the limitation does not affect the liability of a
member or manager who committed the wrongful act.

6. Dissolution

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 a. LLC automically dissolves:

1) expiration of the term of the LLC or as set forth in the articles.

2) written consent of all members.
3) decree of judicial dissolution.

b. Dissociation

This means that the member has ceased to be associated with the firm by
death, voluntary withdrawal, incompetence, bankruptcy or expulsion.
Most states allow the LLC to continue.

c. Distribution of assets rules

1) Creditors
2) Members and former members for unpaid distributions
3) Members for contributions
4) Members for LLC interest

IX. Intro to corporations

A. Nature of a corporation: it is a legal entity, an artificial person owned by

shareholders. It has unlimited liability for corporate obligations. It enters into
contracts and can sue and be sued. The shareholders have limited liability.

B. Types of corporations:

1. Public: e.g. municipal: CTA, Chicago Board of Ed., Ill. ollway Authority

2. Private: IBM, Boeing: Private and publicly held

3. Non-profit: American Cancer Society, Ford Foundation

4. Closely held: owned by one or more small groups of shareholders. Shareholders

are officers and/or directors

5. Publicly held: stock on exchanges: IBM, Boeing: publicly held and private

6. Professional: doctors, lawyers and accountants

C. History

Can only incorporate through states. State of Delaware is the most liberal. Many

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 states follow the Model Business Corporation Act.

D. Characteristics

Limited liability of shareholders, centralized management, free transfer of stock,

issue securities to raise capital

E. Preincorporation

1. Promoter: arranges capital, obtains property, obtains subscriptions for stock, etc.
He is personally liable on contracts until adopted by the corporation. The
promoter’s fiduciary duty includes good faith, fair dealing and full disclosure.

2. Articles of Incorporation

One or more persons called an incorporator file the articles of incorporation.

A certificate of incorporation is issued. It is filed with the Recorder of Deeds
where the corporation does business. Contents:

a. Corporate name. It cannot be similar to another corporate name. It must

have the word corporation, company, incorporated, inc., co., corp. after
its name.

b. Duration. Usually perpetual.

c. Corporate purpose: Can be any lawful purpose

d. Registered agent and address

e. Number of shares authorized and value

f. Number of shares to be issued

g. Signatures, names and addressess of incorporators

F. Organization meetings.

1. After the certificate of incorporation is issued by secretary of state,

2. The shareholders have an organization meeting to elect the directors and adopt the
by-laws. (rules of internal management)
3. The directors then have a meeting to elect and appoint the officers.
4. The stock certificates are then issued and signed by the officers.

G. Corporate statutory powers:

Sue and be sued, hold meetings, mortgage, buy and sell real and personal property.

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H.Ultra-vires acts: e.g. illegal political campaign contributions.

1. These are outside the scope of the corporate powers. Under the
MBCA, the corporation’s power to act may be challenged by a shareholder
against the corporation, in a proceeding by the corporation and in a proceeding
by the attorney general of the state of incorporation or doing business.

2. A corporation may not us ultra vires as a defense to avoid liability. The officers
and directors may be personally liable.

I. Admission of a foreign corporation

A corporation doing business in the state needs a certificate of authority. It also

needs a registered agent and office.

J. Defective corporations

1. A de jure corporation complies with the statute.

2. A de facto corporation has a technical defect. If there is a corporation statute, a

good faith effort to comply and the corporation conducts business as a corporation,
then third party creditors cannot impose personal liability on the shareholders.
e.g. failure to file a charter with the Recorder of Deeds.

K. Piercing the corporate veil

In certain circumstances, it is unjust for shareholders to hide behind the corporate veil,
so liability will be imposed on the shareholders:

1. Insufficient capital

2. Excessive fragmentation

3. Failure to observe corporate formalities e.g. annual meetings

4. Failure to separate corporate and shareholder affairs

5. Fraud: siphon funds

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X. Management of the corporation: Shareholders

A. Meetings

1. They vote for directors and on extraordinary matters. E.g. amendment of

the articles of incorporation to increase authorized shares.

2. They vote at annual meetings at a date stated in the by-laws.

3. There must be a quorum of shares at meetings to do business. A quorum is a

Majority of shares entitled to vote, but not less than l/3.

4. The shareholders can take action without a meeting if a written consent

is signed by all of the shareholders.

5. The record date is the date that shareholders are entitled to vote.

B. Voting

1. Each shareholder is entitled to one vote per share. Treasury shares and
redeemable shares are not eligible to vote.

2. Straight voting: each shareholder is entitled to one vote per share.

3. Cumulative voting: the number of votes is equal to the number of shares

multiplied by the number of directors.

4. Proxies: These are grants by shareholders to allow another to vote his

share. Good for 11 months.

5. Voting trust: A group of shareholders transfers legal title to their shares to

a trustee in exchange for voting trust certificates. The trust must be in
writing. The trustee votes the shares. Cannot have a term longer than
10 years.

6. Voting agreement: Two or more shareholders agree to vote. Need not be in

writing.

C. Shareholder right to information

1. Each corporation is required to keep records of minutes of shareholders

meetings and minutes of directors meetings as well as accounting records.

2. Shareholders may examine the corporate books only for a proper purpose
and on written demand.

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D. Shareholders’ pre-emptive rights.

A shareholder has the right to purchase new issues of shares proportionate to

his present interest in the company only if the pre-emptive right is in the articles of
incorporation.

