Business Law Test 3 Prep PDF

A Real Estate Transaction and Associated Documents: A Real Estate Transaction: ​ $165,000 townhouse in Blacksburg ​ Owners: Paul H. Smith (recently deceased) with 2 sons (John and David) that will receive the townhouse under the Will. John Smith was named executor. ​ Buyers: Susan a...

A Real Estate Transaction and Associated Documents: A Real Estate Transaction: ​ $165,000 townhouse in Blacksburg ​ Owners: Paul H. Smith (recently deceased) with 2 sons (John and David) that will receive the townhouse under the Will. John Smith was named executor. ​ Buyers: Susan and Edward Taylor ○​ Down payment: $100.00 ○​ Loan: NONE–all cash deal ​ Close on March 21, 2022 ​ Special instructions: buyers will pay all closing costs Important Questions in any Transaction: ​ How does a Buyer actually know that the Seller owns the property? ​ What problems can exist if the Seller has debts or liens? ​ How are old liens or judgments eliminated? ​ Good and Marketable Title ​ How does the Lender/Bank protect the loan made to the Purchaser? ​ Note and Deed of Trust Key Documents in a Real Estate Transaction: 1) Contract 2) Deed 3) Promissory Note 4) Deed of Trust 5) Settlement Statement Initial Stage: 1)Contract– the contract is the first document that is prepared and signed by the Buyer and Seller. The contract will describe the property, cite the sales price, note if the Buyers will get a loan, closing date and any other terms. ​ The contract is usually subject to significant negotiation between the parties over several days or weeks, depending on the market. At Closing: 2)Deed– the document that is evidence of the real estate being transferred from the Seller to the Buyer. The Deed needs to be recorded. 3)Promissory Note– the document that is evidence of the loan from the bank to the Buyer. It will recite the amount borrowed, the interest rate, how and when loan is to be paid back, penalties and remedies to the lender if the Buyer goes into default. 4)Deed of Trust– the document that recites the Promissory Note and the real estate that is purchased. The Deed of Trust is what makes the real estate purchased act as the collateral for the promissory note. (in some states called a mortgage). The Deed of Trust needs to be recorded. 5)Settlement Statement– the document that shows how the money moves between all the parties and players in the real estate transaction. Typical Closing Fees and Costs: ​ Title Examination ​ Attorney’s fees ​ Deed preparation ​ Deed of Trust ​ Other Docs ​ Closing fee ​ Title Insurance ​ Real Estate Taxes ​ Montgomery County ​ Town of Blacksburg ​ Note taxes are pro rated ​ Inspection Pro Rating the Real Estate Taxes: ​ Taxes are usually due June 30 and December 30 of each year ​ In order to pro-rate the taxes, first determine the day of Closing. ○​ March 21, 2022, in the example ​ Calculate the number of days each party will own the real estate ​ These figures are then added to the Settlement Statement Real Estate Commissions: ​ 1 Agent v. 2 Agents: ​ 1 Agent:  ○​ The typical commission for a residential property is 6% ○​ So: Joe a Real Estate Agent lists a property for sale for $500,000.00. Joe sells the property to the Smith family who do not use an agent. Joe collects a commission of $30,000 ($500,000 x 6%) ​ 2 Agents: ○​ If the Buyer also has a real estate agent, then the two agents will typically split the commission and take 3% each. Secured Transactions: ​ Secured Transactions are about loans, collateral and how the lender protects his loan. ​ The loans relating to secured transactions involve personal property as collateral. ​ As opposed to the collateral for Deeds of Trust that involve real property as collateral. If the collateral is – ○​ Land, house, building any real property– the loan is “secured” by a Deed of Trust ○​ Personal property (car, machine, inventory)– the loan is “secured” by a Security Agreement Basic Vocabulary for Secured Transactions: 1)Security Interest– means an interest or a right to personal property or fixtures that secures the performance of some obligation. ​ Example: Amy purchases a car for $25,000. The dealership agrees to loan her the $25,000 at 6% interest. She agrees to pay $483.00 per month for 5 years. Even though she drives away with the car, before she does, she will sign a security agreement establishing that the dealership retains a security interest in the car and has certain rights if Amy doesn’t pay, such as re-possessing the vehicle. 2)Secured Party- the person or entity that holds the security interest. In the above example, the car dealership is the secured party. 3)Debtor or Obligor- the person that borrows the money and grants a security interest in property. In the above example, Amy is the debtor/obligor. 4)Collateral– the personal property that is subject to the security interest. In the above example, the vehicle is the collateral. 5)Fixtures– personal property that has been attached to real estate. Examples include a heat pump, an elevator, an electrical fuse box. It is important to determine if property is a fixture or not so that one knows how to secure it. 6)Security Agreement– the contract between the debtor gives a security interest to the secured party (usually the lender) to protect the secured party’s rights in the collateral 7)Perfection– a series of steps that the secured party must make to protect its rights to the collateral against others. This is important because often the debtor may owe multiple parties and when the debtor does not pay, there will often be a dispute over the collateral between creditors.This is a very important concept! 8)Financing Statement- a document that the secured party files that gives notice to the general public that there is a security interest in the collateral. Usually filed in the courthouse. 9)Recording– this refers to the secured party having the security agreement or financing statement registered or filed with the court. By doing this, the secured party gives notice that there is a security interest in the collateral. 10)Default– this is the situation when the debtor fails to pay or otherwise abide by the promise made to the secured party. Most common example is the obligation to make monthly payments. Also, the failure of any term of the security agreement, such as having the collateral insured. 11)Repossession– when the debtor is in default, the secured party has the right to take the collateral. This is known as “repossessing” the property. It is an option of the lender/secured party that is usually set out in the security agreement. Collateral in Personal Property Includes Many Things: You may use all of the following as collateral, and more: 1) Stock certificates 2) Checks 3) Titles (such as for a car or a boat) 4) Accounts receivable 5) Tort claims 6) Other goods a) Consumer goods b) Farm products (crops, livestock) c) Inventory d) Equipment (used in running a business) 7) Software How does a Lender or Other Party Attach a Security Interest? REQUIREMENTS: 1. There must be a security agreement ​ Security Agreement -the security agreement must include the name of the parties, the collateral involved with specificity (serial number, etc), price, monthly payments, interest rate, grant security interest to Seller/Lender etc., provide remedy (repossession) for breach. ​ Example: Home Depot sells a riding lawnmower (ser no. 12345678) to Cutter for $7,000. Cutter will pay $225.87/month for 36 months, interest rate 10%, HD retains a security interest in the mower and if Cutter misses two payments, HD can repossess. 