BUSINESS LAW-MGMT 108

GROUP PROBLEM #2 (part 2) -WINTER 2015

Instructions:
Please provide a complete explanation to ONLY questions 6-10 below. Your responses should be no
more than a total of 1 typed page, single spaced, 11 point font, 1 inch margins, using WORD, not
PDF. You may only discuss the answers to these questions with the members of your group. Please
submit your response prior to class on March 12, in the dropbox at CCLE. Points will be deducted for
not following these instructions.
Shady characters, Inc. is a wholesaler in masks and magic supplies. Shady borrowed $100,000
from Regional bank on June 1 to be used as working capital. Shady duly executed and delivered to
Regional bank a promissory note and security agreement covering Shady's present inventory, proceeds
and after-acquired inventory as well as Shady's equipment, both current and after-acquired. Regional
bank immediately properly filed a UCC-1 Financing Statement covering the transaction on June 2, 2010
In an effort to generate more working capital, Shady borrowed $50,000 from Downtown bank,
using its accounts receivable as collateral to secure the loan. Shady executed a promissory note and
security agreement covering the accounts receivable. Downtown bank properly filed a UCC-1 Financing
Statement on July 1, 2010.
Shortly thereafter, Sam, owner of Shady, approached Monster, Inc. and purchased $10,000 worth
of masks on credit, giving monster a security interest in the masks to secure payment of the purchase
price by signing a promissory note and security agreement. Monster made delivery on August 15 and
had filed a UCC-1 financing statement on August 14. Later that same day one of Shadys favorite
customers, a retail store named Bewitched purchased 200 masks for Halloween for $500.00 cash.
On May 15, 2010 Shady was filed a petition under Chapter 7 of the Bankruptcy Code. Assume
Regional bank's claim remains totally unpaid. Regional bank asserts a security interest in all inventory
and equipment on hand as well as the accounts receivable being used to secure the loan with Downtown
bank. Each question is worth 5 points.
1. Discuss whether Regional has priority over:
(a) Monster with regard to Shadys inventory of masks; and
(b) Bewitched with regard to the masks it purchased on August 16th.

2. Robert executed a valid promissory note and security agreement with First Time Bank covering
Robert's new purchase of machinery and equipment for his new factory. However, First Time Bank
failed to perfect its security interest in the equipment and machinery. Six months later, Robert defaults on
the loan with First Time Bank. Robert did not sell the machinery or use it as collateral for another loan.
Without taking any additional actions (i.e. filing a UCC-1 Financing Statement), can First
Time Bank repossess Roberts new machinery and equipment? (5 points).

3. Perfect Enterprises filed a Chapter 7 bankruptcy petition. The trustee of the estate has sold all
nonexempt assets, performed all other work, and is now ready to distribute the assets of the estate. The
only asset in the estate is cash of $144,000. The following are all of the validly filed claims against the
estate. How much would each creditor receive in the distribution (10 points)?
Trustees fee
$10,000
Attorney fees for assisting Trustee
$ 6,000
Accountant fees for assisting Trustee
$ 4,000
Unpaid wages for 5 employees of
$1,200 each for the month
prior to filing the petition
6,000
Federal Taxes
$12,000
Unsecured Creditors:
Johnson
$20,000
Smith
$30,000
Jones
$30,000
Secured Creditors:
Brown
$80,000
(Browns collateral was sold
for $70,000, and is part of the $144,000
mentioned above, thus he has not received
any money yet)

Homer, single & Marge, married with one child, are starting a business to provide computer
consulting services and web design. They will initially locate in Los Angeles, California. They have
decided to call the business Vircon. Homers net worth is $100,000. Marges net worth is -0-. Homer
is willing to contribute $50,000 to the business. Unfortunately, Marge has no money to contribute, but
has the computer expertise, the essential contacts and is a graduate of the Anderson School. In fact,
Marge already has a possible client in Arizona. They would like to participate equally in making all
decisions. They estimate that $200,000 will be enough money to pay all expenses for 12 months at
which time they project that revenues will cover expenses. Homer and Marge plan on reinvesting most
of the earnings with the goal of expanding and going public within 5 to 10 years. Initially, they would
like to hire two persons, one web designer and one consultant. The consultant will have substantial
decision making authority, will work full-time at either the main office or at client sites, receive a salary,
use Vircons equipment and will not receive any fringe benefits, such as medical insurance. The web
designer will work from his/her home, use his/her own equipment, be paid hourly, will have other clients
and will not receive any fringe benefits, such as medical insurance. Neither have written contracts with
Vircon. Homer intends to keep his job at Robbem & Cheatem, a local law firm for as long as necessary
until the new business takes off. Currently, Marge is unemployed.
4. Is the consultant an independent contractor or an employee? Is the web designer an
independent contractor or an employee? What are the legal consequences of incorrectly
characterizing them? (10 points)