XI. Management of the corporation: directors

A. Management of the corporation

1. They make policy decisions, supervise the corporate officers, determine

executive compensation, declare dividends, make financing decisions,
resolutions such as merger, signing authority, etc.

2. The initial board serves to the first annual meeting. A permanent board is
elected at each annual meeting thereafter.

3. In Illinois a corporation can have one or more directors. If a board has 6 or

more directors, then there can be two or three classes of directors and
their terms may be staggered.

4. Director vacancies by death or resignation are usually filled by the board. The
director elected to fill the vacancy serves until the next annual shareholders
meeting.

5. A director can be removed with or without cause by a majority of the

outstanding shares.

B. Formalities

1. By laws indicate the time for notice of directors’ and shareholders’ meetings.

2. A majority of the board equals a quorum

(By-laws may allow for a quorum of l/3)

3. The board can act by a conference call

4. The board can act without a meeting if written consent by all of the directors.

C. If a director dissents, he may have it entered into the minutes of a meeting or

give written notice of the dissent. It may eliminate or reduce the director’s
potential personal liability. Remember: board votes as a board.

21
D. Committees: The board can delegate certain functions.

Executive, audit, nominating, finance: but the committees cannot authorize

distributions, fill vacancies on the board or amend the by-laws.

XII. Management of the corporation - officers

A. Functions: day to day affairs: President, VP, Sec., Treas.

B. Authority comes from agency law:

1. Express: state corp statute, art. Incorp., by-laws, corp. resolution

2. Implied: may be quite limited. E.g. 3P may require board resolution,

entertainment

3. Apparent: ratify e.g. signing officer exceeds K signing authority

XIII. Duties of management

A. Duty of Care for officers and directors

1. Standard: how an ordinary prudent person under like circumstances would act.

2. BUSINESS JUDGMENT RULE: No liability for honest mistakes on

unbiased transactions for which the director has exercised reasonable care.
Smith v. Van Gorkum 488 A. 2d 858 (1985) p. 672

B. Loyalty and good faith

1. Conflict of interest: The burden of proof is on the director or officer

to remove the conflict of interest

2. Corporate opportunity doctrine: Cannot usurp or prevent an opportunity

that is closely related to the business.

XIV. Corporate financial structure

A security is a share, participation, or other interest in the property of the issuing

corporation. Equity creates ownership. Debt creates obligations.

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A. Equity securities - types

1. Shares: right to distributions, vote and proportionate share on liquidation

a. Preferred: These are usually nonvoting. They are created in the articles
of incorporation. They have superior rights over other classes in dividends
and liquidation. (cumulative/noncumulative)

b. Common: are entitled to dividends after shares with a dividend preference

are paid. If a corporation has one class of shares they are common.

c. Redeemable: they can be reacquired by the corporation

d. Convertible: they are changed to another class of shares at a predetermined

ratio.

2. Options: This is the right to purchase shares at a stated price for a period of
time. E.g. officers of a corporation

3. Issuance of shares: The corporation can issue the number of authorized shares
set forth in the articles of incorporation. They can be par or no par.

a. Consideration: cannot sell for less than the par value.

b. The par value is credited to stated capital. The difference in par value and the
sale price is credited to capital surplus. No par stock is credited all to stated
capital but the board of directors can allocate a portion to capital surplus.

4. Payment for shares

a. Stock subscription: It is irrevocable for 6 months and acceptance is upon

filing the articles of incorporation with the secretary of state. It is an
offer by a subscriber to purchase and pay for a specified number of unissued
shares of a corporation. A certificate is issued when the subscriber
has fully paid for the shares.

b. Consideration for stock is money, property, services actually performed,

services to be performed and promissory notes.

c. Watered shares: If par value shares are issued for less than full consideration
then they are watered shares. This can injure creditors. The debtor/
shareholder is liable to the corporation and creditors. If the shares are
sold to a good faith purchaser by the debtor/shareholder, then the good faith
purchaser incurs no liability to the corporation or its creditors.

B. Debt securities

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 They are issued for loans to a corporation. They are:

1. Debenture: unsecured, like a general creditor

2. Bond: secured on corporate property

3. Both are issued under an indenture, which is a trust agreement between the
corporation and a trustee

C. Ownership and transfer of securities: Certificates specify the person and are on the
corporate books. Debt securities are freely transferable. Equity securities may
have restrictions and a stock transfer agent. If securities are lost or destroyed then
a bond must be posted and affidavits of ownership completed prior to a new issue.

D. Dividends: These are paid out of current and past earnings. They may be paid in
cash, stock, scrip or property. (Scrip is a portion of a share of stock.)

1. Cumulative: includes prior years when dividends not paid

2. Noncumulative: does not include dividends in prior years when a dividend was not
paid.

3. Participating: shares dividends with other classes.

4. Dividends cannot be paid if the corporation is insolvent or the dividend will render
the corporation insolvent.

XV. Special Topics

Extraordinary corporate matters are amendment of the articles of incorporation,

merger and consolidation, sale of all of the corporate assets and voluntary dis-
solution.

A. Method

1. Board of Directors adopts a resolution

2. Written notice to shareholders of the resolution and shareholder vote is sent by the
Board of Directors.

3. Shareholder vote: Illinois requires 2/3 of the shares issued to pass the unless the
Articles of incorporation allow more or less but not less than a majority of the
shares.

