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Corporations

VIEWS: 18 PAGES: 15

									                                     Business Associations
                                       Professor Pratt
                                          Fall 2006
                                        Practice Exam

 [CAVEAT: This practice exam includes questions from past exams. My course coverage varies
from year to year so do not be alarmed if you see an answer option that seems unfamiliar to you.]

Exam Instructions:

1.     The exam is a closed-book exam. The only thing that you may bring to the exam is a hand-
       held calculator that is not a financial calculator.

2.     The practice exam is 2 hours and 10 minutes (130 minutes) long. There are 130 total points
       on the practice exam. The points indicated for each question indicate the amount of time
       that you should spend on each question. There are 90 points allocable to the objective
       portion of the practice exam and 40 points allocable to the essay portion of the exam.

3.     For each multiple choice question, select the answer that you believe best responds to the
       question asked. (On the real exam, you will need to use a pencil to mark the Scantron form.)

4.     The facts are intended to be complete. If you need to know about a fact that appears to be
       missing, identify the fact and explain its importance. Do not assume any additional facts.
       Your answer should explain how the applicable legal rules (statutes, cases, or administrative
       pronouncements) apply to the facts of the exam question.


GOOD LUCK!




                                                 1
                                                 Part I
                                      Multiple Choice Questions
                               (3 points each unless otherwise specified)

1. Which of the following is not a characteristic of a corporation organized pursuant to the state
   law "off-the-rack" default rules for corporations?

    a.    Limited liability.

    b.    Limited life.

    c.    Centralized management.

    d.    Free transferability of ownership interests.

    e.    None of the above.         The traits in (a)-(d) above are all quintessential corporate
          characteristics.

2. The corporate form permits the aggregation of capital. Why has corporate law encouraged the
   aggregation of capital?

    a.    Good managers may not have much capital and rich investors may not be able to run a
          successful firm.

    b.    To increase productivity and efficiency.

    c.    So that corporations serve as quasi-governmental organizations to promote the welfare of
          the various constituencies that interact with the corporations.

    d.    (a) and (b) above.

    e.    (a), (b), and (c) above.

3. Which of the following strategies cannot be used to ameliorate the "other people's money"
   problem (i.e., the problem that arises because corporate ownership and control may be
   separated)?

    a.    Having outside directors serve on the board.

    b.    Mounting a shareholder proxy contest to replace the officers of the corporation.

    c.    Removing existing directors from office.

    d.    Lawsuits alleging a breach of director fiduciary duties.

    e.    None of the above. All of the methods described in (a)-(d) above can be used.


                                                   2
4.   Which of the following statements, in (a) through (c), about corporate charitable giving is false:

     a.    Delaware and California require a showing that the corporate charitable contribution will
           benefit the shareholders.

     b.    The Theodora Holding Company test (that the amount and purpose of the corporate
           charitable contribution must be reasonable) cannot be satisfied if the corporate charitable
           contribution is to the “pet charity” of the CEO or a director.

     c.    If the board of directors uses a good process to make the decision about the corporate
           charitable contribution, the court will be constrained from evaluating whether the
           contribution was, as a substantive matter, a good idea or a bad idea.

     d.    Statements (a) and (b) are false.

     e.    None of the statements in (a) through (c) is false.

5.   Which of the following statements about limited liability is false?

     a.    Limited liability has historically been the main reason why small businesses have
           incorporated.

     b.    Limited liability is defended primarily on efficiency grounds (e.g., that it promotes
           capital formation and risk-taking and reduces monitoring costs).

     c.    Contract and tort creditors invariably pay the price for limited liability.

     d.    Limited liability makes possible the free transferability of corporate stock.

     e.    A court will allow a creditor to "pierce the corporate veil" only in extraordinary
           circumstances.




