REG - Notes Chapter 7

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Agency
Agency – legal relationship in which one person or entity (the principal) appoints another person or entity (the
agent) to act on his behalf
• To create an agency the principal must have capacity (not a minor or incompetent) and consent
• Writing not required unless impossible to perform in 1 year, or purchase or sale of land
• Agent need not have capacity – minor can be an agent
• Consideration not required

Power of attorney – written authorization of agency by principal

Duties of agent to principal – fiduciary duty

• Duty of loyalty – act solely in principals interest
- no kickbacks/self dealings, avoid conflicts of interest, do not disclose confidential information
• Duty of obedience – obey reasonable instructions. Do not exceed your authority
• Duty of reasonable care – liable id negligent to both principal and third party

If agent breaches the duties, the principal can recover damages from the agents
Contract damages – principal collects the money/consideration that was paid to agent

Duties of principal to agent

Compensation is an implied duty
Reimbursement/indemnification – an implied duty to reimburse the agent for all expenses incurred in carrying
out the agency

Either party generally has the power to terminate the relationship at any time. However, the parties don’t
necessarily have the right to terminate at any time
• Exception: Agency coupled with an interest (agent is a creditor of the principle)
- Principal cannot terminate an agency, only the agent can terminate

An agency relationship arises when the principal appoints an agent to act to his behalf. By this appointment, the
agent can bind the principal in contract.

Agency power can arise through

• Actual authority
• Apparent authority or estoppel, or
• Ratification

Type 1: Actual authority – agent reasonably believes he possesses because of the principals communications to
the agent. Actual authority can be either express or implied:
• Express actual authority – oral or written instructions
• Implied actual authority – the authority to do things reasonably necessary (in the ordinary course of
business) to carry out the agency
- Implied authority to hire/fire employees, purchase inventory and pay business debts
- No implied authority to sell business fixtures or borrow money on the principals behalf

Termination of actual authority is automatic by operation of law due to the following events
• Death
• Incapacity of the principal
• Discharge in bankruptcy of the principal
• Failure to acquire a necessary license
• Destruction of the subject matter of the agency
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• Subsequent illegality\
New employees are sub agents, who owe a fiduciary duty to both principal and primary agent

Type 2: Apparent authority – an agent might not have actual authority, but still has the power (not the right) to
bind the principal
• Title/position carries apparent authority
• Failure to give notice to 3rd parties after agent is terminated

A principal’s secret limiting instructions, while effect to limit the agents actual authority, are not effective to
limit the agents apparent authority. (Owner tells manager not to buy inventory over $250, supplier offers
inventory for $300 and manager buys it. The owner must pay the supplier)

Apparent authority is based on the third party’s reasonable belief. that the agent has the power to bind the
principal. While actual authority arises from the agent’s reasonable belief that he has the power to bind the
principal

To terminate apparent authority, principal must give notice to third parties who might have knowledge of the
agency:
• Actual notice – must be given to terminate apparent authority to old customers
• Constructive notice – must be given to terminate apparent authority to new customers

There are situations where apparent authority is terminated by operation of law, and no notice is required:
• Death of principal or agent
• Incapacity of the principal, or
• Principal receives a discharge in bankruptcy

Type 3: Ratification – allows principal to choose to become bound by a previously unauthorized act of his
agent
• All material facts must be disclosed to the principal
• The principal must ratify the entire transaction – there can be no partial ratification

Generally any act may be ratified unless

• Performance would be illegal
• Third party withdraws prior to ratification
• Not fair to the third party

Agents liability to 3rd party for contract duties

• Disclosed principal – agent is not liable if authorized
• Partially disclosed and undisclosed principal – agent is liable (principals identity is not disclosed to 3rd
party)
- 3rd party can hold either principal or agent liable, but not both
- There is no apparent authority with an undisclosed principal
- There is no effect on actual authority
- Principal is bound if the agent had authority, regardless of the principals disclosure
- If the agent did not have authority, the principal is bound only if he ratifies

Tort liability – wrongful act. Can be either intentional or negligent

As a general rule a principal is not liable for the torts committed by his agent
Exception: Respondeat superior doctrine – an employer can be liable for an employees torts committed within
the scope of employment

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- The injured party may sue both the employer and employee under this doctrine