2. The debtor has authenticated the security agreement OR The Lender has possession of the collateral ​ The Debtor Authenticates or Secured Party Possesses -In the example above, if Cutter signs the agreement he has authenticated. If Cutter does not authenticate the agreement, Secured party must possess. ​ Example: In the above example since Cutter is purchasing the mower in order to use it, it makes no sense for HD to possess the mower. Therefore, HD will insist that Cutter sign or “authenticate” the security agreement.  ○​ What kind of collateral might the Secured party choose to possess? 3. The Secured party has given value to obtain the agreement ​ The Secured Party Must have Given Value- There must be some value given. ​ If a bank loans $1,000,000 to a small business, the money is the value. ​ If a ski manufacturer delivers 500 sets of skis to a merchant for a small down payment and monthly payments, the skis are the value.4. The Debtor has rights in the collateral ​ The Debtor must have Rights in the Collateral- Ordinarily the Debtor has purchased the collateral so he/she obviously has rights to the collateral. ​ There are examples where an entity holding property as a bailment uses the property as collateral. Even though this would be unethical, it would technically satisfy the rights in the collateral requirement. ​ Don’t worry about the bizarre, extraordinary or rare situations. Attachment: ​ So, if the secured party goes through these steps to make sure that his Security Agreement has ATTACHED to the collateral, what does that really mean?? ​ How does the ATTACHMENT help the secured party??? ​ It means that the Secured Party will have remedies (primarily repossession) against the Debtor. ​ So, Attachment gives rights against the Debtor. ​ But what if there are multiple parties in addition to the debtor?? ○​ Example: Acme Furniture Manufacturer makes 500 desks and sells them to James River Furniture. James River buys the desks for $1,000 each. James River pays $50,000 down payment and finances $495,000 over 5 years at 6% interest. James River takes possession and puts them in their retail stores for sale. ○​ Blacksburg Library buys 100 desks for $1,500 each and pay $10,000 in cash to James River at 3% interest over 2 years. The 100 desks are delivered to the library. ○​ James River sells 200 desks for $1,500 each to on same terms to Stonehenge Apartments. Stonehenge only takes possession of half the desks and plans to take the other half in 6 months. ○​ Three months later, James River goes bankrupt. ​ Acme Furniture is still owed well over $400,000. ​ Can they repossess the 200 desks left at James River? ​ Can they make Blacksburg Library return their desks? ​ Can they make Stonehenge return the portion of the desks that they took? ​ In order to put Acme Manufacturer in the best position against the other companies, Acme will want to Perfect their security interest in the original 500 desks. ​ Perfection involves taking certain actions and often involves giving notice in some way to others who may potentially acquire an interest in the collateral. ​ There are 4 ways to perfect a security interest: ○​ 1) Perfection by filing ​ Perfection by Filing- The most common way to prefect the security interest in collateral is to file with the local authority where the collateral is found (The local authority is usually the Clerk’s Office of the Court of Record). ​ In Virginia, file with the Clerk’s Office of the Circuit Court ​ A filing is valid for 5 years but may be renewed indefinitely as long as it is refiled before the current 5-year period ends ​ Filing must include the obvious: ​ 1) Name, address, Tax ID, other relevant contact info of Debtor ​ 2) Name, address, etc of Secured Party ​ 3) Clear and complete description of the collateral ​ 4) Titles or Parties designation? Special collateral? Fixtures? ​ Filing is the only method to perfect a security interest in accounts or general intangibles ​ What is the benefit of Filing? How does this form of Perfection Work? ​ Example: ABC Corp. in NY manufactures vinyl siding for homes. XYZ Construction in VA needs 100,000 square feet of siding to build 30 homes. ABC and XYZ agree on a price of $2 mil with XYZ paying $100k down and financing $1.9 mil over 3 years at 8%. ​ Before ABC delivers the siding to XYZ in VA and XYZ pays $100,000 down. ○​ What is the first thing ABC should do? ○​ What is the second thing ABC should do? ​ ABC Corp should: ○​ 1) Execute a Security Agreement making sure that it attaches to the vinyl siding collateral. ○​ 2)Perfect the security interest with a Financing Statement and file it with the Clerk’s Office in Virginia (and perhaps elsewhere). ​ What effect do these two actions have? ○​ By executing the Security Agreement, ABC has superior rights to the collateral over XYZ. ○​ By perfecting the Security Agreement, ABC has superior rights to the collateral over everybody else. ​ Same Example, but after the security agreement is signed, but before ABC files anything, XYZ borrows $50k from New Horizon Inc. New Horizon would not loan the money without some collateral, so XYZ offers the warehouse of newly delivered vinyl siding. ​ New Horizon executes a security agreement with XYZ and rushes down to the Courthouse to quickly file a financing statement in the VA courthouse.  ​ XYZ goes bankrupt, defaults on the loans to ABC and New Horizons ○​ Between ABC and New Horizons, who gets the collateral? ​ Even though ABC loaned the money first and had a security agreement, New Horizons, who had the security agreement second, perfected first by filing. So New Horizons takes the collateral. ​ How could ABC have won? ○​ By going the next step and Perfecting the Security Interest by filing ○​ 2) Perfection by possession/control ​ A Creditor may perfect his security interest by simply possessing the collateral Examples include a diamond ring or shares of stock. ​ Possession by one creditor would obviously give notice to other potential creditors that collateral is subject to some kind of lien, if it is held by another. ​ Possession allows the creditor to make sure the collateral is protected and not subject to misuse, damage or loss. ​ Possession allows for immediate repossession if debtor defaults. ​ The main drawback is that possession by the creditor is not practical in many situations because the debtor is ordinarily borrowing the money to buy and use the collateral ​ A Creditor that perfects a security interest in collateral by possessing the collateral has a duty to use reasonable care to keep it safe from harm. ○​ 3) Perfection of consumer goods ​ Consumer Goods are goods used primarily for personal, family or household purposes. ​ Purchase Money Security Interest (PMSI) are created when: ​ A merchant sells consumer goods (the collateral) on credit to a debtor OR a lender loans money to a consumer to purchase consumer goods ​ IN these situations, once the security interest is established it is Automatically Perfected ​ Example: Susan wants to purchase a new TV and entertainment center. Best Buy has the electronics she wants for $1,000. Best Buy sells her the merchandise for $100 down and $100/mo for 