                                                    3
6. Which of the following statements, in (a) through (d), regarding limited liability companies is
   false?

     a.   Running a business as a limited liability company (LLC) enables the investors in the
          business to “get the best of both worlds,” meaning that they can get both limited liability
          and pass-through federal tax treatment.

     b.   The organizing documents for a limited liability company must be filed with the
          Secretary of State, but a partnership can exist even in the absence of any formal
          documentation.

     c.   The Internal Revenue Service takes the position that all LLC's receive pass-through
          treatment for federal tax purposes.

     d.   In interpreting state LLC statutes, courts will have to look to both partnership and
          corporate law, and where the partnership and corporate rules differ, it is difficult to
          predict which rule the court will apply.

     e.   None of the statements in (a) through (d) is false.

Facts for Questions 7 and 8:

Alice and Bob, two brilliant but starving Ph.D. candidates at Stanford, have hit on an idea for a
business that they hope will make them millionaires. Alice and Bob will each own half of the
business, which they will call Minicomp. A Silicon Valley venture capital firm will lend Minicomp
$200,000 (at a high interest rate) to get the business started. Alice and Bob will initially pay
themselves meager salaries and try to build the business for a few years. Minicomp may pay Alice
and Bob dividends from time to time.

7.   Assume that Minicomp is a C corporation. Which of the following statements is false?

     a.   A C corporation is a taxable entity separate from its shareholders, so Minicomp will have
          to file tax returns each year and pay tax on its net earnings for each year.

     b.   Salary paid by Minicomp to Alice and Bob is deductible by Minicomp.

     c.   Dividends paid by Minicomp to Alice and Bob are deductible by Minicomp.

     d.   Interest paid by Minicomp to the venture capital lender is deductible by Minicomp.

     e.   If Minicomp loses money, the loss will not pass through to Alice and Bob, but can offset
          income Minicomp earns in another year.




                                                  4
8.    Now assume instead that Minicomp is an S corporation. Which of the following statements, in
     (a) through (d), is false?

     a.    An S corporation is not a taxable entity separate from its shareholders, so Minicomp will
           file only an information return each year and Alice and Bob will report Minicomp's
           income or loss on their individual income tax returns.

     b.    A second layer of tax will be paid on Minicomp's earnings if they are distributed to Alice
           and Bob as dividends.

     c.    Minicomp will, for the most part, be taxed as if it were a partnership.

     d.    If Minicomp later issues stock to a foreign shareholder, Carlos, the company will be
           converted into a C corporation.

     e.    None of the statements in (a) through (d) is false.

9. (4 points) John, a wealthy investor, will invest $200,000 in a new start-up company. Susan,
   who just received her M.B.A. degree, will run the day-to-day operations of the company but
   John plans to supervise the operations of the business. The business will also borrow
   substantial funds from a local bank.

     John may have trouble ensuring that his liability with respect to the start-up company is limited
     for which of the following reasons?

     a.    If the business is a limited partnership and John is a limited partner, John will be treated
           as a general partner if he exercises too much control over the business.

     b.    If the business is a corporation, the creditors may insist on getting a personal guarantee
           from John.

     c.    If the business is a corporation, the bank will be able to pierce the corporate veil if the
           business is later unable to pay its debts as they come due.

     d.    (a) and (b) above.

     e.    (a), (b), and (c) above.




                                                   5
10. Which of the following statements, in (a) through (d), about the bylaws of a Delaware
    corporation is false?

    a.    The titles and general duties of the corporate officers are often specified in the bylaws.

    b.    If a provision in the certificate of incorporation contradicts a provision in the bylaws, the
          provision in the certificate of incorporation controls.

    c.    The board of directors must first approve an amendment to the bylaws before the
          shareholders can vote to amend the bylaws.

    d.    The bylaws typically contain many of the "ground rules" for operating the corporation.

    e.    None of the statements in (a) through (d) is false.

11. Which of the following statements, in (a) through (c), is false?

    a.    Equity holders sometimes have an economic incentive to choose riskier corporate
          projects than creditors would choose.

    b.    Limited liability sometimes permits shareholders to disregard some of the costs of doing
          a particular corporate project.

    c.    Corporations that invest in riskier projects will have to pay well-informed lenders a
          higher rate of interest than corporations that invest in less risky projects.

    d.    Statements (a) and (b) are false.

    e.    None of the statements in (a) through (c) is false.