4. Documents are filed with the secretary of state (except for sale of assets).

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B. Amendment of Articles of Incorporation.

The corporation has the power to amend the articles of incorporation. This usually
involves the capital structure such as stock.

C. Merger and consolidation

In a merger two or more corporations merge and one is the surviving corporation and
the other corporation dissolves. In a consolidation, two or more corporations merge
into a new corporation and the old corporations dissolve. If a parent owns 90%
of a subsidiary’s stock they may merge if they are solvent without shareholder
approval. Shareholders must be notified.

D. Sale of assets

If one corporation sells its assets outside the ordinary

course of business, it is an extraordinary transaction and shareholder approval
of the selling corporation is necessary.

E. Dissolution and Liquidation

1. Voluntary dissolution is an extraordinary corporate matter.

Assets are liquidated and distributed. Creditors must receive actual and
constructive notice.

2. Involuntary

a. Judicial: Attorney General dissolves the corporation for not filing annual
Report, not paying franchise tax, abuse of authority, failure to keep an agent.

b. Shareholders: If there are deadlocked directors and shareholders cannot break

it and there is irreparable injury to corporation; or directors are fraudulent;
or assets are wasted.

c. Creditor: Can dissolve if he has a judgment, it is unsatisfied and the

corporation is insolvent or the corporation admits the debt and is insolvent.

25
F. Appraisal remedies

These are available to shareholders who dissent from actions requiring shareholder
approval.

1. Notice of the shareholder meeting must state that the shareholder has
the right to dissent.

2. Before the vote, the shareholder must file a written notice of

intent to demand fair compensation for shares.

3. The corporation then offers the shareholder what the corp. deems fair value.

4. The shareholder than files an estimate of fair value.

5. If it goes to court, the court determines fair value.

G. Corporate litigation

1. In a shareholder derivative suit the shareholder brings suit in the corporate name.
The judgment is paid to the corporation, not the shareholder. The shareholder
must exhaust intracorporate remedies, show contemporaneous share ownership
at the time the injury occurred and post a bond. E.g. political campaign
contribution.

2. In a shareholder direct suit, recovery goes to the individual. E.g. fraudulent

Financial statements.

XVI. Securities Regulation - 1933 Act

A security is a contract, transaction or scheme whereby a person invests his money

in
a common enterprise and is led to expect profits solely from the efforts of a
promoter
or a third party (Howey test)

The 1933 Act governs the public distribution of securities. It prohibits the offer or
sale of securities to the public unless the offering is properly registered.

A. Persons covered are underwriters, dealers and issuers.

1. Underwriter purchases securities from an issuer with the intent to distribute

to dealers and/or the general public. E.g. UBS

2. Dealer sells or trades securities. E.g. Charles Schwab

26
 3. Issuer is an entity whose securities are being sold. E.g. IBM

B. Section 5 of the 1933 Securities Act

It governs sales through interstate commerce. A registration statement must be

filed with the SEC and a prospectus prepared. Periods are:

1. Pre-filing: It is unlawful for issuers, underwriters or dealers to sell securities.

2. Filing: The registration statement is effective 20 days after filing with SEC.
Securities cannot be sold during the waiting period but offers such as
“tombstone” ads are allowed. They include the name of the company, kind
of security, price, who executes purchase orders, and location to obtain
a prospectus.

3. Post-effective period: sales can be commenced.

C. Contents of Registration statement S-l: signed by issuer, ceo, cfo, chief accounting
Officer, and a majority of the board of directors.

It must have the following material information:

1. Balance sheet

2. Profit and loss statement

3. Certification by independent accountants

4. Facts affecting price of securities. E.g. foreign exchange rate

5. Facts affecting a higher risk. E.g. Alzheimer drug

6. Status of issuer. E.g. pending litigation and claims

7. Management of issuer, including compensation to senior executives

D. Exemption from registration

1. Regulation A

This is not a complete exemption. An issuer may not exceed sales of

$5,000,000 in a 12 month period. The SEC is notified by the filing of an
offering statement which includes a notification and an offering circular.
Investors receive an offering circular similar to a prospectus.

a. Not applicable to 1934 Act issuers

27
b. No restrictions on number or qualification of investors
c. Securities be freely resold

28
2. Regulation D: Exempt transactions (see Sec. 4(2) of 1933 Securities Act)

a. Four requirements: Subject to exceptions under Rules

l) Shares cannot be immediately reoffered to the public (except under

Rule 504). Shares may be resold only by registration or in a
Transaction exempt from registration.

2) Solicitation and general advertising are not allowed. (See 504)

3) Purchasers of securities must be furnished an audited balance sheet

(unless the purchaser is an accredited investor or the transaction
Is under Rule 504)

4) SEC must be notified within 15 days of sale of the securities

b. Rule 504

1) Offering cannot exceed $1 million in a 12 month period.

2) Unlimited number of investors or unlimited type of

Investors.

3) Not applicable to issuers required to report under the

1934 Securities Act

4) General solicitation is allowed under certain limits.

c. Rule 505

1) Offering cannot exceed $5 million within a 12 month period.

2) No more than 35 unaccredited investors.

3) Unlimited accredited investors.

4) Information to unaccredited investors.

