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This Document Contains Chapters 14 to 15 Chapter 14 Business Forms and Arrangements Instructor’s Manual–Answers by Dorothy DuPlessis I. TEACHING OBJECTIVES After studying this chapter, students should have an understanding of • the characteristics of the major forms of business organizations • the advantages and disadvantages of the major forms of business organizations • the legal consequences of a partnership • methods of arranging business activity This chapter introduces and compares the three basic forms of business associations: the sole proprietorship, the partnership, and the corporation. The focus is on the partnership form as there is little law pertaining to the sole proprietorship as such. The two chapters that follow (15 and 16) are devoted to a detailed examination of the corporate form. In comparing the three forms, it is useful to emphasize the importance of the agency relationship introduced in the preceding chapter (13): • Sole proprietorship often uses the services of an agent as it is difficult for the sole proprietor to do everything herself. • Partners in a partnership are agents for the partnership. • A corporation can conduct business only through agency. In addition to comparing the basic forms of business vehicles, this chapter introduces several arrangements or methods of doing business. This helps the student to understand the distinction between a business form and a business method. Students are also encouraged to recognize that the basis of business arrangements or methods is a contractual agreement between the parties. II. TEACHING STRATEGIES In presenting the material in this chapter, it is useful to keep in mind the varying levels of legal background that students will bring into the course. Students who have taken courses in accounting may already be familiar with the distinction between the three basic forms of business organizations. Other students who have not had this exposure will benefit from a review of the various features, advantages, and disadvantages of each. To ensure that all students have the basics in place, the first part of the chapter makes the comparisons. What are the three basic forms of business associations? What are the characteristics of each? What are the advantages and disadvantages of each form? Question for Critical Thinking (QCT) 6 (page 349) What follows is an account of those points that an instructor may want to emphasize when presenting the three main business vehicles. • Sole proprietorship: the sole proprietor is the business, because a sole proprietorship does not refer to any formal legal structure. This business form could be suitable for someone who has a special talent or skill and who would like to and is capable of running her own business. If this method is chosen, it is important to register the name if a name other than the sole proprietor’s is being used, obtain necessary licences and permits for carrying on the business, and acquire appropriate insurance coverage. • Partnership: a partnership is, of course, very much like a sole proprietorship except that it is operated by more than one person. The key point about partnerships is that each partner is personally responsible and can be held accountable for any obligation of the partnership, including obligations that another partner might incur on behalf of the partnership. It is also noteworthy that a corporation can be a partner for purposes of carrying on business activity. The partnership form is most often used by professionals who are not permitted to limit liability through incorporation; by individuals who want to work with others that they trust, and by those who want to be “hands-on” in the business. As with a sole proprietorship, it is important to register the name, obtain licences and permits, and acquire insurance. • The corporation: it is well known that a corporation is the most popular way to operate a business. The salient point about incorporating is that it is the creation of a separate entity that is responsible for its own debts and obligations. A corporation is a suitable way to carry on most any type of business. Unlike a sole proprietorship and a partnership, a corporation can only come into existence through a formal process. In addition to carrying out the incorporation process, those who want to carry on business by using this form need to register any business names of the corporation, obtain licences and permits, acquire insurance, and possibly enter into a shareholder’s agreement (discussed in Chapter 16). How does each form of business allocate risk? QCT 6 (page 349) The liability risks associated with each form can be explored and reinforced by building on the Business Law in Practice featuring Luke, Raina, and Roger. Ask the students to consider the following question: What is Luke’s liability under a lease if he operates his business as a sole proprietorship, in partnership with Raina and Roger, or as a corporation? • Sole proprietorship: if the premises for the business are leased, this is Luke’s personal responsibility. Luke is the lessee (or tenant) since the business does not exist in law. If the business does not have the income to pay its monthly rent, it is Luke who is liable for the default. • Partnership: if the premises for the business are leased, each partner is 100% responsible for each monthly payment simply because the partnership has no legal existence apart from the partners themselves. Since the partners are the partnership, they are jointly liable to the landlord for the rent. The landlord can proceed against one, two, or all three of them, at its discretion. • Corporation: if the corporation requires office space, it has the legal capacity to enter into a lease under its own steam. If the corporation fails to makes its monthly payments, it alone is liable for the default. The second major focus of the chapter is on partnership, which is of particular importance to students entering the accountancy profession as many will work for partnerships and become partners themselves. How is a partnership created? QCT 4 (page 349) One suggestion in relation to this question is to build on the practical application of the law by examining a sample partnership agreement. Using an actual document is useful as familiarity promotes comfort and makes the formal language less daunting. To strengthen