An employer is liable for only for torts of an employee and is usually not responsible for torts of independent
contractors, determine by:
• Right to control – control the manner is which the person performs. An employer has the right to control
employees, but has little control over the methods used by independent contractors
• Other factors: provides his own tools and facilities, length of employment, basis of compensation, degree of
supervision
• Exception: an employer can be liable for torts when the independent contractor’s work involves ultra
hazardous activities (blasting)

The employer is usually liable only for an employees negligence and is not liable for intentional torts

Bankruptcy
Chapter 7 liquidation – available to individuals, P/S, and corps
• A trustee is appointed and collects the debtors assets, liquidates them, and uses the proceeds to pay off
creditors to the extent possible
• Debtors debts are discharged

Chapter 11 reorganization – available to individuals, P/S, and corps

• Trustee not required, so the debtor remains in possession of the estates assets
• No liquidation
• Debtor files a plan that must be accepted by creditors holding between 1/2 – 2/3 of allowed claims
- must be accepted by equity security holders with at least 2/3 of allowable claims
- the court will confirm the plan

Chapter 13 Adjustment of debts of individual with regular income – individuals only

• Debtor repays all or a portion of his debts over a 3-5 year period
• Trustee oversees the handling of a chapter 13 proceeding
• Chapter 7 is preferred to chapter 13

A chapter 7 case by an individual consumer debtor may be dismissed if there is abuse/means. Means/abuse test:
1. Determine avg monthly salary over the previous 6 months prior to filing
- if equal or less than state median income – Chapter 7 permitted
- if debtors income exceeds state median income – means test applied to determine whether debtor has
sufficient income to repay debts using chapter 13
2. Current monthly income * 60 (social security payments not included and certain expenses deductible)
- if less than $6,000 chapter 7 permitted
- if $10,000 or more – presumption of abuse, either chapter 13 or dismissed
- if between $6,000-$10,000 – a presumption of abuse will arise only if this amount equals at least 25%
of the debtors unsecured claims not entitled to priority

Railroads, insurance companies, banks, saving institutions, and small business investment companies may not
file for chapter 7. No RIBSS

Brokers, companies, banks, saving institutions, and small business investment companies may not file for
chapter 11. No BIBSS

Debt relief agencies – agencies paid to assist consumer debtors in filing bankruptcy petitions
• May not advise a person to incur more debt in anticipation of a bankruptcy filing

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When a bankruptcy petition is either voluntary or involuntarily filed, an automatic stay (stops collection
efforts) becomes effective against most creditors

After a petition is filed, if the debtor is an individual, a certificate from the non-profit budget and credit
counseling agency that provided the debtor counseling service, along with any plan of repayment developed by
the agency

Chapter 7 and 11 may file voluntary or involuntary (Ch 13 is voluntary only)

Voluntary cases
• Debtor files for order of relief (for debts of any amount not capable of paying when due)
• Debtor need not be insolvent to file, but must pass means/abuse test
• Spouses may file jointly to avoid duplicate fees

Involuntary cases
• Unsecured creditors may petition a debtor into bankruptcy proceedings when the debtor is defaulting (not
paying debts when due)
• Only creditors who are owed, individually or in aggregate, at least $12,300 in unsecured, undisputed debt
may petition debtor for bankruptcy
- If debtor has fewer than 12 creditors, at least 1 creditor must be owed $12,300 to file a petition
- If debtor has more than 12 creditors, at least 3 creditors owed $12,300 in aggregate may petition

Section 341 meeting – within 20-40 days after the order for relief, a meeting of the creditors is held

Property of the bankruptcy estate

• The estate also includes rental, royalty, interest and dividend income
• It also includes property the debtor receives from divorce, inhereitance or insurance within 180 days after
filing the petition
Property excluded from estate
• Post petition earnings
• Generally things necessary to live (homestead, vehicle, household goods, unmatured life insurance
contracts)
• These exemptions do not apply if the creditor is a PMSI, mortgage on the property, or tax liens

Fraudulent transfers – any transfer with intent to hinder, delay, or defraud creditors. 2 year looking period
- concealing assets, selling below FMV, gifting items, sell it but keep equitable interest