Accredited investors are individual investors, a bank, or a corporation with

More than $5,000,000 in asset; a natural person with a net worth which
exceeds $1,000,000, and any person whose income exceeded $200,000
in each of the preceding two years and who reasonably expects to earn
an income in excess of $ 200,000 in the current year.

29
 d. Rule 506

1) Unlimited dollar amount offering

2) No more than 35 sophisticated investors.

3) No unaccredited investors.

4) Unlimited accredited investors

Sophisticated investors are those that the issuer reasonably believes that as
Unaccredited investors they have sufficient knowledge and experience in
Financial matters to be capable of evaluating the risks of the investment or
Be represented by a person who is sophisticated.

3. Intrastate

3 (a)(11) exemption applies if securities are offered and sold only to persons
who are residents of issuer’s state. (see Rule 147 on safe harbor).

4. Section 4 (b) of 1933 Securities Act: $ 5 million/accredited investors

E. Liabilities

1. Section 11: Civil liability may be imposed for untrue statements of a material
fact or omission of a material fact, EVEN IF INNOCENT.

a. The remedy for an injured party is a civil suit against signers of the
registration statement including issuers, directors, accountants,
underwriters and attorneys.

b. The injured plaintiff needs to prove a material misstatement of fact or

omission of a material fact and damages.

c. Material: failure to disclose information which makes statements in the

registration statement misleading.

d. Buyer can rescind or get damages.

e. Due diligence is a defense to all but issuer who has strict liability. Due
diligence: Defendant has reasonable grounds to believe and did believe
that there were no untrue statements or material omissions.

2. Section 12 (a)(1) Purchaser can rescind and re-cover for any sale made in

30
 violation of Section 5 of the 1933 SEC Act(which governs sales of
securities through interstate commerce) e.g. issued a security that was
required to be registered and was not.

3. Section 12 (a)(2) (anti-fraud provision) Fraud recovery is allowed, e.g. false

statement in an oral or written offer. This imposes liability on seller to
immediate purchaser.

4. Section 17(a) (anti-fraud provision) Broad prohibition against fraud.

5. Section 24 of 1933 Security Act: Criminal recovery of $10,000 fine/5 years

Against one who willfully violates 1933 Securities Act.

XVII. Securities Regulations 1934 Act

The 1934 Act regulates securities markets, exchanges, dealers, l0K annual reports,
10Q quarterly reports, 8K current reports. It governs companies whose securities
are traded on a national exchange. It also governs companies that have assets of more
than $10,000,000 and 500 or more shareholders.

A. Section 10 (b) (5) Anti-fraud provision (applies to all securities)

This requires misrepresentation of a material fact, reliance, purchase or sale of

security, scienter, causation of injury and damages. Remedy is
actual damages or rescission. This deals with fraud and insider trading.
REMEMBER FRAUD IS NOT NEEDED FOR LIABILITY UNDER SECTION 11
OF THE 1933 SEC Act.

1. An insider is a person who has information not known to traders or investors.

He has access to information. E.g. Directors, officers, 10% or more share-
holders, tippers, tippees (know insider breached fiduciary duty by disclosing
insider information), brokers, corporate employees, attorneys,
accountants and underwriters

2. Material means a substantial likelihood that a reasonable investor would

consider the information important in making an investment decision. E.g.
substantial changes in dividends or earnings, misstatement of asset value,
acquisitions, etc.

3. Insider information is information disclosed to people working for the

Corporation but not to the general public.

4. If a defendant negligently made a false statement, he may be liable under

Section 11 of the 1933 SEC Act but not under Section 10 b 5 of the
1934 SEC Act because he had no intent to deceive.

31
 5. Plaintiff can get actual damages or rescission The SEC/US Attorney
May impose fines, criminal penalties and injunctions.

B. Section 13 (d) tender offers

This comes into play with the purchase of 5% or more of a company’s security.
The purchaser must file with the SEC a statement of purpose, source of funds,
number of shares, etc.

C. Section 16 (b) short swing profits

This applies to a 10% shareholder, director or officer who buys and sells stocks
within a 6 month period and makes a profit. Profits are calculated by subtracting the
lowest buy price from the highest sale price. Liability is absolute. Highest sale
price is matched against the lowest buy price. Profit goes to the corporation.

D. Foreign Corrupt Practices Act

It imposes internal control requirements on companies with securities

Registered under the 1934 SEC Act.

E. Section 18: civil liability for false statement in any report, etc., unless
One acted in good faith.

F. Section 32: criminal liability under SOX: $5 million or imprisonment of

Not more than 20 years or both.

XVIII. Miscellaneous Security Regulation

A. 1933 Act - Exempt securities

1. Bank, savings & loans

2. Charitable and Not for profit

3. Securities issued by federally regulated common carriers

4. U.S., state and local government securities

5. Short term commercial paper (9 months or less)

6. Insurance policies

B. 1934 Act - Exempt securities

32
 1. Investment Companies

2. Savings and loans

3. Charitable organizations

XIX. Bankruptcy - Chapter 7

This is a federal law and the statutes were enacted pursuant to Article 1, Section 8,
clause 4 of the Constitution.

Chapter 7 is a straight bankruptcy and calls for liquidation. Chapters 11 and 13 are
reorganizations by which the debtor pays out of future earnings.

A. Commencement of the case

1. Voluntary: The debtor files a petition with the bankruptcy court. There is an
automatic order for relief. This can be done by corporations, partnerships and
individuals.