students’ understanding of contracts, they could be asked to consider whether and how the following contract fits the definition of the ideal contract. For reference, see sample partnership agreement on pages 14-7 to 14-13 of this Instructor’s Manual. Questions to be asked include, How is the form and content of this contract ideal? Does the contract address the parties’ rights and obligations? Does it address contingencies? How does the contract allocate risk? Are all of the terms defined? Are the terms clear and unambiguous? After discussing the ideal partnership agreement, it is worth noting that a contract is not a panacea for all problems. It does not assure the success of the partnership; it cannot replace trust; and it does not address the partners’ relationship with the outside world. The following series of questions and text references provide an outline for an in-depth review of general partnerships and partnership variations: • What factors are indicative of a partnership? Business Application of the Law: The Lottery Partnership? (page 328), Situation for Discussion (SD) 1 (page 349) • What is the relationship of partners to each other? SD 6 (page 350) • What is the relationship of partners to outsiders? SD 2, SD 3 (page 350), Strother v 3464920 Canada Inc. (page 331) • How does a partner differ from an agent in terms of liability? SD 7 (page 351) • What steps can you take to avoid a finding of partnership? How can you minimize the effects of being a partner? QCT 4 (page 349), Business Application of the Law: Managing Partnership Risks (page 334) • How does a limited partnership differ from a general partnership? • How does a limited liability partnership differ from a general partnership? SD 4 (page 350), QCT 3 (page 349) The final section of the chapter examines various kinds of business arrangements with the focus on franchising. The following provides some background information on franchising in Canada. Franchise facts: franchising is big business. Canada has the second-largest franchising industry in the world. It generates approximately $68 billion each year. Franchising directly employs more than 1 million Canadians—approximately 1 out of 14 working Canadians (). Thousands of Canadians are drawn to franchising each year as a way to mine their entrepreneurial spirit without taking all the risks inherent in an independent small business. . There are approximately 78 000 individual franchise operations in Canada under 1300 franchise brands. Individual investment in franchises runs from under $10 000 to over $1 000 000 and franchise fees range from $5000 to $75 000. Source: Canadian Franchise Association, “Franchising fast facts,” online: . A franchisee normally pays an initial licensing fee and a yearly royalty from sales and often contributes to national advertising funds. The franchisor markets the product or service, usually selects a site for the business, trains the franchise owner, and often supplies the product (i.e., cookie dough for a cookie franchise). For further information about franchising see the Canadian Franchise Association’s website at . • What is a franchise? • Describe the relationship between a franchisor and a franchisee. QCT 1 (page 349), SD 5 (page 350), Fairview Donut Inc. v The TDL Group (page 343) In Jirna v Mister Donut, [1975] 1 SCR 2, the Supreme Court of Canada, rejected the proposition that the franchisor–franchisee relationship is a fiduciary relationship. The court’s analysis in this area could be examined in light of subsequent cases that have discussed duties of fair dealing and good faith in the relationship, and the enactment of franchise legislation in several provinces. • What is the purpose of franchise legislation? How does the legislation affect the relationship between a franchisor and a franchisee? , Business and Legislation: Manitoba’s Franchise Legislation (page 342) III. STUDENT ACTIVITIES Task 1: One of the underlying themes of the textbook is the integration of the law into the functional areas of business, namely, marketing, accounting, finance, human resources, and management. Students are often urged to consider how the law affects various business decisions. In this chapter, students could be encouraged to build on knowledge from their marketing courses where they would have studied various business strategies, such as licensing, franchising, distributorship, and the like. • In small groups, have students identify in the local market examples of the various arrangements of carrying on business and consider why the business is using this arrangement. • Have students speculate on what kind of contract is present in the arrangements identified, what the contract might contain, and what the nature of the relationship is between the parties. Students could also develop a contract checklist for the various business arrangements that they have identified. Task 2: The DVD that supports the Instructor’s Manual has a segment called “Lotto Disputes” on the Bell Canada lottery dispute. After students view the segment and read the Business Application of the Law: The Lottery Partnership? (page 328), have students discuss the following questions: • What is the nature of the relationship between the winners and the claimants? • What factors do the courts consider in determining whether a partnership exists? • What duties do partners owe to each other? • How does a partnership end? As a means of integrating or reviewing the material on dispute resolution (Chapter 4), have students consider how dispute resolution methods (negotiation, mediation, arbitration, and litigation) could be used to resolve the dispute between the winners and the claimants. Have students articulate the advantages and disadvantages of each method. IV. EXPLANATION OF SELECTED FEATURES Page 328 Business Application of the Law: The Lottery Partnership? Critical Analysis: Do you think this decision precludes a lottery group from being a partnership? How could the parties have prevented this dispute? This decision does not preclude any group from being considered a partnership so long as it meets the definition of a partnership. That said, it is difficult for groups like this to be considered partnerships because of the difficulty in establishing the “carrying on business” requirement in the definition of partnership. It is questionable whether the contributing of money towards purchasing lottery