Preferential transfer rules – prevents one creditor from receiving an unfairly large repayment relative to other
creditors. When the payment is “set aside” by the trustee, the payment is taken back from the creditor who
received it and becomes part of the bankruptcy estate. A preferential payment is:
• A transfer made to or for the benefit of the creditor
• On account of an antecedent (existing) debt of the debtor
• Made within 90 days
• Made while the debtor was insolvent, and
• Results in the creditor receiving more than the creditor would have received under the bankruptcy code

To have a claim against an estate, unsecured creditors must file a proof of claim

There are certain things that will prevent a party from getting a discharge in bankruptcy: DRAWING
• Discharge within 8 years

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• Records, failure to keep
• Assets, failure to explain whereabouts
• Willfully concealing assets
• Not an individual
• Not obeying court orders
• Guilty of a bankruptcy crime

Under chapter 7 and 11, not all debts are discharged. WAFTED
• Willful and malicious injury liabilities
• Alimony
• Fraud
• Taxes
• Educational loans
• Debts undisclosed in bankruptcy petition

Distribute the assets of debtors estate in the following order

1. Secured claims
2. Priority claims (9 categories SAG WEG CTI)
3. General creditors
Payments are made in full to secured claimants to the extent of the value of the collateral securing claims. If
there is not sufficient money to pay all creditors at a particular level, the creditors share pro rata

The order of payment for the 9 priority creditors: SAG WEG CTI
• Support obligations to spouse and children
• Administrative expenses of bankruptcy proceeding
• Gap creditors (claims that accrue between in ordinary course of business between order of relief and invol.)
• Wages up to $10,000 if earned within 180 days prior to filing
• Grain farmers and fisherman up to $4,925
• Consumer deposits for goods paid but not delivered
• Taxes
• Injuries caused by drunk driving

There are 3 restrictions on priority payments for unpaid wages and unpaid employee benefit plans:
• Only unpaid wages and benefit plans that arose within 180 days prior to filing are entitled to priority. Those
that arose after filing are general creditors and receive no priority
• It is only unpaid wages and unpaid employee benefit plans up to $10,000 that receive priority
• Unpaid employee benefit plans are reduced by any amount paid to the employee for a priority wage claim

Securities Regulation
Securities Act of 1933 – regulates original issues of securities (IPO’s)
Securities Exchange Act of 1934 – regulates purchases and sales after initial issuance

Security – any investment contract

Securities act of 1933 – purpose is to provide investors with sufficient investment information to make an
informed investment decision. The SEC does not guarantee the accuracy of this information or evaluate the
financial merits

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The 1933 act applies only to issuers, underwriters and dealers

The registration statement contains two parts

• Part I: the prospectus – a written offer to sell securities
• Part II: information about the securities being issued
- Audited B/S and I/S
- Contact info on directors and officers, amount of security being issued, principal purposes of proceeds
from issuance, pending litigation

Shelf registration – registration statement for future issuances

Blue sky laws – state laws governing stock sales

Timetable
Before registration – no sales activity allowed
Between registration and filing date (20 day waiting period) – some sales allowed
After registration is effective – securities may be sold

Two types of exemptions from the 1933 act:

• Securities exemptions: securities issued by
- Banks and savings & loans (CD’s)
- Not-for-profit, charitable organizations
- The government (municipal bonds)
- Regulated common carriers (railroads)
- Short term commercial paper (9 months or less)
- Insurance policies
• Transaction exemptions
- Casual sales
- Exchanges with existing stockholders/corp reorganizations (stock dividends, stock splits)
- Intrastate sales (offered and sold only to persons who are residents of the issuers state
- Regulation A – partial exemption, simplified registration for firms with less that $5 mil in sales over 1
yr. Generally unaudited F/S ok
- Regulation D – private offering exemption. No advertising allowed, purchasers must hold for 2 yrs +
Rule 504 - $1 million limit. No limitation on the type of purchaser
Rule 505 - $5 mil limit. No limit on accredited investors and 35 or less unaccredited investors
If any unaccredited investors, all investors must be given at least annual report with F/S
Rule 506 – no $ limit. No limit on accredited investors and 35 or less sophisticated investors
If any unaccredited investors, all investors must be given at least annual report with F/S

Liability under the 1933 Act

• Section 11 – imposes civil liability for misstatements in registration statements, regardless of intentionality
• Section 12 – registration not made, prospectus not given to all investors, false statements were made
• Section 17 – fraud