2. Involuntary: This can be done if the claims of petitioning creditors are worth at
least $11,625 and three of the 12 creditors join in the petition. If there are less
than 12 creditors, then only one creditor may file if his claim equals $ 11,625.

B. Automatic stay:

It prevents the further efforts of the creditors to collect debts, e.g. lawsuit,
creditor collectors. It continues until the order of discharge.

C. Trustee

He investigates, amasses the property, invalidates certain transfers and distributes

the money. An interim trustee is appointed after the order for relief is entered.
A trustee serves at the creditors meeting where the debtor and creditors appear.

The bankruptcy petition does not stop executory contracts and leases. The trustee
can assume them or reject them. The debtor must appear, furnish a list of creditors,
cooperate and surrender the property.

D. Estate

This consists of all property of the debtor. However, post-petition property is

subject to claims:

33
 1. Within 180 days after filing: Property that is inherited, or as the result of a divorce
property settlement with a spouse or the proceeds of a life insurance policy.

2. Rents and profits received from the property of the estate.

3. Property acquired by the estate.

4. Property recovered by the trustee under the powers of avoidance.

E. Exempt property

1. $15,000 on equity of a residence

2. $ 2,400 on an automobile

3. $ 4,000 for home furnishings, apparel and jewelry

4. Health aids

5. Social security, unemployment, veterans benefits and disability benefits

6. Alimony and child support

7. Pension, profit sharing and annuity payments

F. Trustee’s Avoidance Powers

The bankruptcy trustee becomes a lien creditor. He asserts the position of the
unsecured creditor.

G. Voidable Preferences

A preference occurs when one creditor is favored over other creditors. However,,
the trustee can recover from the favored creditor if the following occur:

1. The transfer is for the benefit of a creditor; and

2. The transfer is for an antecedent debt; and

3. The debtor was insolvent at the time the transfer was made. (Insolvency is
Presumed if the transfer is made within 90 days prior to filing, or in the case
Of an insider, the transfer was made within l year of filing.) and

4. The creditor received more than he would receive under the bankruptcy rules.

34
 Preferences are not fraud. Trustee does not reduce the net worth of the estate but
the assets and the liabilities are reduced equally. (Insider is relative, partner, or a
corporation where the debtor is an officer or a director.)

H. Fraudulent conveyances

1. Trustee can avoid conveyances which were made up to one year before the filing;
and

2. The intent of the debtor was to hinder, delay or defraud past or future creditors;
And

3. Trustee can avoid those conveyances in which the debtor received less than full
Consideration.

I. Distribution of the estate

The creditors must file a proof of claim within 90 days of the date set for the
creditors meeting. It is prima facie evidence and allowed unless other creditors
object. Priorities:

l. Secured creditors

2. Unsecured creditors are paid according to their class. Each class must be paid
in full before the next class is paid in full.

a. Administration expenses

b. Gap creditors (after commencement of case but before appt of trustee or

order for relief)

c. Up to $ 10,950 in wages within 180 days before filing

d. Claims to employee benefit plans up to $10,950 per employee within l80

days before filing.

e. Up to $ 5,450 by grain or fish producers against a storage facility.

f. Up to $ 2,425 for consumer deposits, e.g. purchase of furniture

g. Specified taxes, e.g. income, property, employment and excise

J. Discharge

This absolves from any further liability on debts. It voids any judgment EXCEPT:

35
1. Certain taxes and custom duties

2. Liability for obtaining money under false pretenses

3. Liability for willful injuries to person or property

4. Debts not scheduled

5. Alimony and child support

6. Debts created by fraud

7. Student loans unless the debt would impose “undue hardship”

8. Debts which the debtor was denied in a previous bankruptcy

9. Consumer debt in excess of $550 for luxury goods

10. Cash advances to the debtor of more than $ 825 within 70 days of order for relief

11. Liability for a court judgment for driving a motor vehicle while legally
intoxicated.

12. Fines and penalties

13. Condo and co-op fees after order for relief

14. Restitution for federal crimes

36
K. Order of Discharge will not be granted:

1. The debtor is not an individual (no discharge under Ch. 7 for corps or partnerships)

2. The debtor has destroyed or falsified records

3. False oath by the debtor

4. Debtor has transferred property to defraud creditors5

5. The debtor has been granted a discharge in bankruptcy under Ch. 7, 11 or 13

within six years of filing the next bankruptcy.

6. Debtor has refused to obey court order.

7. Debtor failed to explain losses

8. Debtor executed a written waiver of discharge

L. Reaffirmation of debts

1. Agreement must be signed and filed before discharge

2. Debtor has right to rescind within 60 days after filing.

XX. Bankruptcy - Chapter 11

A. This is usually filed by a corporation. It can be converted to a Chapter 7. It can

be commenced voluntarily or involuntarily.

1. Commencement of the case:

a. Debtor remains in possession of property (DIP) and continues to manage and

operate the business. A trustee need not be appointed but the court may appoint
a trustee for cause including fraud, etc.

b. Debtor must file a list of creditors, a schedule of assets and liabilities and a
statement of affairs.

c. A creditors committee is appointed by a court. They are normally the 7 largest

creditors. The committee investigates, etc.

37
2. Formulation of the plan of reorganization

A debtor files the plan within 120 days of order for relief. The plan is divided into
classes.