tickets and purchasing tickets is “carrying on a business.” As well, it does not seem to be a “trade, occupation, or profession.” More likely, the relationship between the players in most situations is a series of contracts. Members of lottery groups are more likely to be considered partners if they sign an agreement indicating that they are partners or are in a partnership. Lottery gaming organizations suggest that groups can protect themselves and their winnings by ensuring that they appoint one person as the manager or captain, who coordinates group members, collects payments and validates tickets. They also suggest that groups use the lottery’s group play form where the group members are listed along with any group rules. This advice may help to reduce disputes but will probably not prevent them. See: “Two year Canadian lottery dispute ends,” Maple Gambling (16 November 2012) online: Maple Gambling . Page 328 Photo caption: Is the relationship between the members of a group of lottery players a partnership? The relationship between members of a group of lottery players is contractual. The players will normally have a written or oral agreement specifying the terms and conditions of their participation in the purchase of lottery tickets. It is debatable whether their relationship is one of an ongoing partnership because members do not appear to be carrying on a business. Page 330 Business and Legislation: The Partnership Act: The Relations between Partners Critical Analysis: When are the optional rules appropriate for partners? The optional rules will apply to partners when they do not have a partnership agreement or the agreement is silent on the issues covered by the optional rules. The rules would be most appropriate for a partnership where partners are equal in all respects. Page 331 Case: Strother v 3464920 Canada Inc, 2007 SCC 24, [2007] 2 SCR 177 Critical Analysis: What are the implications of this decision for the Canadian legal profession and other professions, such as those providing financial advisory services? This case represents a big win for Davis & Company because under the earlier appeal court ruling, it would have had to remit to Monarch several million dollars in fees that it earned from Strother’s tax-shelter business. Under the Supreme Court of Canada ruling, it will only have to pay if Strother defaults, which is unlikely. How should partnerships like Davis & Company manage the risk of liability for the actions of one of their partners? In other words, what more could the Davis partners have done to keep Strother out of trouble? Strother is important in that it confirms that lawyers have a higher duty to their clients than found in the strict terms of a retainer agreement. A lawyer has no duty to advise a client of any change of an opinion after the retainer agreement has expired; however, if the lawyer continues to provide legal services to the client, there is a duty to the client to keep her advised of any change to the opinion. Presumably, this duty is not restricted to lawyers but would also apply to other professionals, such as those providing financial advisory advice. In Strother, the Davis partners who were innocent of any wrongdoing were held liable for the transgressions of Strother. With the trend toward law firms increasing in size, firms, especially those that operate nationally, must be careful to pay attention to organization and diligently examine their partners’ activities to ensure that the partners are not in a conflict of interest. In short, “watch your partners.” Source: Gary Fraser, “Broadening of fiduciary duty of lawyers and other professionals?” In Brief (Winter 2007/2008) at . Page 334 Business Application of the Law: Managing Partnership Risks Critical Analysis: How do the partnership variations discussed below reduce the risks associated with a general partnership? In a general partnership, each partner is personally liable for the whole debts of the partnership, including debts and liabilities arising from the dishonest or negligent conduct of another partner. In a limited partnership, the liability of the limited partner for the debts of the partnership is limited to his capital investment as long as the limited partner does not take an active role in the management of the partnership. In a limited liability partnership, partners are protected from liability arising from the negligent or wrongful acts of another partner provided the partner was not involved or did not know about the wrongful or negligent act that gave rise to liability. In some jurisdictions, partners are also protected from the contractual obligations of the partnership, such as accounts payable and general debts. Source: See: “Structuring firms to manage risk,” Lawyers Professional Indemnity Company (Summer 2003) at . Page 336 Photo caption: Most large accounting and law firms have registered as limited liability partnerships. What are the advantages of changing from a general partnership to an LLP? The advantages of a limited liability partnership relate to the protection it affords partners. In some jurisdictions, it provides a partial shield that protects a partner from liabilities arising from the negligent or wrongful acts of her partners or employees (so long as she was innocent or uninvolved in their negligence or wrongful acts). In other jurisdictions, the legislation provides a full shield that not only protects a partner from the negligent or wrongful acts of her partners or employees (as long as she was innocent or uninvolved in their negligence or wrongful acts) but also protects the partners from the contractual obligations of the partnership. Page 341 Photo caption: What legal factors are important to the success of a franchise? The success of a franchise is due primarily to a strong concept, commitment, and adequate financial and human resources, but legal factors can also be key. In particular, an equitable franchise agreement that provides the opportunity for both the franchisee and the franchisor to make money needs to be in place. . Page 342 Business and Legislation: Manitoba’s Franchise Legislation Critical Analysis: What are the advantages of franchise legislation? What are the problems, if any, with franchise legislation? The advantage of franchise legislation is that it protects franchisees by giving them the tools they need to make an informed decision about whether to