                                                  6
12. Which of the following statements, in (a) through (d), is false?

    a.    The rights of corporate bondholders must be stated in the corporation's certificate of
          incorporation.

    b.    Corporations can take a tax deduction for the interest they pay on corporate
          indebtedness.

    c.    If a corporation sells bonds to bondholders, the corporation is the borrower and the
          bondholders are the lenders.

    d.    Interest compensates a lender for the time value of money and the risk of the borrower
          defaulting on the debt.

    e.    None of the statements in (a) through (d) is false.

13. Which of the following statements, in (a) through (c), about GAAP is false?

    a.    GAAP are a set of standardized mechanical accounting rules that permit accountants to
          prepare financial statements without having to make subjective judgments.

    b.    All public corporations must use GAAP.

    c.    GAAP are "conservative," meaning that GAAP tend to understate income and the value
          of assets.

    d.    None of the statements in (a) through (c) is false.

14. Which of the following items would not appear on the asset side of a balance sheet?

    a.    Goodwill that the corporation did not purchase.

    b.    Accumulated depreciation.

    c.    Accounts receivable.

    d.    Future expenses that the corporation already has paid.

    e.    (a) and (d).




                                                  7
15. Which of the following statements, in (a) through (d), is false?

    a.    The balance sheet shows assets at their cost and shows the accumulated depreciation
          allocable to the depreciable assets.

    b.    Consistent with the matching principle, the cost of an income-producing asset (such as a
          flower shop delivery van) should be matched with the income generated by that asset
          (such as the revenue from the shop’s sale of flowers) to accurately reflect income.

    c.    If inventory costs are rising, the LIFO inventory convention produces a higher cost of
          goods sold and lower income than the FIFO inventory convention would produce.

    d.    The aggregate amount shown as shareholders’ equity on the balance sheet is typically a
          good proxy for the true aggregate value of the shareholders’ stock.

    e.    None of the statements in (a) through (d) is false.

16. (5 points) Alana will invest $100,000 for three years. The return on the investment will be
   20% per annum, compounding semi-annually. Her $100,000 investment, plus the return on her
   investment, will be paid to her at the end of the third year. What is the approximate future
   value of the $100,000 investment? (Round your answer up or down to the nearest thousand.)

    a.    $160,000.

    b.    $165,000.

    c.    $173,000.

    d.    $177,000.

    e.    $181,000.




                                                  8
17. Which of the following statements, in (a) through (d), about the capitalization of earnings
   valuation method is false?

    a.    In a sale of a business, the buyer of the business will argue for a lower capitalization rate
          than the seller.

    b.    The capitalization rate for a business is typically chosen by looking at comparable
          businesses in the industry in which the business operates.

    c.    The riskier the business is, the higher the capitalization rate for the business is.

    d.    The higher the capitalization rate for the business is, the lower the current value of the
          business is.

    e.    None of statements in (a) through (d) is false.

18. (5 points) Biz Co. is buying the assets of Wizkids, Inc. Biz Co. and Wizkids Inc. have
   negotiated an agreement for the sale of the assets. At the closing, it becomes clear that Wizkids
   Inc. has not met one of the conditions of the agreement. Representatives of Biz Co. tell Able,
   who is president and Chief Operating Officer of Wizkids, Inc., that the deal is off unless Able
   immediately agrees to an amendment of the purchase agreement. You are the lawyer for
   Wizkids, Inc. at the closing. Able does not want the deal to fall through but he is not sure
   whether he has the authority to amend the purchase agreement on his own. He asks you
   whether Wizkids, Inc. will be bound by the amendment he will sign. Which of the following
   answers to Able's question, in (a) through (d), is false?

    a.    Able may have authority to bind Wizkids, Inc. even if the certificate of incorporation,
          bylaws, or corporate resolutions of Wizkids, Inc. do not specify that he has authority to
          amend agreements such as the purchase agreement.

    b.    Able's amendment of the agreement cannot bind Wizkids, Inc. unless the board of
          directors of Wizkids, Inc. subsequently votes to ratify the amendment.

    c.    Able is the president of Wizkids, Inc., so his title alone may give him the authority to
          bind Wizkids, Inc. by signing the amendment.

    d.    Wizkids, Inc. may be bound by Able's amendment of the agreement even if Able tells
          Biz Co. that he is not sure if he has authority to amend the agreement.

    e.    None of the above. Statements (a) through (d) are all true.