3. Adequate protection

For secured creditors, the automatic stay prevents seizure of the collateral.
However, the trustee can use, sell or lease property subject to a security interest.
Adequate protection must be given to creditors. If not, the automatic stay can
be lifted.

4. Confirmation of plan

a. In each class, it must be accepted by 2/3 of the dollar amount of claims and more
than 1/2 of allowed creditors. Then there is a hearing. The court will approve
the plan unless it is discriminatory.

b. Cramdown: A plan is approved over the objection of one or more classes of

creditors. This is usually allowed when the objecting class will be paid in full.

5. Implementation of plan

It binds the debtor. All are bound.

XXI. Bankruptcy - Chapter 13

A. This is adjustment of debts of an individual with regular income, including sole

proprietors. Filed by debtor only.

B. Debtor must have unsecured debts less than $ 336,900 and fixed secured debts
of less than $ 1,010,650. This can be commenced only by the debtor.

C. Debtor retains property but the trustee is appointed to oversee the plan.

D. The estate includes property and earnings before and after the case is commenced.

E. Formulation of plan: filed by debtor

1. It provides for submission to the trustee of a portion of the debtor’s income

necessary for implementation of the plan

2. It must provide for full payment to those entitled to priority.

3. It must provide identical treatment of all claims in a particular class.

38
F. Confirmation: only the court must approve. It must have:

1. Terms required under the Bankruptcy Code

2. Filing fee paid

3. Good faith

4. Unsecured creditors receive what they would under Chapter 7

5. Secured creditors are protected

6. Debtor can make all required payments

G. If a creditor or trustee objects to the plan, the court does not have to approve
the plan unless:

1. Amount distributed pays the objecting creditors in full and

2. Plan provides that a portion of the debtor’s disposable income

is to be used for 5 years to make payments under the plan.

H. Miscellaneous

1. The debtor pays the trustee and then the trustee pays the creditors.

2. A debtor is discharged of all debts. Debtor can retain collateral.

XXII. Bankruptcy updates

XXIII. Suretyship

A. Definition

It is the relationship between the principal (for whose debt the surety is liable),
the creditor (to whom the principal and surety owe their duties) and the surety
(who is liable on the debt of the principal).

1. Creation: It is usually at the request of the Principal, i.e., express contract.

A surety relationship by operation of law is an assignment, the surety is the
assignor
And the principal is the assignee.

39
2. Compensated surety: He engages in the business of executing surety contracts
for a compensation known as a premium. E.g. probate estate bond with
Trans Am (fidelity bond against embezzlement), performance bond on a
building contract.

To discharge a compensated surety, the creditor must vary the surety’s risk
(building material from brick to wood) and that risk must result in injury to the
Surety.

3. Uncompensated surety: There is no payment made to the surety. E.g. a father

signs an auto loan for his son. If the creditor varies the risk (cancels insurance)
then the uncompensated surety father is discharged.

4. A surety is a primary promise as distinguished from a guarantor. A guarantor is

liable to creditors if the debtor does not perform his duties, i.e. the debtor defaults.

5. A guarantor of collection is liable only after the creditor has exhausted all legal
remedies e.g. default debt of principal is reduced to judgment.

B. Surety contract

1. If the surety is compensated, the contract is strictly construed against the surety.

2. The consideration for the surety’s promise is the creditor’s extension of credit
to the principal.

3. Surety contracts must be in writing under the Statute of Frauds.

C. Surety’s rights

1. Against the principal

a. Reimbursement: This is the right of the surety to be paid by the principal after
payment on the obligation.

b. Exoneration: This is the surety’s right to compel the principal to perform and
pay the creditor.

c. Subrogation: This is the equitable assignment of a creditor’s rights to the surety

after the obligation to the creditor is satisfied. The surety can succeed to the
rights of the creditor, including enforcement of security and priority in the
bankruptcy of the creditor.

40
 2. Against the creditor

a. Surety can compel the creditor’s collection from the Principal if the surety
believes the principal is likely to become insolvent or a right of action has
accrued on the contract.

b. Surety can compel the creditor to apply security held if the surety’s right to
reimbursement against the principal is worthless and enforcing the security
will not result in unreasonable expense or delay.

c. Surety cannot compel creditor to apply payments from principal to principal-

surety obligation unless directed by the principal.

D. Defenses of surety against the creditor

1. Forgery of principal or surety’s signature

2. Fraud of creditor on surety

3. Duress on principal that surety did not know about

4. Principal’s obligation was illegal

5. Non-performance by creditor.

E. Not defenses of a surety

1. Bankruptcy of the principal

2. Fraud, misrepresentation, duress of principal on the surety

3. Incapacity of the principal

F. Alterations of a surety’s risk

1. Surety is not liable if the creditor does not exercise reasonable diligence and
the security is lost.

2. Release of security discharges the surety’s performance.

3. If creditor refuses payment, the surety is discharged.

41
G. Co-surety

If there is more than one surety on a single obligation, they are jointly and severally
Liable. The surety has the following rights against the co-sureties:

1. Exoneration

2. Subrogation

3. Contribution from his co-sureties on their share of payment. It can be determined

by contract; if there is no contract, then the solvent sureties are obligated for
Equal amounts

XXIV. Bailments, Documents of Title, Common carriers and Letters of Credit

A. Bailments

A bailment is the transfer of possession of personal property by a bailor to a bailee

without the transfer of title. There are two requirements: Physical control by the
bailee ( e.g. valet parking ) and must have intent to have control. (scarf in a fur coat).