invest in a franchise and by providing a commercial framework that ensures that franchisees will be treated fairly by the franchisors. The legislation does this by requiring the franchisor to deliver to a proposed franchisee disclosure document, containing detailed information, and by imposing on the parties a duty of fair dealing and good faith. In addition, the legislation also imposes statutory remedies for the failure to disclose and for breach of the duty of fair dealing and good faith. The problem with franchise legislation is that because it imposes onerous and exacting obligations, franchisers may gravitate to those provinces that do not have legislation. Page 343 Case: Fairview Donut Inc. v TDL Group Corp., 2012 ONSC 1252, [2012] OJ No. 834, aff’d 2012 ONCA 867, CarswellOnt 15496, leave to appeal refused (2013), CarswellOnt 6051, CanLII 26760 (SCC). Critical Analysis: Once the judge dismissed the action, the question of certification was moot. He did, however, indicate that if the claims had not been dismissed, he would have certified the class action. He also stated that franchise disputes are frequently suitable for certification. Why do you think franchise disputes are suitable for class action certification? Once a certification is granted, the class action is most often settled and does not proceed to trial. Why do you think that happens? Franchise disputes are frequently suitable for class action certification “because of the existence of a clearly identifiable class, a common standard form contract and a common business system, coupled with a franchisor that treats every franchise in the same way.” Source: Judge Strathy in Fairview Donut Inc. v The TDL Group Corp., 2012 ONCA 867 (CanLII). The percentage of class actions going to trial in Ontario is about 8 to 10 percent. The small percentage going to trial may be attributable to a number of factors including fear of adverse publicity, potentially adverse judgment or both. Sources: Julius Melnitzer, “Are class actions going to trial more often?” Law Times (2 September 2013) online: Law Times ; Edward Levitt & Bruce S. Schaeffer, “Canada’s Tim Hortons case: Lessons learned about franchisors’ rights, class action certification and rules of expert testimony,” Aird & Berlis LLP (22 June 2012) online: Aird & Berlis . Page 344 Photo caption: Why are franchising companies a magnet for class action litigation? Franchising companies are a magnet for litigation because of the power imbalances. In most cases, the franchisors have power over the franchisees and this power extends from the initial drafting of the franchise agreement, through to powers over pricing, raw materials and the like, to power over termination and repossession. This imbalance often results in a dispute and a class action is most often the desired vehicle for litigation because “the relationship is uniquely disposed towards class action treatment. That’s because the very nature of franchising involves uniform agreements and similar relationships between the big company and its franchisees.” In other words, franchisees are in a good position to meet the certification requirements for a class action. Furthermore, Canadian courts have strongly endorsed class actions as an appropriate vehicle to address claims by franchisees against franchisors. Source: Andi Balla, “Franchise Class actions here to stay,” Canadian Lawyer (25 April 2011) online: Canadian Lawyer . Page 345 Photo caption: What are the legal risks with joint ventures? The legal risks with joint ventures relate to the uncertain nature of the fiduciary relationship. In some circumstances, a joint venture may be a partnership, in which case the joint venturers owe fiduciary obligations to each other. In other circumstances, the joint venture is considered a purely contractual arrangement and not a partnership with resultant fiduciary obligations owed. See: Bernard J Zinkhofer, “Joint ventures—The limited fiduciary relationship status” (June 2009) at Continuing Legal Education Society of British Columbia at . Page 346 International Perspective: Going Global Critical Analysis: What are the risks associated with using a strategic alliance to access a foreign market? Why would a country require that a foreign business have local participation? Can you think of any legal reasons? A legal risk associated with using a strategic alliance to access a foreign market is that the alliance may be considered a partnership, with all of the attendant risks (i.e., unlimited liability and agency). A country may require that a business have local participation as this furthers the development of local capital, creates local managerial and technical expertise, provides access to technology, and prevents foreign domination of key business sectors. From a legal perspective, the requirement of local participation, which entails establishing a subsidiary, may mean that a country is in a better position to regulate business activities (i.e., the people are located in the country). Chapter 15 The Corporate Form: Organizational Matters Instructor’s Manual–Answers by Dorothy DuPlessis I. TEACHING OBJECTIVES After studying this chapter, students should have an understanding of • a corporation as a legal person • the distinction between federal and provincial incorporation • the share structure of a corporation • the selection of a corporation’s name • how a corporation is created • how the corporation is financed • how securities are regulated The previous chapter introduced the corporate form for comparison with other business forms. Chapters 15 and 16 provide a detailed examination of issues related to various aspects of the organization and operation of a corporation. Both chapters are designed to include coverage that is particularly relevant to students majoring or concentrating in accountancy or finance. Chapter 15 provides an account of the issues involved in the formation of a corporation. In particular, this chapter examines pre-incorporation issues, such as whether to incorporate federally or provincially, the incorporation process, and the capitalization of the corporation. The last section deals with the regulation of securities. The focus is on helping students understand and appreciate that the most dramatic consequence of incorporation is the creation of a new legal person, separate from its shareholders II. TEACHING STRATEGIES The Corporation and the