9 months. Susan signs a security agreement with Best Buy, but it is never filed in the Clerks Ofc of the courthouse. Susan then borrows $500 from her brother and tells him the electronics are collateral. Susan dies. Who gets the electronics? ​ Best Buy gets the electronics even though they did not perfect by filing. ​ Because the agreement with Susan was for consumer goods and the loan was to purchase those goods, it constituted a purchase money security interest and therefore automatically perfected  ​ Same Facts, except Susan purchased a large display cabinet for her business. ​ Since the display cabinet would ordinarily not be considered a consumer good, the deal with Best Buy would NOT involve a purchase money security interest. ​ What should Best Buy do in this case? ​ File a financing statement to perfect. ​ When in doubt if you have a PMSI, simply file. ○​ 4) Perfection of movable collateral and fixtures ​ Movable Goods– what happens when a security interest is perfected in one state and the collateral is moved to another state? ​ The general rule is that the perfected security interest in the first state is valid against the collateral in the new state for a period of 4 months after the debtor moves to another state, or for a period of 1 year after the collateral is moved to another state ​ Motor Vehicles and the Like– cars, trucks, boats, motorcycles, farm tractors ​ When these types of items are used as collateral, because they are so easily movable and not ordinarily subject to possession by the creditor, special rules are in effect. ​ In most states, to prefect a security interest in a motor vehicle, the security interest or lien must be noted directly on the title ​ Fixtures:– the law on perfecting security interests in fixtures is complex and if you find yourself in such dispute about a fixture as collateral, consult an attorney. ​ Example: James owns a house that he purchased a year ago valued at $500,000 which he financed and still has a balance of $475,000. James bought an expensive generator to power the house if he loses electricity. He paid $50,000 for the generator and financed it with the hardware store and still owes $48,000. The generator required a cement pad to be mounted to by 25 steel bolts and is wired directly into the electrical system of the house. James dies and has no assets in his estate to pay any of his outstanding debts. The hardware store goes to repossess the generator. The Bank that loaned the money for the house objects and takes the position that the generator is a fixture to the real estate and subject to the Deed of Trust that was recorded a year prior to the purchase of the generator. What happens????? ​ In this example on fixture, the Courts will consider many factors, but primarily: ​ 1) When was the security interest in the generator created. Was it at the time of purchase before taken to the home? or was security interest established after it was affixed to the property?  ​ 2) What is the status of real estate? Does the debtor for the generator also have an interest in the real estate? (In this case yes) But not in all cases. ​ 3) What was recorded first? The Deed of Trust on the home? or the personal property (generator)? Was it a PMSI? ​ 4) The physical status of the fixture. Is it easy to remove without damaging the real estate? Priority Among Creditors: ​ What happens if multiple creditors have security interests in the same collateral? ​ Usually this happens when the debtor is unable to pay everyone or even anyone. ​ The party that has priority gets the collateral. ​ How do we determine which creditor has priority? ​ Apply these General Rules in determining PRIORITY among creditors: ○​ 1) A party with a perfected security interest takes priority over a party without a perfected security interest. ○​ 2) If both parties have perfected security interests, the first party to file or otherwise perfect, takes priority. ○​ 3) If neither party is perfected, then the first party to attach their security interest to the collateral. ​ What about priority between one party that has perfected by possession or control and a second creditor that has perfected by filing? ​ In this situation, the party that has possession or control has priority. ​ Even if the creditor that filed had filed before the other creditor took possession. Buyers: ​ What about Buyers? How does the law treat innocent buyers that may purchase something in good faith, fully pay the price, and find out later that what they purchased was secured by a creditor? ​ What if that creditor had attached their security interest and it was properly perfected as well? Buyers in the Ordinary Course of Business (BIOC): ​ A buyer in the ordinary course of business buys goods in good faith from a seller who routinely deals in such goods ​ A Buyer in the Ordinary Course of Business will take goods free of a security interest created by its seller even though the security interest is perfected. Buyers of Consumer Goods: ​ Buyers of consumer goods from a debtor-seller take free of a security interest if the buyer is: ○​ a) Not aware of the security interest ○​ b) Pays value for the goods, ○​ c) is buying for his own family or household use  ​ This can get complicated when there is a PMSI on the other side. ○​ Again, get an attorney ​ Just remember that in certain circumstances, the innocent buyer may have rights that supersede the perfected security interests of a lender. Negotiable Instruments: Some Terminology: ​ Commercial Paper– is a contract to pay money. It can be used in 2 ways: ○​ a) As a substitute for money – such as a check. When a check is written and delivered, it is a promise to pay the amount on the check ○​ b) As a loan of money – such as a promissory note. Such a document is a promise to pay the amount, perhaps with interest, over a period of time. ​ Instrument – is a written document. ​ Negotiable– means that the instrument is freely transferable in the marketplace. ​ Maker– the person or entity that makes the promise to pay by instrument. ​ Payee– the person or entity that the promise to pay is made. ​ Promissory Note– is an instrument that has a maker and a payee. ​ Due Date– the date that the payment is due and legally required to be paid. ​ Payable on Demand– an instrument without a specific due date but that must be paid upon demand of the payee. ​ Certificate of Deposit(CD) – a note made by a bank to an investor with a due date in the future. This is different than a simple deposit by a customer that may withdraw their funds at any time. ​ Draft– is an order directing someone else (such as a bank) to pay money. The most common example is a check ​ Drawer– is the person that order the payment. ​ Drawee– the person or entity that is ordered to pay ​ Payee– the entity that is paid by the drawee on behalf of the drawer ○​ Example: Jason goes the Virginia Tech bookstore and finds 3 books that he needs for his class. He goes to check out and is told the three books cost $259.00. Jason has a checking account with Wells Fargo, and he writes a check on his bank account in the amount of $259.00 to the Virginia Tech bookstore to pay for the books. In this example: ​ Jason is the Drawer ​ Wells Fargo is the Drawee ​ Virginia Tech is the Payee ​ The check itself is Draft Checks: ​ Check– a draft that is an order to a bank to pay money to another. ​ Cashier’s Check– a draft that is drawn on a bank by the bank itself, but at the direction of the account holder.  ○​ Examples: James draft above directing his bank to pay Virginia Tech for the books is a check. If James wants to buy a car for $30,000.00, the dealership may not accept his check. Even though the check is a promise, the dealership may not be convinced that James has $30,000.00 in his checking account to cover the check. So, James goes to his branch of Wells Fargo and asks for a cashier’s check ○​ A cashier’s check is a special type of check that is drawn by the bank on the bank. In this instance the bank is the drawer and the drawee. James tells the bank the amount and to whom it is to be paid. Wells Fargo then prints out a check to the dealership in the amount of $30,000.00, that a representative of the bank has signed and gives the check to James. James then delivers the cashier’s check to the dealership. ○​ The dealership accepts the cashier’s check because since it is drawn by the bank it is guaranteed that the funds are present to cover the $30,000.00. In fact, the funds are removed from James’ account at the time the cashier’s check is made. The Basic Rule of Commercial Paper: ​ The possessor of a piece of commercial paper has an unconditional right to be paid so long as: ○​ 1) The paper is negotiated ○​ 2) The paper has been negotiated to the possessor ○​ 3) The possessor is a holder in due course ○​ 4) The issuer can not claim a limited number of “real” defenses What does it mean to be Negotiated? What is negotiability? ​ It is an instrument that may be freely transferable in the marketplace. ​ What are the requirements for an instrument to be negotiable? ○​ 1) The instrument must be in writing. There is no such thing as an oral negotiable instrument. But the writing does not have to be anything fancy or formal. Remember the napkin that satisfied the statute of frauds? Same concept here. ○​ 2) The instrument must be signed by maker or drawer. It may be the drawer’s name signed in the traditional cursive, or it may be simply a symbol, logo or mark made with the intent to indicate a signature. ○​ 3) The instrument must contain an unconditional promise or order to pay. The instrument may not contain any conditions. ​ For example, a note that says, “I will pay Lucy $5,000.00 for the refrigerator as long as the icemaker produces at least 3 gallons of ice per hour.” This is not negotiable because it has a condition. “I promise to pay Lucy $5,000.00 for the refrigerator” is a negotiable instrument. ​ There also must be an order to pay. Simply writing “I owe Lucy $5,000.00” is not negotiable because there is no order. If it said “I will pay Lucy $5,000.00” then that is negotiable.  ○​ 4) The instrument must state a definite amount of money and the amount must be located in the “four corners” of the instrument ​ What about these? ​ “I promise to pay what I owe Edward Johnson” ​ “I promise to pay one thousand five hundred dollars.” ​ “I promise to pay the amount due and listed in the sales contract dated 1/6/23.” ​ “I promise to pay $10,000.00 in gold.” ​ One exception to the definiteness is with respect to interest rates. The note may cite “with interest at 1% above the prime rate as of 10/24/23.” OR it may simply list the interest rate to be used in calculating the amount due. ○​ 5) The instrument must be payable “on demand” or at a definite time ​ The instrument must have a date that the payment is due OR it must state that it is payable “on demand” which means that it is payable whenever the payee requests (demands) payment. ​ What if an undated instrument says, “payable in 90 days” ? ​ What if a dated instrument says, “payable in 90 days” ? ​ What if the instrument is a check to VT that says, “payable when Professor Calico is no longer teaching” ? ​ What if the instrument is simply signed with no due date? ​ What if the instrument says, “payable 5 days after Thanksgiving 2023” ○​ 6) The instrument must be payable to order or to bearer ​ “Pay to the Order of James Wilson” means to pay James Wilson or his designate. The instrument may NOT say “Pay to James Wilson” Why not? ​ If the Note says “Pay to James Wilson” that means that James Wilson is the only person that can receive payment. If James Wilson is the only person that can receive payment, then it is NOT Negotiable. ​ If the instrument says “Pay to Bearer” that means pay to whoever possesses or “bears” the note. “Bearer” instruments: ​ Examples relating to “Bearer” instruments: ○​ “To Bearer” ○​ “Pay to the Order of Cash” ○​ “Pay to the Order of Happy Birthday” ○​ “Pay to the Order of ____________________________” How do Courts interpret ambiguous terms? ​ 1) Words win over numbers  ○​ Example: A check has amounts of $15.00 and Fifteen Thousand Dollars In this case the words win, and check is for $15,000.00 ​ 2) Handwritten terms win over typed and printed terms ​ 3) Typed terms win over printed terms ​ What if the interest rate is left blank? It does not mean 0% Courts will apply “the legal rate” The legal rate is the rate that Courts apply to court ordered judgments. It is set by the legislature and may change from time to time. Currently the legal rate in Virginia is 6%. It is found in Code 6.1-302 How Does One Negotiate and Instrument? ​ Remember to be negotiated the instrument has to be transferred to the holder by someone other than the issuer. ​ Example: Mike writes a check that says “Pay to the Order of Susan” Susan then signs the back of the check and gives to Edward. This is a negotiated instrument because it was transferred to the holder by someone other than Mike. ​ In this example we also learn how this type of check is negotiated: ○​ If Susan wants to negotiate this instrument, she has to ​ 1) Sign the instrument AND ​ 2) Deliver the instrument to another ○​ So “Pay to the Order of X” instruments must be signed and delivered How does one Negotiate Bearer instruments? ​ Remember bearer instruments are good to whoever possesses (bears). Thus, the only requirement for negotiation of bearer instruments is delivery ​ Example: Mike writes a promissory note for $5,000 “TO Bearer” and gives it to Susan. Susan owes Edward so she simply delivers the promissory note to Edward. The note has been properly Negotiated and now Mike must pay Edward. Holder In Due Course: ​ The Final Requirement to be Negotiable is that the recipient of the instrument must be a Holder In Due Course. (in above examples we assumed they were). ​ What is a holder in due course? ○​ 1) Must be a holder, i.e. must possess the instrument ​ A Holder– for Order instruments or Order paper, a holder is anyone that is in possession of the document if the document is made out to them. ​ Example: If Anthony holds a note that is payable to the Order of Anthony, he is a holder ​ Example: If the instrument is bearer paper, a holder is anyone in possession ○​ 2) Must have given value for the instrument ​ For Value– a holder in due course must give some value for the instrument. Value in this situation means that the holder has already done something for the instrument. If the note requires a future act, then the  holder has NOT given value and the person in possession is NOT a holder in due course. ○​ 3) In good faith ​ In Good Faith– to be a holder in due course, the possessor must have taken the instrument in good faith. To