1. Liability: A benefits test is used to determine whether a bailee exercised ordinary

care. The burden of proof is on the bailor to show that the bailee failed to exercise
ordinary care.

a. Bailor’s benefit: the bailee is liable for gross negligence, e.g. bailor’s car
tuned up by bailee neighbor.

b. Bailee’s benefit: the bailee is liable for slight negligence, e.g. bailor loans
his lawn mower to bailee neighbor.

c. Mutual benefit: the bailee is liable for lack of ordinary care, e.g. bailor’s clothes
at the bailee dry cleaners.

2. Misdelivery: Bailee is liable even if misdelivery in good faith, e.g. fur storage gives
My coat to someone else.

3. Absolute liability of the bailee: This is use contrary to the terms of the bailment.

a. Sale or Misdelivery

b. Use as collateral for a loan

c. Use not authorized, e. g. auto mechanic using your car for a vacation

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B. Innkeeper Liability

Under common law the innkeeper was an insurer of a guest’s safety and
A guest’s goods. States now have statutory limits on an innkeeper’s
liability for a guest’s goods. However, The innkeeper is still liable for a guest’s
safety.

C. Documents of Title

These are documents possessed by one in the business entitled to receive goods.

1. Bill of lading

This is the document evidencing receipt of goods for shipment by a shipper.

A consignor is the person from whom the goods are received. A consignee
is the person to whom the goods are delivered.

2. Warehouse receipt

This issued by a storage person.

3. Negotiable documents of title.

The yellow copy is delivered to bearer or order. The white copy is nonneg-
otiable.

D. Common carrier loss liability

The common carrier is absolutely liable for loss, damage or destruction of goods
in transit except.

1. Natural disaster: earthquake, flood, etc.

2. Act of the enemy: war must be declared, e.g. Iraq not Cuba

3. Act of public authority: e.g. sheriff serves a writ of replevin on the carrier when
the seller unlawfully withholds the goods from the buyer

4. Act of shipper/consignor: e.g. improper packaging

5. Inherent nature of goods: e.g. perishables, hazardous materials.

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 Liability starts on acceptance and ends upon tender at destination. Liability can be
limited by a warehouseman, innkeeper or a common carrier in the contract.

E. Letters of credit

This is the engagement by a bank or other person that at the request of the customer
the bank will honor drafts in accordance with its terms. E.g. bill of lading.
A standby letter of credit provides that the bank will pay if the customer
defaults.

XXV. Real Property

A. Fee simple absolute

An estate is ownership interest in property. A fee simple absolute is ownership that is

unlimited in duration and freely transferable.

B. Defeasbile fees are conditioned on the occurrence or nonoccurrence of an event.

1. Fee simple determinable

A possibility of reverter exists: upon termination of the fee simple determinable,

the property auto-matically returns to the grantor or his successors. The fee simple
determinable uses the following language: “so long as”, “until”, “during”, “while”.

e.g. To the University of Illinois so long as the parcel is used for educational
purposes.

2. Fee simple subject to a condition subsequent

A power of termination exists: the grantor or his successors may terminate the
fee if property is used for a purpose other than that in the granting language.
The granting language is: “Upon condition that”, “provided that”, “on con-
dition that”.

3. Fee simple subject to an executory interest

The property goes to a third party upon termination of the fee.

C. Life estate

It is limited in duration to the life of one or more persons. It can be transferred,

it can be for the life of a third party. The life tenant cannot commit waste.
The life tenant pays the taxes.

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D. Other future interests

1. Reversion

A future interest remains in the grantor who transfers less than his entire
interest.

e.g. G grants Blackacre to A for life. G has a reversion

2. Remainder

It is a future interest which arises in a third party which is effective in possession

and enjoyment on termination of the preceding estate.

a. Vested: remainderman is unconditionally entitled to possession.

e.g. G grants Blackacre to A for life, then to B. B is the vested remainderman.

b. Contingent: remainderman is uncertain.

e.g. G grants Blackacre to A for life, then to the children of B. The children
of B are contingent remaindermen.

E. Co-ownership

1. Joint tenancy

This is created when the four unities of time, title, interest and possession are
present. (The granting language must state that the property is in joint tenancy
with a full right of survivorship and not as tenants in common.) When one joint
tenant dies, the other joint tenant receives the property. A joint tenancy can
be severed by conveying out, mortgage and divorce. Joint tenancy property
passes outside of probate.

2. Tenants in common

Property is held jointly but upon death it does not go to the surviving tenant.
The property goes to the dying tenant’s successors according to his will or
intestate.

3. Tenancy by the entirety

Property is conveyed to two joint tenants who are husband and wife. Only
joint debts can be levied on the property.

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F. Co-ops and condos

In a co-op residents in a multi-unit building own shares in a corporation that owns

the building. In a condominium each resident purchases his own unit and owns an
interest in the common area.

G. Landlord and Tenant

1. Lease

It is a contract for the possession of property for a stated period of time in

return for rent. It requires the parties names, description of the property, term,
rent and time for payment. An estate for years is typical apartment lease.
A lease can also be period to period such as month to month or if the tenant
holds over. There can also be a tenancy at will. A lease does not terminate
upon death.