Incorporation Process Students often have difficulty grasping the notion that the corporation is a separate legal entity, especially when the corporation is owned and operated by one person. It is often worthwhile to spend time studying the concept of a separate legal entity as it helps students understand the liability of the corporation, the limited liability of shareholders, the application of agency, taxation, and so on. • What are the characteristics of a corporation? A detailed examination of the issue of separate personality as presented in the Salomon v Salomon Ltd decision (page 353) can help in this regard. (Please note that the issue of the validity of the debenture and the relationship to lender, Broderip, is not covered in this summary since it is not germane to the separate existence issue and may confuse students.) The summary (on pages 15-4 to 15-6 of this Instructor’s Manual) provides more detail than space considerations in the textbook allowed. This longer summary can be used as the basis for the instructor’s presentation of the case or can be distributed, in its entirety, to the class as a foundation for more detailed analysis and discussion. Landmark Case: Salomon v Salomon Ltd, [1897] AC 22 (HL) The historical context: When Salomon was decided, the corporation—or company, as it is called in England—was just coming into wider usage. At the time, it was unclear whether or not small companies (companies with very few shareholders) would be recognized as a separate legal entity. This was an issue because the British government, in introducing the Companies Act (legislation that granted limited liability to companies), apparently did not intend for it to be used as a way for sole proprietors or partnerships to shelter personal assets by simply incorporating. Rather, it was seen as a mechanism exclusively for the benefit of larger business organizations. However, there was nothing in the legislation restricting its operation to the more sizeable enterprise. (Source: Paddy Ireland, “The triumph of the company legal form, 1856–1914” in John Adams, ed, Essays for Clive Schmitthoff (Abindgdon: Professional Books Limited, 1983) 29 and Jacob Zeigel et al., Cases and Materials on Partnerships and Canadian Business Corporations, 3rd ed (Scarborough: Carswell, 1994) at 122.) Factual background: Aron Salomon carried on a profitable shoe manufacturing business for many years as a sole proprietor. He then decided that he wanted to convert his unlimited liability into limited liability. He therefore formed an incorporated company—called Aron Salomon and Company, Limited—as the vehicle through which to run his business. The Companies Act, which set out the rules for creating a company, required that a company have a minimum of seven shareholders. Therefore, Aron, his wife, his daughter, and his four sons took one share each in the company. Aron became the managing director. Practically speaking, Aron Salomon and Company, Limited was a one-person company since Aron entirely controlled the company. Put another way, the other participants in the company had no involvement in operations: any decision the company made was because Aron wanted to follow that course of action. Ownership Structure of Aron Salomon and Company, Limited on date of incorporation Son 1 Son 2 Son 3 Son 4 Aron Aron’s Wife Daughter (1 share) (1 share) (1 share) (1 share) (1 share) managing director (1 share) (1 share) Next, Aron Salomon and Company, Limited agreed to purchase the assets of Aron’s sole proprietorship for a sale price of approximately 38 000 pounds (£). This price was partially paid by the company issuing to Aron 20 000 shares representing £20 000 of the purchase price. Aron also received a cash payment of £6000, debentures amounting to £10 000, and a few other benefits. Generally understood, a debenture is a corporate IOU: it is a promise by the company to Aron that it will pay him a specific sum of money. Aron’s debentures were “secured” meaning that if the company failed to pay Aron the £10 000, he was automatically entitled to certain company assets in lieu of the cash. In this way, Aron became a creditor of his own company and a highly protected one, at that. Soon thereafter, the business suffered financial problems because of a series of strikes and the loss of government contracts. The company became insolvent and a trustee was appointed to deal with its creditors and close down the business. Many creditors of Aron Salomon and Company, Limited—including Aron himself—lined up for payment. As a secured creditor, Aron was at the head of the line but payment of his debt would leave nothing for the unsecured creditors. In response, the trustee refused to recognize Aron as a legitimate creditor and, furthermore, took the position that Aron was personally responsible for all his company’s debts. Vaughan Williams J, for the lower court, treated Aron harshly, ruling that to allow a man who carries on business under another name to set up a debenture in priority to the claims of the creditors of the company would have the effect of defeating and delaying his creditors. There must be an implied agreement by him to indemnify the company.... I do not mean to exclude from my judgment that the debentures were given to Mr. Salomon by his agent, the company, and that the necessary effect of Mr. Salomon, as principal, taking these debentures from his agent, the company, was that his creditors—for, according to my view, the creditors of the company were his creditors—were defeated and delayed by the debentures. See Broderip v Salomon (1894), [1895] Ch 323 at 331–332. The Court of Appeal was hardly any more sympathetic and dismissed Aron’s appeal. In Lord Justice Lindley’s words, We have carefully considered the proper form of order to be made on this appeal, and the order of the Court will be as follows: The Court, being of the opinion that the formation of the company, the agreement of August, 1892 [i.e., the contract of sale by Aron of his business assets to the limited company] and the issue of debentures to Aron Salomon pursuant to such agreement, were a mere scheme to enable him to carry on business in the name of the company with limited liability, contrary to the true intent and meaning of the Companies Act, 1862, and, further, to enable him to obtain a preference over other creditors of the company by procuring a first charge on the assets