                                                   9
19. The Delaware statute provides that the board of directors of a Delaware corporation may
   designate one or more committees of directors. Which of the following statements, in (a)
   through (d), about such committees is false?

    a.    A committee may not amend the certificate of incorporation.

    b.    Committees can generally act on behalf of the corporation; they are not required to first
          make recommendations to the board for a vote by the board.

    c.    The compensation committee must include at least one independent director, but inside
          directors also may serve on the compensation committee.

    d.    An audit committee oversees the flow of financial information to investors.

    e.    None of the statements in (a) through (d) is false.

20. Under Delaware law, on which of the following are shareholders not entitled to vote?

    a.    Amending the certificate of incorporation.

    b.    A merger.

    c.    A sale of most of the assets of the corporation.

    d.    Firing the CEO.

    e.    None of the above.

21. Which of the following constitutes a proper purpose for a shareholder to inspect corporate
   records?

    a.    To learn the trade secrets of the corporation and reveal them to competitors.

    b.    To harass corporate executives whose policies the shareholder dislikes.

    c.    To pursue social policy goals (e.g., to pressure a company to stop discriminating against
          certain employees).

    d.    To get a shareholder list to sell to a catalog company.

    e.    None of the above is a proper purpose.




                                                 10
22. Which of the following statements, in (a) through (d), about shareholders' meetings is false?

    a.    Shareholder's can act by written consent in lieu of a meeting.

    b.    Shares held by a shareholder of a public corporation count towards the quorum
          requirement at the annual meeting of shareholders if the shareholder is physically present
          at the meeting or votes by proxy.

    c.    Under Delaware law, special shareholders' meetings may be called by the board of
          directors or other persons as authorized in the certificate of incorporation or the bylaws.

    d.    The corporation must give written notice of a shareholders' meeting to the shareholders
          of record as of the record date.

    e.    None of the statements in (a) through (d) is false.

23. Which of the following statements, in (a) through (d), about the federal proxy rules is false?

    a.    The federal proxy rules are intended to expand the substantive voting rights that
          shareholders have under state law.

    b.    Subchapter S corporations are not subject to the federal proxy rules.

    c.    The term "solicit" is defined very broadly under the federal proxy rules.

    d.     The federal proxy rules prohibit (1) the inclusion of any false or misleading statement
           regarding a material fact in a proxy statement and (2) the omission of any material fact
           from a proxy statement.

    e.    None of the statements in (a) through (d) is false.




                                                 11
General facts for Questions 24-27:

A, B, C, and D formed a new Delaware Corporation, Tot-Toys, Inc., to manufacture children's toys.
The certificate of incorporation authorizes the issuance of 50,000 common shares with $1 per share
par value. A, B, C, and D each paid $2 a share cash for their shares: A paid $15,000; B paid
$1,000; C paid $2,000; and D paid $4,000. (In answering the following questions, use the standard
nomenclature for the shareholder accounts, i.e., stated capital, capital surplus, and earned surplus,
instead of the Delaware convention of combining capital and earned surplus.)

24. (4 points) What amounts are in the stated capital and capital surplus (sometimes called paid-in
   surplus) accounts at the start of business?

    a.    Stated capital equals $11,000 and capital surplus equals $11,000.

    b.    Stated capital equals $22,000 and capital surplus equals zero.

    c.    Stated capital equals zero and capital surplus equals $11,000.

    d.    Stated capital equals $11,000 and capital surplus equals zero.

    e.    None of the statements in (a)-(d) is correct.

25. (4 points) Tot-Toys, Inc. loses $10,000 in year one and earns $2,000 in year two. What
   amounts are in the capital surplus and earned surplus accounts at the end of year two?

    a.    Capital surplus equals $22,000 and earned surplus equals negative $8,000.

    b.    Capital surplus equals $11,000 and earned surplus equals zero.

    c.    Capital surplus equals zero and earned surplus equals $12,000.

    d.    Capital surplus equals $22,000 and earned surplus equals zero.

    e.    None of the statements in (a)-(d) is correct.