determine whether there has been good faith there are two tests – and the possessor must meet BOTH of the tests: ​ Subjective Test– Did the holder believe the transaction was honest in fact? ​ Objective Test– Did the transaction appear to be commercially reasonable? ○​ Example: James offered to sell Steven 100 bottles of miracle cure that would allow bald men to grow hair. The price was $100 per bottle. Steven gave James a note for $10,000. James then sold the $10,000 note to Reggie for $2,000. James never delivered the bottles. Reggie then asked for payment of the $2,000 from Steven. Steven declined payment claiming that Reggie was not a holder in due course because he did not meet the test of purchasing the note in good faith. What happens? ○​ The Courts would likely side with Steven and not require that he pay Reggie. ○​ Subjective Test– was it reasonable for Reggie to believe that such a transaction of selling a miracle hair growth product for $100/bottle was honest in fact? Probably Not. ○​ Objective Test– does the transaction appear to be commercially reasonable? No. To sell at $10,000 note for only $2,000 is suspect on its face. To discount a note by 80% would not be commercially reasonable in most circumstances. If the note had been discounted from $10,000 to $9,750 or $9,500 that would be more appropriate or commercially reasonable. Ask yourself, does this seem fishy? Is this too good to be true? Is there any reason to suspect that something is going on or something is wrong with this? ○​ 4) Without Notice ​ Without Notice - The last requirement to be a Holder in Due Course is that the person in possession must take the note without notice of any defects (This is somewhat similar to the “good faith” requirement just discussed) ​ There are four common defects that would establish Notice of a Defect: ​ a) The instrument is overdue ○​ – if the instrument has a due date that has passed, the recipient should be suspect, and this would ordinarily be notice of a defect  ​ b) The instrument has been dishonored ○​ To dishonor a note is to refuse to pay. If the possessor of the instrument is aware that the issuer has refused to pay this is an obvious defect. ​ c) The instrument is altered, forged or incomplete. Markings, erasures, anything that appears to be suspect to a reasonable person may give notice that the instrument has a defect. Use your common sense here. ​ d) The possessor has notice of claims and disputes. If the holder knows that the issuer has been sued by a previous holder or that there is simply a dispute involved, this will constitute notice of a defect. Agency Law: ​ Agency Law: Agency Law deals with the rights and responsibilities that are created when one acts on behalf of another. It also deals with whether or not an agency relationship exists. ​ Basic terminology: ○​ Principal– is the person that has another person acting for them ○​ Agent– is the person that is acting for someone else What is required to create an Agency relationship? ​ 1) A principal ​ 2) An agent ​ 3) The parties mutually agree that the agent will act on behalf of the principal ​ 4) The agent will be subject to the principal’s control ​ 5) Thus, creating a fiduciary relationship Consent: ​ Consent– same as with contract law, it is an agreement for the agent to act on behalf of the principal. Bob agrees to walk Sharon’s dog. ​ Terry drove down the highway and struck a vehicle that has been stalled on the side of the highway. The crash killed the owner of the broken-down car. Terry called his lawyer Dave and asked what to do. Dave told Terry to meet him at the hospital and give a sample of his blood. Terry and Dave met, and Terry gave the sample. Although the test results showed that there was no alcohol in his system, it did show high levels of cocaine. The prosecutor charged Terry with manslaughter and sought to introduce the test results at trial. Dave argued that the hospital was his agent, and the attorney client privilege prevented the prosecutor from using the test results at trial. ​ The court held that the hospital had not consented to an agency relationship and therefore was not an agent of the attorney and client. Therefore, the prosecutor could use the test results at trial. Terry was convicted.  ​ Control– the principal exercises control over the agent. As a result, the principal is responsible or liable for the acts of the agent. If there is no control, then there is no agency relationship. ​ Fiduciary Relationship– a fiduciary relationship is based on trust. The beneficiary places confidence in the fiduciary who is obliged to act in good faith and do what is in the best interest of the beneficiary. The fiduciary can not act in his own best interest over that of his beneficiary. ○​ An agent has a fiduciary duty to his Principal. What is NOT required for an Agency Relationship: ​ 1)Written Agreement– an agency relationship does not have to have a written agreement to be binding. Virtually all agency relationships may be oral agreements. There is, however, one exception: equal dignities rule– this rule applies when the agency relationship is to perform a task that must be in writing. In such a situation, the agency relationship must also be in writing. Thus “equal dignities.” ○​ Example: Theo wants to sell a piece of real estate to Winston. They sign a contract and set a closing date of November 1. Winston then finds out that the bank will lend the money until all of his application is complete and that will take three weeks. So, the closing date for the transaction is pushed back to November 24. Theo will be out of town on that date, so he has his friend Anthony act as his agent to appear at the closing and sign the Deed conveying the property to Winston. Since the statue of frauds requires that the real estate transaction be in writing, then the agency relationship for Anthony to be Theo’s agent must also be in writing under the equal dignities rule. ​ 2)Formal Agreement– as we learned above the agency relationship does not ordinarily require a written agreement, it also does not ordinarily require even a formal agreement. ○​ The principal and agent need not formally agree to the relationship. They do not even have to ever use the words “agent,” “agency,” or “principal.” The law only requires that they act like a principal and agent ​ 3)Compensation– the last area that is not required to be an agency relationship is compensation. There is no requirement that the agent be paid. As you will recognize, this is very different from contract law which would require consideration. In the agency relationship no money need pass hands. Agency relationships establish duties between Principals and Agents: Duties that the Agent has to the Principal ​ 1) Duty of Loyalty ○​ Duty of Loyalty – an agent has a fiduciary duty to act loyally for the principal’s benefit in all matters related to the agency relationship. The agent may not engage in self dealing or act for his own benefit over the benefit of the principal. ○​ Example: Musician George Harrison had an agent, Allen Klein. Bright Tunes sued Harrison claiming that Harrison’s hit song My Sweet Lord violated the copyright of the song He’s So Fine by the Chiffons. Klein met with Bright Tunes on behalf of Harrison to negotiate a settlement. During the discussions, Bright  Tunes suggested that Harrison simply purchase the rights