A friend of Marges, Jacques, feels the business will be very profitable and has offered to
contribute $30,000 to the business. He lives in and is a citizen of France. He only visits the United
States once a year. He would like to be a passive owner in the business.
On October 29, before a new business entity was formed, Homer signs a lease for a three year
term for immediate occupancy for the business. The lease was entered into on behalf of and in the
name of the business. Thus, he signed the contract "Homer, agent for Vircon" The business was
subsequently formed, and they moved in on November 25th. The business paid the rent directly to the
landlord.
Assume for purposes of answering questions 5-12 that Homer and Marge form a corporation and
that each owns 50% of the corporate shares. Marge is the president and Chief Financial Officer and
Homer is the Secretary. Both are on the board of directors.
Six months after the corporation is started, there was a cash flow problem and it is necessary for
Homer to lend $20,000 to the business to enable it to cover its operating expenses. Four months later they
hire, Helmut, as Vice President of Sales & Marketing.
Vircon now realizes that it leased too much space and subleased a small portion of its space to two
CPAs, Rippoff & Shyster, LLP, a California limited liability partnership. Rippoff & Shyster, LLP
signed a 2 year lease with Vircon in the name of the LLP. A year later Rippoff & Shyster LLP move out
of the their office space, breaching the lease with Vircon.
During the next few years, the business did well. Vircon, however, never obtained liability
insurance. Homer and Marge keep meticulous records of receipts and payments, but did not document
certain corporate transactions, such as salaries and shareholder meetings. In one year the corporation
paid six of Marges mastercard bills because she was having severe personal financial problems and also
paid for her daughters college tuition for her first semester.
There are now five persons on the board of directors, Homer, Marge, and three outside directors,
Harry, Susan and Marvin and 50 shareholders. A few month later, the corporate Chief Financial Officer
of Vircon borrowed $60,000 from Nice Bank on behalf of Vircon, executing a promissory note in the
corporation's name. The corporation's secretary later sent a letter to Nice Bank confirming the promissory
note and the receipt of the loan proceeds. Thereafter, the board of directors, with knowledge of the loan,
authorized the use of the proceeds to acquire new equipment. Nice Bank presented the loan for payment,
but the corporation refuses payment arguing that the bylaws do not authorize its Chief Financial Officer
to borrow money.
5. Is Vircon liable for the $60,000 loan made by its Secretary? (5 points)

A few months later, Marge wishes to obtain a personal loan from her bank for $100,000, but the
bank requires someone to co-sign the note. Marge co-signed the note in the name of the corporation and
signs as the president. Later Marge defaults on the note, and the bank sues the corporation for payment.
6. Is Vircon liable to Marges bank for the $100,000 personal loan? Please exclude the concept of ultra
vires from your answer. (10 points)

At one of the board of directors regular meetings Homer & Marge attended, Harry was patched
in on a conference phone call, and Marvin gave his proxy vote to Homer. Homer, Harry and Marvin (via
his proxy) voted in favor of the motion to borrow $500,000 from Bank of America. Marge voted against
the motion. Susan who did not receive notice nor attend the meeting wants to challenge the validity of
the action passed at the meeting for, among other reasons, lack of proper notice. Vircon's Bylaws provide
that a majority of the authorized directors constitutes a quorum and any action passed at a board meeting
must be approved by a majority of those directors present.
Marge also serves as an outside director on the board of directors of Cellular Information
Systems (CIS). CIS has five members on its board and approximately 500 shareholders. During a special
meeting of directors of CIS, all five directors present voted to declare a $100,000 cash dividend.
However, three of the directors learned through their position as CIS officers that CIS had just lost a
customer who was its chief source of revenue. This information was not disclosed at the meeting,
although all the other board members asked numerous questions about the financial situation of the
company.
7. Discuss the personal liability, if any, of each of the CIS directors for approving the dividend (10
points)