                                                 12
26. (4 points) Assume the facts stated in Question 25. If Tot-Toys, Inc. wants to pay a dividend at
   the end of year two, how much may it lawfully pay without amending its certificate of
   incorporation? (Assume that the payment of the dividend would not render Tot-Toys, Inc.
   insolvent and that the corporation had paid no prior dividends.)

    a.    Zero.

    b.    $2,000.

    c.    $3,000.

    d.    $14,000.

    e.    None of (a)-(d) is correct.

27. (4 points) Assume the facts stated in Question 25. Also assume that Tot-Toys, Inc. does not
   pay a dividend at the end of year two, and in year three, the corporation loses $4,000. What
   amount may Tot-Toys, Inc. lawfully pay as a dividend at the end of year three? (Assume that
   the payment of the dividend would not render the corporation insolvent and that the corporation
   had paid no prior dividends.)

    a.    Zero.

    b.    $2,000.

    c.    $3,000.

    d.    $11,000.

    e.    None of (a)-(d) is correct.


                                    Go on to Part II of the exam




                                                13
                                             Part II
                                   Essay Question (40 minutes)

1. (40 minutes) Samantha is the sole shareholder of three corporations, Cycles Unlimited Inc.
(“Cycles Inc.”), Rolling Wheels Tours Inc. (“Tours Inc.”), and Like-New Repairs Inc. (“Repairs
Inc.”). Cycles Inc. operates a store that sells new and used bicycles. Tours Inc. operates luxury
bike tours in Europe. Tours Inc. buys bikes for the tours from the same manufacturers that supply
the store. When the bikes get too old to use on the tours, Samantha adds them to the used bike
inventory at the Cycles Inc. store. Tours Inc. and Repairs Inc. both operate out of the Cycles Inc.
store. The tour and repair businesses do not pay any rent to the store. Samantha and her husband,
Sal, are the directors and officers of each of the three corporations. Samantha is generally quite
meticulous about keeping the books and records of each corporation and complying with corporate
formalities. Occasionally, she borrows money for her personal use and the petty-cash needs of the
other businesses from the cash registers of the three businesses at the store, but she usually pays it
back promptly.

        The Cycles Inc. store is well established and profitable. Repairs Inc. earns a smaller profit
but draws customers into the store and supports the store's bike sales business. Tours Inc. was not
very successful at first, and Cycles Inc. loaned it significant sums until its business picked up. As
soon as Tours Inc. started doing well, Cycles Inc. began receiving regular payments of principal and
interest on those loans. Several newspapers have featured Tours Inc. in their travel sections and
that publicity has significantly increased the sales of the Cycles Inc. store.

        Samantha has made Tours Inc. an important benefactor of various AIDS charities; Tours
Inc. donates used tour bikes to AIDS bike racing fundraisers and gives about 2% of its net income
in cash to AIDS charities.

        Recently, there was a terrible mishap on one of the bike tours. One of the more oblivious
employees of Tours Inc. got lost and negligently took his group of guests down a treacherous
mountain path. On the way down the mountain, three of the guest riders crashed and were very
seriously injured. The guests had not signed any releases with respect to the trip. Tours Inc. has no
insurance and its assets will be insufficient to pay its debts and satisfy judgments in favor of the
injured riders; Tours Inc. will probably be forced to file a bankruptcy petition.

       What arguments will the creditors of Tours Inc. make to collect their debts from the assets
of Cycles Inc., Repairs Inc., or Samantha? Will they prevail?




                                                 14
Answer Key for Multiple Choice Questions

1.    b
2.    d
3.    b
4.    d
5.    c
6.    c
7.    c
8.    b
9.    d
10.   c
11.   e
12.   a
13.   a
14.   a
15.   d
16.   d
17.   a
18.   b
19.   c
20.   d
21.   e
22.   e
23.   a
24.   a
25.   e
26.   c
27.   b




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