to the song He’s So Fine. ○​ During the negotiations, the agency contract between Harrison and Klein expired. Thereafter Klein purchased the rights to He’s So Fine for himself. ○​ After a trial, the Court found that Harrison owed 1.6 million for violating the copyright. Since Klein now owned the rights to the song, Harrison owed it to him. Harrison sued Klein for breach of his duty of loyalty as Harrison’s agent. ○​ The Duty of Loyalty that the Agent has to the Principal also includes: ​ a) Not secretly dealing with the Principal ​ b) Engaging in appropriate behavior ○​ Example: ABC Book Publishing company hires Sadie as their agent to find up and coming authors that they might sign to do their publishing. Sadie secretly has been working on her own book and wants to get it published. Under her duty of loyalty, Sadie can not “sign herself” to the publishing deal and bind ABC. ○​ After a long flight from NY to LA two flight attendants from Delta Airlines went to a bar. After two hours of heavy drinking, they climbed on top of the bar and did a strip tease where they took off their company uniforms. Did they violate their duty of loyalty to Delta by engaging in inappropriate behavior? ​ 2) Duty to Obey Instructions ○​ Duty to Obey Instructions - an agent must obey the instructions of the principal unless the principal directs her to do something illegal or unethical. ○​ Principal Paula directs her real estate agent Angie to call her if the Smiths accepted the offer to sell Paula’s property. Angie has a duty to do what Paula told her to do. ○​ If Paula told Angie to tell the Smith’s that the house had a brand-new roof, when they both know that the roof is old and it leaks, then Angie does not have to obey Paula’s instruction. ​ 3) Duty of Care ○​ Duty of Care– an agent has a duty to act with reasonable care under the circumstances. If the agent has special talents or skills, then the agent has to act with a higher standard in conformity with those skills. If the agent has no special skills, then there may be a lower standard of care. ​ 4) Duty to Provide Information ○​ Duty to Provide Information– the agent has a duty to provide any and all information that the principal may want to know that is in her possession. If the Smith’s made a counteroffer, then Angi has a duty to tell Paula. What Remedies does the principal have against the agent who fails in any of these duties? ​ a) Damages – the principal may due the agent for damages that were caused by the breach of the duty ​ b) Profits – if the agent breaches the duty of loyalty and personally gains due to the agency relationship, the principal may sue for those profits ​ c) Rescission – the principal may rescind or cancel a contract or agreement that the agent wrongfully entered. Duties of Principals to Agents: ​ 1) Duty to Compensate if required by the oral or written agreement ○​ Duty to Compensate the Agent is just that. The principal has to pay the agent for her work that is done a part of the agency relationship unless it is gratuitous agency ​ 2) Duty to Indemnify ○​ Duty to Indemnify– the principal has a duty to indemnify the agent for any reasonable expenses incurred by the agent as part of his duties. ○​ These expenses fall into 3 categories: ​ a) Ordinary expenses and damages– often this involves simply reimbursing the agent for costs paid. ​ Example: the agent drives to another state to consummate the sale of an automobile for the principal. The principal should reimburse the agent for his mileage. ​ b)Certain Tort claims to 3rd parties- principals have a duty to indemnify an agent against a 3rd party if the claim is based on the agent’s behavior and the agent did not realize he was committing a tort. ​ Example: William owns 7 of the 8 trailers that are on State Street. He hires Fred to clean out all of his trailers and take whatever is inside to the dump. William forgets to tell Fred that he doesn’t own the 8th trailer. Fred cleans out all 8 trailers and takes everything inside to the dump. When the owners of the 8th trailer return home from vacation and find an empty residence, they sue Fred. William has a duty to indemnify Fred for any losses sustained in the lawsuit. ​ c) Certain Contracts – the principal must indemnify the agent against 3rd parties as a result of entering into a contract on the principal’s behalf ​ Example: Carter wanted to purchase tennis racquets for his sporting goods store. He hired Donald to purchase 500 racquets from Wilson Corp.When the racquets arrived, they were made of wood instead of then modern-day graphite. Donald complained and Wilson said they thought he wanted old vintage racquets. Carter refused to pay, and Wilson Corp sued Donald on the contract. Donald lost the case and sued Carter. The Courts would hold that Carter owed a duty to Donald to indemnify him for his loss. ​ 3) Duty to Cooperate ○​ Duty to Cooperate– the principal has a duty to cooperate with the agent. That cooperation involves three main components: ​ a) The principal must furnish the agent with the opportunity to work ​ b) The principal can not unreasonably interfere with the agent’s ability to accomplish his task. ​ c) The principal must perform his part of the contract if any Principals Liability to 3rd Parties:  ​ Principals are ordinarily liable to 3rd parties for the acts of their agent whether the acts involve contracts or torts. ​ 1)Principals Liability for Contracts ○​ Principals are liable for contracts their agents enter into with 3rd parties provided ○​ (1) the agent had authority, OR (2) the principal ratified the contract. ○​ In order to consider liability, particularly whether the agent had “authority,” we must consider the different types of authority and the effect thereof. Authority: ​ Express Authority– the principal grants express authority by words or conduct that, reasonably interpreted causes the agent to believe the principal desires him to act on the principal’s behalf ​ Implied Authority– the agent’s authority to engage in a contract with a 3rd party includes any other acts that are reasonably necessary to accomplish it. The agent’s authority to do those other acts is implied. ​ Apparent Authority– the principal is liable to a 3rd party even when the agent does not have authority to engage in certain activity if the agent reasonably believes that the agent is authorized, or if it is apparent to the 3rd party. ​ Example:James was a stock-broker with Goldman Sachs. James gave a seminar at GS offices to a group of 50 potential investors. James handed out brochures listing certain investments that he recommended. One of the investments was a stock that was not registered, and that GS did not recommend or even follow. One of the potential investors signed up with James and purchased some of the unregistered stock. A short while later the stock crashed and lost all its value. The investor sued. The Courts would hold that GS, as the principal, was liable to the 3rd party even though James did not have the express or implied authority to sell the stock, but to the 3rd party, James had the apparent authority Principals Liability for Negligent Physical Torts: ​ Respondeat superior– let the master answer ​ General Rule: A principal is liable for physical torts negligently committed by an employee acting within the scope of his employment (in this instance we are using the “employee” as a substitute for “agent.”) ​ The issue of liability is determined based on the classification of the agent. ○​ Is the agent and Employee or an Independent Contractor ​ Whether an agent is an Employee, or an Independent Contractor will determine if the principal is liable to the 3rd party. ○​ If the agent is an EMPLOYEE, the principal IS LIABLE. ○​ If the agent is an INDEPENDENT CONTRACTOR, the principal is not. ​ So, the classification will determine liability. ​ How do Courts determine what class the agent is? ​ Courts will look to the amount of control the principal has over the agent. The more control, the more the agent is an employee. The less control the more likely the agent is an independent contractor.  ​ Courts will consider whether: ○​ 1) The principal supervises details of the work ○​ 2) The principal supplies the tools and place of work ○​ 3) The agent works full time for the principal ○​ 4) The agent receives a salary or hourly wages, not a fixed price for the job ○​ 5) The work is part of the regular business of the principal ○​ 6) The principal and agent believe they have an employer-employee relationship ○​ 7) The principal is in business Business Organizations Basic Types of Business Organizations: ​ 1) Sole Proprietorships ○​ Sole Proprietorships– involves only one person and the easiest to form. Once a person starts conducting business, there is a sole proprietorship. ​ No filing or registration required or charter to obtain from the state ​ No formal documents to prepare describing business operations, etc. ​ Tax “pass-through” meaning the business is not separately taxed ​ No shield or protection from liability, personal liability exists ​ 2) Partnerships ○​ a) General Partnerships ​ General Partnership– an unincorporated association of two or more co-owners who operate a business for profit. ​ Very easy formation. Actually, the default status for two or more people that do not know any better ​ Tax “pass-through” with profits reported on individual tax returns ​ Individual liability for debts and claims against the partnership even if the debt or claim was caused by another partner ​ Unless there is an agreement otherwise, the partners share equally the profits of the business ​ Unless there is an agreement otherwise, the partners share the management duties of the business ​ Raising capital is more difficult. Since not a corporation the business can not sell stock and must rely on the individual contributions of the partners ​ Partnership interests can not be transferred/sold, etc without the permission of the other partners ○​ b) Limited Liability Partnerships ​ Limited Liability Partnership– another form of partnership that maintains certain benefits but also limits the personal liability of the partners ​ Easy to form ​ Maintains the tax “pass-through” to individual partners and it is not taxed separately  ​ Partners are NOT liable for the debts and claims against partnership ​ Does require filings to create with the state ​ Regular filings required and ordinarily there is strict compliance required ​ Example: Joe and Bill form a limited liability partnership by filing all the required documents with the state. For the first two years they also file the annual reports and other docs required. The third year they do not and in the fourth year the partnership is sued by a third party. Because they were not in good status by failing to file, the Courts held that no limited liability partnership existed, and they were each personally liable. ​ 3) Corporations ○​ a) Class C Corporations ​ Corporations– a formal organization that is created (incorporated) by the state. General corporations are class C corporations. These organizations: ​ Corporations can be expensive to form and maintain ​ Their primary aspect is that there is NO LIABILITY to shareholders/owners of the corporation. The corporation itself may be liable for debts and claims, but not the owners. ​ The primary disadvantage of a class C corporation is that it is double taxed. The corporation is taxed on profits and when profits of the corporation are distributed to individual shareholders, it is taxed again ​ Transferability is relatively simple as owners can freely come and go simply by buying or selling shares of stock in the company ○​ b) Subchapter S Corporations ​ Subchapter S Corporations– sometimes simply called “S corps”. These types of corporations have the best of both worlds: ​ Individual shareholders/owners are NOT LIABLE for the debts or claims against the S corp, although the S corp is. Profits of the S corp do “pass-through” directly to the owner/shareholder and the S corp itself is not separately taxed ​ But there are limitations on who can form an S corp ○​ a) There is a limit of 100 shareholders ○​ b) There can only be one class of stock ○​ c) Shareholders must be individuals, estates, charities, pension funds or trusts and not partnerships or corporations ○​ d) All shareholders must be citizens of the US or entities located there ○​ e) All shareholders must agree the business is to be an S corp ○​ c) Closely Held Corporations  ​ Close Corporations– these corporations are designed to protect small business owners and are somewhat similar to S corps. ​ Typically has a small number (50 or less) of shareholders ​ There is usually protection of the minority shareholders. ​ Example: Since these corporations have few shareholders and little stock it is difficult if not impossible to sell the stock as there is no real market. It would be easy for the majority shareholder(s) to mistreat the minority. Therefore, close corporations usually require that the majority have a fiduciary duty to the minority. In addition, many also require that corporate action be done only on a unanimous vote ​ Ordinarily shareholders operate the business themselves ​ Transferability may require that existing shareholders be offered the first option to purchase shares of a shareholder that wants to sell ​ Often these corporations may operate without a formal Board of Directors and office holders ○​ d) Professional Corporations ​ Professional Corporations– also known as PCs, these organizations are still around but newer options may prove better for new formations. They are primarily used by groups such as doctors and lawyers that wanted to limit liability. ​ There is NO LIABILITY for the actions of other members of the corporation. ​ Example: four doctors form a professional corporation. Doctor 1 performs surgery on the wrong foot and the patient wants to sue. The patient has to sue the professional corporation and can not sue Doctors 2, 3 and 4. Unlike a partnership where Doctors 2, 3 and 4 would be liable for the malpractice of Doctor 1. ​ All shareholders must be members of the same profession. Thus, the four doctors are the only ones that can own stock. The executive director of the professional corporation (that is not a licensed doctor) can not. ​ Taxation of the professional corp and its shareholders is very complex ○​ e) Limited Liability Corporations ​ Limited Liability Company- this business form is the best of both worlds ​ Relatively new form of business first created in 1977 in Wyoming ​ Most other states established them in 1991 ​ Owners of the LLC have no personal liability, only the LLC ​ There is no double tax like a Class C corp, there is a “pass-through” ​ Very