of the company by means of such debentures, dismiss the appeal of Aron Salomon with costs. Legal questions: Was Aron liable for the debts of Aron Salomon and Company, Limited? Was Aron a legitimate creditor of the company? Resolution: The House of Lords held that a corporation—large or small—is a separate legal entity and, as such, is totally responsible for its own obligations. In the words of Lord MacNaghten, Among the principal reasons, which induce persons to form private companies...are the desire to avoid the risk of bankruptcy and the increased facility afforded by borrowing money. By means of a private company ... a trade can be carried on with limited liability, and without exposing the persons interested in it in the event of failure to the harsh provisions of the bankruptcy law. The House of Lords rejected the argument that there was something essentially improper about an individual conducting his business through a one-person corporation to secure the protection of limited liability. As Lord Herschell observes at 42, I am unable to see how it can be lawful for three or four or six persons to form a company for the purpose of employing their capital in trading, with the benefit of limited liability, and not for one person to do so.... How does it concern the creditor whether the capital of the company is owned by seven persons in equal shares, with the right to an equal share of the profits, or whether it is almost entirely owned by one person, who practically takes the whole of the profits? The creditor has notice that he is dealing with a company the liability of the members of which is limited, and the register of shareholders informs him how the shares are held, and that they are substantially in the hands of one person, if this be the fact. Furthermore, the House of Lords confirmed that there is nothing wrong with a shareholder being a creditor of the corporation, even when that shareholder essentially controls the company in question. Per Lord MacNaghten, A company, too, can raise money on debentures.... Any member [i.e., shareholder] of a company, acting in good faith, is as much entitled to take and hold the company’s debentures as any outside creditor. Every creditor is entitled to get and hold the best security the law allows him to take. The result was that Salomon’s conduct was unimpeachable and he was not personally responsible for the corporation’s debts. The creditors had chosen to deal with Aron’s company—not with Aron, the individual—and furthermore, had done so on an unsecured basis. They, in turn, must live with the adverse outcome of that business decision. (end of case summary) A follow-up to the Salomon case is a discussion of how the creditors could have protected themselves: • How can creditors like the ones in Salomon protect themselves from the effects of limited liability? Question for Critical Thinking (QCT) 1 (page 374); Situation for Discussion (SD) 2 (page 376); SD 5 (page 376) Students’ understanding of the separate legal existence of the corporation may be enhanced by examining the documents used in the process of incorporation: • How is a corporation created? When should a business incorporate federally and when should it incorporate federally? The forms used to incorporate federally under the Canada Business Corporations Act are available online at . The examination and completion of the forms will reiterate for students the idea that a separate entity is being created (i.e., filing the Articles of Incorporation is like applying for a birth certificate). One of the more interesting and contentious issues in incorporation is the selection of the corporate name: • What are the requirements for a corporate name? SD 3, SD 4 (page 376) Business Application of the Law: The Tangerine Name Dispute (page 361) The material relating to corporate names can be cross-referenced to the tort of passing off in Chapter 12 and the discussion of trademarks in Chapter 18. The following questions complete the process of incorporation: • What are the share structure requirements for incorporation? • Why would incorporators put restrictions on share transfers? On the business the corporation may carry on? As a summary of share structure and as an introduction to securities regulation, the following question may be useful: • What are duel class structures? What are the advantages and disadvantages? Business Application of the Law: The Trials of Lord Black of Crossharbour—Continued (page 358), QCT 3 (page 375), SD 6 (page 376) Securities Regulation The following questions provide an outline to the last section in the textbook. • How are securities regulated in Canada? Why do we not have a national regulator? Would a national regulator be advantageous? What are the primary features of securities legislation? Business and Legislation: A Co-operative National Securities Regulator (page 367), QCT 5 (page 375) • What is crowdfunding? How is crowdfunding affected by securities regulation? Business and Legislation: Crowdfunding (page 365); QCT 6 (page 375). • Should Internet securities activities be treated differently from securities activities carried out by other means? QCT 4 (page 375) • Describe the secondary market liability amendments to securities legislation? How do the amendments enhance investor protection? See Business and Legislation: Securities Legislation and Secondary Market Liability (page 369), SD 1 (page 375) • What are the major problems with securities legislation in Canada? Ethical Considerations: Bre-X Minerals: The Final Chapter (page 371), SD 7 (page 377), SD 8 (page 377) III. STUDENT ACTIVITIES Task 1: In pairs or individually, have students complete the form used to incorporate federally under the Canada Business Corporations Act. The forms are available online at (). Refer to Teaching Strategies above for specific questions to accompany the exercise. Task 2: The DVD that supports the Instructor’s Manual contains a clip from the CBC Power & Politics titled “MPs on security regulation.” After viewing the segment, assign QCT 5 (page 375) for discussion. Have students prepare arguments for and against a national securities regulator. Task 3: Have students research securities class actions in Canada for examples, prevalence of actions (see Business Application of the Law: Securities Class Actions, page 367), settlements and status of the class action suits. As a way of integrating