Recently, Helmut severely injured Thelma and her prize poodle Fifi in a car accident while he
was on his way back to work after visiting a new supplier, located about fifteen minutes from the office.
Thelma and Fifi live in Arizona and were only in Los Angeles, where the accident occurred, to get Fifi
groomed by her favorite stylist for her next show. Needless to say, Thelma is furious and plans to sue
Vircon and Helmut for at least $300,000. Remember, Vircon does not have insurance coverage.
8. On what legal theories, if any, can Thelma sue Vircon for the injuries she sustained in the
accident? (5 points)
9. Assume that instead of getting into an accident with Thelma on his way back to work, Helmut
drives approximately another hour out of his way to go to a store to do a personal errand. As he
was leaving the parking lot of the store, he negligently hit Petes car. Is Vircon liable in this case,
why or why not? (5 points)
10. On what legal theory can Thelma sue Homer and Marge, individually, as shareholders of
Vircon? (5 points)
11. On what legal basis can the shareholders of Vircon sue the individual members of its Board
of Directors and hold them personally liable if Vircon is held liable for $300,000 in damages to
Thelma. (5 points)
On July 25, of the next year Vircon borrows $100,000 from Susan, one of its directors at the
prevailing interest rate for a term of three years. The loan was properly approved by the board at its
regular meeting.
At the Board's October meeting, it seriously considers filing bankruptcy. On November 1, Vircon
paid back, in full, the money borrowed from Susan. At that time, Vircon had stopped making payments
on all its debts.

At the board of directors regular meeting held on December 20th, the Board properly voted in
favor of filing a petition for a Chapter 7 under the Bankruptcy Code. At that meeting the directors
invited outside legal counsel and its accountant to answer any questions regarding a Chapter 7 . The
Petition was filed on December 30th.
12. What legal effect, if any, does the repayment of the loan from Susan have on Vircon's
bankruptcy? (5 points)
8. Joe, Mike and Judy, three independent sole proprietors, decided to pool their resources and form a
general partnership. Joe contributed $15,000 in capital, Mike contributed $30,000 in equipment and Judy
contributed $25,000 in cash and equipment. The partnership commenced business on September 1, 1981,
but the parties did not sign a formal partnership agreement until October 15, 1981. In 1982, the
partnership made $6,000 in profits. The partnership agreement is silent on how profits and losses are
shared. The parties are now in dispute as to how profits and losses are to be shared. Which, if any, of the
following statements is/are correct? (5 points)
a)
b)
c)
d)
e)

Mike cannot transfer his share of profits to someone outside the partnership because this is
partnership property.
Mike, Joe and Judy will each receive $2,000 in profits.
Mike will receive twice as much of the profits as Joe will receive
The partnership began its existence on October 15, 1981.
Two of the above are correct.

9. Under current income tax rules, an "S" corporation: (5 points)

a.
b.
c.
d.
e.

Can have only a limited number of shareholders, currently 100

Can have only one class of stock
Is generally not considered a taxable entity
Is generally subject to "double taxation"
All but D

10. All but which of the following could become partners in a general partnership:(5 points)
a. Jose, age 23
b. The XYZ Partnership
c. The JT Corporation
d. Maria, age 16
e. All of the above could become partners
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PLEASE BE PREPARED TO DISCUSS THE FOLLOWING QUESTION IN CLASS

What form of legal entity would you recommend for this business if only Homer and Marge
participate? What form of legal structure would you recommend if Jacques, Homer and Marge
participate? In your answers, explain the pros and cons of utilizing a general partnership, limited
partnership, limited liability company (LLC), regular corporation ( also known as a C corporation)
and S-corporation for Homer and Marge and also for Jacques, Homer and Marge . Exclude
LLLPs and close corporations from your answer.