2. Rights and obligations of landlord and tenant

a. Possession and use: The landlord cannot enter the premises but the tenant
can use for any lawful purpose.

b. Rent: Tenant has a duty to pay rent if the leased premises are destroyed.
If the leased premises are located in a building that is destroyed, then the
Tenant does not have a duty to pay rent.

c. Landlord gives a covenant of quiet enjoyment. If it is breached the tenant

can opt for constructive eviction and vacate the premises.

d. The landlord gives an implied warranty of habitability that the residence is

habitable for residential use. If not, the tenant does not pay rent.

3. Transfer of interest in leased premises

a. An assignment occurs when the tenant transfers his entire interest. A sublease
occurs when the tenant transfers less than his entire interest.

b. If an assignee assumes the lease he is held liable for covenants running with
the land (duty to pay rent) during occupancy and after reassignment. If the
assignee does not assume the lease, the assignee is liable only during the
tenancy.

c. In a sublease there is no relation between the sublessee and the lessor.

d. When there is a sale of leased premises, the buyer takes subject to the lease.

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XXVI. Decedents Estates

A. Introduction - definitions

1. Testate means a person dies with a will

2. Intestate means a person dies without a will

3. A will is a formal instrument by which one makes disposition of his property

on his death

4. An estate is all property, personal and real

5. An administrator is appointed when there is no will

6. An executor is appointed as named in a will

B. Wills

1. Formalities

It must be in writing, signed and witnessed by two adult people. The

attestation clause states that it was properly executed, signed in the presence of
witnesses, etc.

2. The testator must be 18 or older. His capacity must be of sound mind: look at
the nature of the property, the persons who are the natural recipient of his bounty
and his disposition of the property.

3. A devise is a transfer of real property under a will. A legacy is a transfer of

money and a bequest is the transfer of personal property.

4. Revocation can be by physical act such as tearing up the old will, subsequent
writing of a new will or a codicil, or by operation of law (divorce).

5. Prevention of bequests

a. Lapse occurs when the beneficiary predeceases the testator. In the absence of
an
anti-lapse statute, it goes into the residuary clause.

b. Ademption is when the gift is no longer in the estate. This applies to a

specific bequest.

c. Abatement occurs when the share is reduced by creditors of the estate.

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C. Intestate succession

Heirs receive property in accordance with the probate statute on descent and
distribution according to kinship. E.g. If H dies, half to W and half to kinds.

1. Per stirpes means that the issue of the decedent receive his share.

2. Per capita means that the estate is divided by the number of surviving
descendants.

XXVII. Trusts

A. Definitions

1. Trustee holds legal title

2. Beneficiary holds equitable title

3. Settlor creats the trust

4. Corpus is the subject matter of the trust.

5. Intervivos: trust created in life time of settlor

6. Testamentary: trust created in Will

B. Types of trusts

1. Express: language of settlor creates a trust. The settlor desires to be grat-

uitous to the beneficiary, e.g. education, spendthrift, mentally disabled.

2. Implied: constructive trust by operation of law

C. Creation, modification and termination of trusts

1. They can be created intervivos or testamentary

2. There must be a specific intent to make a trust

3. Formalities: Trust must be in writing under the statute of frauds.

a. Intent to make a trust

b. Identity of beneficiaries

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 c. Identity of trust property

d. Purpose of trust

D. Trustee can be a person or a corporate administrator

E. Beneficiary must be identified in the trust instrument or easily ascertainable, e.g.

grandchildren. In a spendthrift trust, the beneficiary cannot voluntarily transfer
income and creditors cannot reach the trust.

F. Modification and termination: A trust cannot be revoked unless the settlor reserves
the power of revocation. However, a trust can be modified or revoked if the
purpose is accomplished and all the beneficiaries agree.

G. Trust Administration

1. The trustee’s powers are in the trust instrument and by statute. They have
fiduciary duties. Under the prudent person rule, the trustee makes only
those investments that a prudent person would make.

2. Liability is for breach of trust, normally the trustee posts a bond.

XXVIII. Accountant’s Legal Liability

A. Common Law Liability

1. Contract: An accountant agrees to perform in a competent and professional

manner. The accountant may be liable to third party beneficiaries. The
accountant must substantially perform for his or her fee.

2. Tort

a. Negligence: An accountant will be held liable if he did not exercise the

degree of care that a reasonably competent accountant would exercise
under like circumstances. He is not liable for honest errors. He is not an
insurer.

b. Fraud: It is a false representation of a fact, material, made with knowledge of

its falsity and with the intention to deceive, justifiably relied upon, plus

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 damages. He may also be liable for compensable and punitive damages.

B. Criminal Liability

An accountant may be held criminally liable if he knowingly and willingly certifies

false statements, etc.

C. 1933 Securities Act

Section 11: An accountant is subject to civil liability for untrue statements or

Omissions of a material fact even if innocent, unless he can prove the “due diligence
Defense”.

D. 1934 Securities Act

Section 18: An accountant is subject to civil liability for statements filed under the
1934 Securities Act. There is also liability under 10 b5, criminal and civil.

E. Accountant’s privilege

1. Federal law does not recognize the accountant’s privilege.

2. By Illinois statute, information or evidence obtained by a public accountant in his

Confidential capacity as a public accountant is privilege, and the accountant
cannot
Be compelled to divulge the information or evidence so obtained. The privilege
May be invoked only by the accountant, not by the client.

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