and reinforcing earlier learning have students review QCT 3 in Chapter 4, page 92 (who benefits and loses from class actions) and the photo caption, “Why are franchising companies a magnet for class action litigation?” in Chapter 14, (page 344). In the latter, have students consider whether the same can be said for the securities industry and if so, why? IV. EXPLANATION OF SELECTED FEATURES Page 353 Landmark Case: Salomon v Salomon Ltd, [1897] AC 22 (HL) Critical Analysis: Do you think that the court went too far in giving independent existence to the corporation, especially when the interests of Aron and his company were virtually identical? Should the shareholder of a one-person company be entitled to limited liability? How could the creditors, other than Aron, have better protected themselves in this situation? The questions at the end of this case invite a discussion of why the legislatures provide for separate legal entities. One purpose is to encourage and foster investment by permitting investors to limit their liability for the corporation’s debts and obligations. If this is permissible for several investors, than why not for one investor? An important lesson from the Salomon case is that a creditor must understand whom he or she is doing business with: if it is the corporation, then the corporation alone is liable; if it is an individual, then he or she is liable. The creditors of the company could have better protected themselves by getting a personal guarantee from Aron Salomon or by becoming secured creditors, ranking ahead of Aron Salomon. Page 358 Photo caption: What are the advantages of a private corporation? The advantages of being a private corporation relate to privacy and control. First, shares of the private corporation are not publicly traded and therefore the corporation’s financial figures are not available to the public. This allows the corporation to keep much information confidential. Second, there is restriction on transfer of shares, which allows shareholders to maintain control of the corporation and prevent the intrusion of outsiders in the management of the corporation. Page 358 Business Application of the Law: The Trials of Lord Black of Crossharbour—Continued Critical Analysis: How did the share structure of the Hollinger companies contribute to the alleged abuse of the corporate form of carrying on business? Are there any lessons to be learned from the Conrad Black case? Lord Black instituted a dual-class structure: different classes of shares had different voting rights. Hollinger Inc. owned all of Hollinger International’s Class B shares, which gave it 30 percent of the equity but 73 percent of the votes. This allowed Black to elect directors handpicked by him and therefore control the board. When Black entered into the questionable deals and spent money it was not questioned by the board. In the end, it allowed Black to reign as he wanted without the normal checks and balances that a corporate structure should have. Aside from the issue of duel-class structures, much has been written about the trial itself and the distinctions between the Canadian and U.S. systems of justice. In his book Titled: The Trial of Conrad Black, Steven Sturka, a Toronto criminal defence lawyer, offered lessons that can be learned from the Black case: (1) a defendant in a U.S. court requires a lot of money, (2) video evidence of removing boxes is more incriminating for juries than perks like trips, (3) the most valued currency in U.S. justice is cooperation with the government, (4) there are many dissimilarities between a trial in Canada and one in the United States, (5) it is helpful for an appeal to have been convicted on a vague law, and (6) never publicly condemn a system of justice when you are about to be re-sentenced. See also Adrian Humphreys, “Six lessons gleaned from the Conrad Black case,” The National Post (25 June 2011) at . Page 361 Business Application of the Law: The Tangerine Name Dispute Critical Analysis: What is the problem with similar names for businesses? The problem with identical or similar names for businesses is that the public may be confused or deceived into thinking the businesses are the same or related. Page 361 Photo caption: What are the basic requirements for a corporate name? Why is the name of a business important? The basic requirements for a corporate name are as follows: • It must be distinctive (different from other existing names in the same field; • It must not cause confusion with any existing name or trademark. • It must include a legal element (e.g., Limited or Ltd., Incorporated or Inc., or Corporation or Corp., or the French equivalents). The purpose of the word is to distinguish a corporation from a partnership and a sole proprietorship and to signal to the public the fact of limited liability. • It must not include any unacceptable terms (e.g., it must not suggest a connection that does not exist, falsely describe the business, or be obscene or scandalous). The name of a business is important because it is how the public identifies the business and distinguishes it from other businesses in the marketplace. It can be a very valuable asset. Page 365 Business and Legislation: Crowdfunding Critical Analysis: What is driving the growth of crowdfunding? What are the pros and cons of crowdfunding? “Three main factors are driving the growth of crowdfunding. First, far more Canadians are connected online, giving budding entrepreneurs a global market or audience. Next, a tepid Canadian job market is spurring more self-employment, an area that comprises 15 percent of the workforce. And dwindling venture and seed capital for startups makes crowdfunding a logical alternative.” Tavia Grant, “To find seed money, Canadian startups follow the crowd,” The Globe and Mail (24 March 2014) B1. Proponents of crowdfunding say it is a good idea because it allows people who may not be able to access conventional financing to get their ideas developed and marketed. In addition to accessing capital, crowdfunding provides an opportunity for the entrepreneur to validate her company and product, help establish a customer base, and provide marketing exposure. The cons of crowdfunding are that the ideas that are being crowdfunded are not protected in any way so someone else could steal the idea, it is not right for all products and projects because of their complexity, and it is generally