easy to create with little annual paperwork to maintain ​ But should have a well-planned operating agreement that addresses duties, percent ownership, transfer of interest, etc ​ Flexibility of ownership with other businesses having the option to be members of the LLC; example- a Class C corporation may be an owner of a LLC; a partnership may be an owner of an LLC, etc. ​ The duration of an LLC is perpetual unless the operating agreement provides otherwise ​ Limited Liability Companies – while one of the primary benefits of an LLC is that members are free of personal liability, there are a few situations that a Court may “pierce the corporate veil,” (allow for individual liability): ​ a) Failure to Observe Formalities – if the member does not observe the distinction between their individual status and the status of the LLC or if the member does not treat the LLC like a separate organization. ○​ Example: If an individual member enters into a contract with the LLC, they should put it in writing and observe all formalities. Otherwise, a Court may simply determine that the LLC is a mere shell and not really a separate entity ​ b) Commingling Assets – owners need to keep their personal accounts separate and distinct from the assets of the LLC. If a Court can not determine the owner, it will most likely pierce the corporate veil. ​ c) Inadequate Capitalization – if the owners of the LLC do not contribute enough money to the LLC to reasonably operate it, then the Court may require further contributions from the members. ​ d) Fraud – a Court will not allow a member to use the protection of an LLC as a shield against liability for their own wrongdoing. ○​ Example: Joe started a business in his garage selling plants. He formed an LLC with himself as the only member with an official address the same as his home address. Joe contact a nursery and bought $50,000 worth of plants to sell by paying $5,000 downpayment and financing the remainder with the nursery. The owner of the nursery had not taken Business Law and did not know to get a security interest in the plants. After a couple of months, Joe realized that selling plants was hard and nobody really liked the ones he was selling. But before Joe shut down the business, he purchased a new computer on credit for $2,000. Joe was the only employee of the business. Joe decided to shut down the business which had no money in the LLC accounts. ○​ The Nursery and the computer store both sue the Joe for the debts owed on the plants and the computer. Joe responds that the LLC bought the products and has not money, so there is nothing to get. The Nursery and the computer store claim that the Court should pierce the corporate veil and hold Joe personally responsible. ○​ What is the likely result? The Test Applied to Determine Whether to Pierce the Corporate Veil of an LLC:  ​ 1) Did the defendant (individual or owner) control the LLC? ​ 2) Did the defendant engage in improper conduct? ​ 3) As a result of the improper conduct, was the plaintiff (lender or creditor) unbale to collect from the LLC? ​ If the answer is YES to all three questions, the Court will likely pierce the corporate veil and determine that Joe is personally liable. ​ 4) Other ○​ a) Joint Ventures ​ Joint Ventures– a joint venture is simply a partnership for a limited purpose. The liability for taxes and debts is shared among the participants in the venture, like it were a partnership. ​ Once the venture is over, the business relationship ends ​ Often it is simply a partnership between two businesses that recognize they can profit by working with each other, without the need to actually merge. ​ The partners maintain their independence ○​ b) Franchises ​ Franchises– although not specifically a separate business formation, franchises are an important concept. There are over 750,000 franchised business outlets that employ almost 10,000,000 people. ​ A franchise combines the best of both worlds by allowing the franchisee to be a relatively independent owner with the advantage of working as part of an existing business. EX: a McDonalds franchise in a small town allows the franchisee to own and operate the day-to-day business with all the existing logos, food products, personnel policies, etc of a long- standing national corporation. The franchisee also receives a continuing level of support and national advertising from the franchisor. Most franchises have a detailed operating manual. ​ Some Drawbacks to a Franchise: ​ 1) Control – some franchisors exert fairly tight control over their franchisees that may interfere with the franchisee’s desire to be relatively independent. ​ 2) Cost – costs can be very high, especially at the beginning. ○​ a) Upfront costs are usually several thousand dollars at a minimum and over a million or more. ○​ McDonald’s franchisee applicants must have a minimum of $500,000 available in liquid assets and pay a $45,000 franchise fee. Those looking to launch a new McDonald’s franchise can expect to shell out between $1,314,500 and $2,306,500. Existing franchise operations can cost upwards of $1 million.  ○​ b) Royalty Fees are ordinarily required to be paid back to the franchisor as a percentage of gross sales. ○​ c) Supplies such as the food packaging, napkins, drink cups, etc, are often manufactured by the franchisor and the franchisee must purchase the products from them. ○​ d) Joint advertising. Also common is when the franchisor engages in national or regional advertising, the franchisee may be required to contribute to those costs and expenses. ○​ e) System Standards. In order to maintain a uniform look and modern image, franchisees are also ordinarily required to update their buildings and change furniture, counters, etc. which can cost substantial sums. ​ Legal Requirements for a Franchise: ​ The Federal Trade Commission has a Franchise Rule to protect would be franchisees. The rule requires that 14 calendar days before a franchise contract is signed or any money is paid to the franchisor, the franchisor must provide a copy of their Franchise Disclosure Document. This document sets out, at a minimum, the following: ○​ 1) History of the franchisor and its key executives ○​ 2) Litigation with franchisees ○​ 3) Bankruptcy filings by the company and its officers and directors ○​ 4) Costs to buy and operate the franchise ○​ 5) Restrictions, if any, on suppliers, products and customers ○​ 6) Territory that the franchisee may operate ○​ 7) Business continuity explaining what circumstances the franchisor can terminate the franchisee and the franchisee’s rights to renew or sell ○​ 8) Franchisor’s training program ○​ 9) Required advertising expenses ○​ 10) A list of current franchisees and those that have left in the prior 3 years ○​ 11) A report on prior owners of stores that the franchisor has reacquired ○​ 12) Earnings information is not required, but if disclosed, the franchisor must reveal the basis for this information ○​ 13) Audited financials for the franchisor ○​ 14) A sample set of the contracts that a franchisee is expected to sign ​ We will consider all of these forms of business organizations and discuss the advantages and disadvantages of each type. In our analysis we will focus on: ○​ 1) Ease or Difficulty of Formation ○​ 2) Tax Consequences ○​ 3) Liability of Owners ○​ 4) Length of Existence ○​ 5) Ease or Difficulty of Transfer