not viable for large capital needs. Neil Gross of the Foundation for Advancement of Investor Rights identifies five risks related to equity crowdfunding: • Extreme failure rate of startups • Internet fraud—difficulty in distinguishing between legitimate and fraudulent portals • No accountability—- few obligations to inform investors on how their money was used • Illiquidity—- no stock exchange for shares • Dilution—startups will bring in more investors if the startup shows promise diluting value of shares Sources: Neil Gross, “Crowdfunding has a place, but it’s a crazy way to invest,” The Globe and Mail (1 June 2015) B4; Mark Quinlan, “The pros and cons of crowdfunding,” CBC News (22 June 2012) online: CBC News ; Lyn Blanchard, “Is crowd funding right for you? Pros and cons,” Wavefrontac.com (6 June 2013) online: Wavefrontac.com . Page 367 Business and Legislation: A Co-operative National Securities Regulator Critical Analysis: What are the policy arguments in favour of a single securities regulator for all of Canada? What are the policy arguments against a single regulator? There are many arguments for a single securities regulator. Among the arguments are that it would • ensure uniformity of standards across Canada • ensure uniformity of application of standards across Canada • take advantage of economies of scale • facilitate transactions with other counties that have a single regulatory body • avoid competition among provinces to have the slackest standards, thereby attracting the most companies (the race to the bottom) Among the arguments against a single regulatory body are the following: • Competition among the various provincial bodies generates efficiencies (the race to the top) • Financial bodies work well without a single body • Provincial regulation ensures that the regulation is responsive to local and regional needs • A single body is not necessarily cheaper than several bodies • There is a risk of over-regulation with a regulatory monopoly that has a captive market Source: Montreal Economic Institute, Media Release, “Should provincial securities commissions be replaced by a single national body?” (17 January 2008) at . Page 367 Business Application of the Law: Securities Class Actions Critical Analysis: What do you think is the purpose of the leave requirement? The leave requirement in class action lawsuits was demanded by corporate Canada to protect it from frivolous litigation. It was meant to keep shareholder class actions in Canada from becoming as common as class actions suits in the United Sates. The leave requirement has been criticized by plaintiff counsel as slowing a process that is time consuming. See Allison Martell, “Canada’s reformed class-action law wins few friends,” The Financial Post (20 July 2011) at . Page 368 Figure caption: What factors may account for the increase in Canadian securities class action lawsuits? The increase in Canadian securities class actions is probably due to a number of factors, such as (1) amendments to Securities Acts that introduced secondary market liability (see Business and Legislation: Securities Legislation and Secondary Market Liability, page 369), (2) amendments to class proceedings legislation that has made it easier to commence a class action, (3) the increase in the number of law firms specializing in this area, and (4) the global downturn. See Donalee Moulton, “Number of securities class actions sets new record,” The Lawyers Weekly (3 April 2009) 1. Page 369 Business and Legislation: Securities Legislation and Secondary Market Liability Critical Analysis: How do the amendments enhance investor protection? Do the amendments do enough for investors? Amendments enhance investment protection in a number of ways. First, the amendments create a new statutory cause of action for investors in the secondary market who suffer damage from misleading disclosure. Previously, an investor had only statutory recourse for misrepresentations made by an issuer in the prospectus when the investor purchased in the primary market. Second, by no longer requiring a plaintiff to show that there was reliance on the misrepresentation or failure to disclose in making their trading decision, a significant obstacle to the certification of a class action is removed. Courts are less likely to allow lawsuits to proceed as class actions if there are issues, such as reliance, that are not common to the group. It is debatable whether or not the amendments do enough for investors. On the one hand, they have made it much easier to sue, but on the other hand, the legislation may not provide full compensation for an investor’s losses because of limitations on liability provisions. Page 371 Ethical Considerations: Bre-X Minerals: The Final Chapter Critical Analysis: After the dismissal of the remaining class actions, lawyer Clint Docken who represented some of the investors stated, “It’s a sad day…We have arguably Canada’s largest (ever) fraud and no accountability. There’s no criminal accountability, there’s no regulatory accountability and (now) there doesn’t appear to be any civil liability.” What factors do you think contributed to the lack of accountability? [footnote deleted] A number of factors could be discussed: • Prosecution for insider trading is difficult because of a lack of evidence particularly non-circumstantial evidence. There are often no witnesses, no written documents, and events may have occurred in another country. In addition, the burden of proof is beyond a reasonable doubt when securities commissions elect to deal with insider trading in a court as opposed to in front of a panel of commissioners. Courts are preferred because of the seriousness of the charges and the potential for a prison sentence as punishment. • Lack of a national securities regulator to protect investors and ensure market integrity. • As there was no realistic prospect of realizing any significant recovery through litigation and as the costs of litigation were prohibitive, the parties gave up on legal action Sources: “Bre-X scam exposes weakness,” Winnipeg Free Press (17 June 2014) online: Winnipeg Free Press ; Madhavi Acharya & Tom Yew, “Bitter investors still looking for answers,” The Star.com (2 August 2007) online: The Star.com . Instructor Manual for Canadian Business and the Law Philip King, Dorothy Duplessis, Shannon O'byrne 9780176570323, 9780176509651, 9780176501624, 9780176795085