Section 12 and 17 are anti-fraud provisions which also apply to unregistered exempt securities (not for profits)

Section 11 makes anyone who signed the registration statement liable for all damages caused by any
misstatement of material fact in the registration statement. A person wishing to sue need only show:
• The plaintiff acquired the stock (need not be the initial purchaser
• Plaintiff suffered a loss/damages
• The registration statement contained a material misrepresentation or material omission of fact

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Plaintiff need not prove an intent to deceive (scienter), negligence or reliance
Officers, directors, corporate lawyers, underwriters and auditors can be liable
Plaintiff need not be in privity with the defendant under federal law

Defendants, other than issuers, are not liable if they can prove they used due dillegence
For auditors, use GAAP, GAAS defense by showing workpapers
Another defense is to show that misstatement was not material or the plaintiff knew of the omission at the time
they purchased the securities

The securities act of 1934 – regulates subsequent trading, reporting requirements

Anti-fraud provisions apply to all purchasers and sellers

One 2 types of companies must register their securities

• Companies whose shares are traded on a national exchange
• Companies that have at least 500 shareholders in any outstanding class and more than $10 mil in assets

Reporting requirements
• 10K – filed annually within 90 days of the end of the fiscal year, certified/audited auditors
• 10Q – filed within 45 days of the end of the first three quarters, reviewed by auditors
• 8K – filed within 15 days after a major change in the company
• Any person acquiring 5% must file a report with the SEC
- The report must include background information about the purchaser, the source of funds, and the
purpose in buying
• Insiders (officers, directors, 10% stockholders, accountants, attorneys) must file a report with the SEC
disclosing their holdings and make monthly updates
• Tender offer – an offer to all shareholders to purchase stock for a specified price for a specified period of
time
• Proxy solicitation/statements – a written request for permission to vote a shareholder’s share at a
shareholder meeting

Antifraud provisions Rule 10B-5 – prohibits fraud in connection with the purchase or sale of any security
To recover damages under 10B-5 plaintiff must prove:
• The plaintiff acquired the stock (need not be the initial purchaser
• Plaintiff suffered a loss/damages
• The registration statement contained a material misrepresentation or material omission of fact
• Scienter (intent to deceive or reckless disregard for the truth)
• Reliance

The SEC investigates but does not prosecute. They send evidence to U.S. attorneys office

CPA Legal Liability

CPA legal liability can arise in any of the following ways: breach of conduct, commission of a tort (negligence,
fraud, or constructive fraud), violation of a statute

If CPA breaches the contract, the client or third party beneficiary is entitled to recover compensatory damages
(money to compensate for the contract not having been performed)
- defenses: client failed to cooperate, hindered our performance

For negligence, plaintiff must prove:

• Defendant owed a duty
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• Defendant breached that duty
• Breach caused plaintiff’s injury, and
• Damages

Examples are failure to warn the client about known internal control weaknesses or failure to have critical
review at every level of supervision
To whom is the duty owed?
Majority rule – any person or limited foreseeable class of persons whom the CPA knows will be relying on the
CPA’s work

Ultramares decision – limits CPA liability to persons in privity of contract with the CPA and intended third
party beneficiaries

Gross negligence – fraud and constructive fraud, bad faith

• Same elements as actual fraud, except instead of intentionally deceiving, the defendant acts recklessly
• CPA can be held liable to anyone who proves the above elements
• Privity is not a defense to fraud
- best defense to fraud: lack of scienter and/or good faith

CPA is liable to general public for fraud and negligence

If the auditor detects information of illegal acts, he should inform the clients audit committee of the act

The clients board is to report to the SEC the receipt of any such notice within 1 day after receiving it and must
furnish the auditor with a copy of the notice.

If the CPA fails to receive a copy of the notice within 1 day, the CPA is to furnish the SEC with a copy of the
report within 1 day

Keep all workpapers for at least 7 years

No accountant-client privilege under federal law

• CPA can be forced to disclose client information, including workpapers, if subpoenaed and relevant to a
federal court case

Work papers belong to the accountant and is prohibited from showing them to anyone without the clients
permission. Except:
• Subpoenaed
• Voluntary quality control review
• Defend a lawsuit brought by a client
• AICPA/state trail board

Exam trick: if the CPA sells his practice, still need clients permission to disclose the work-papers to new owner

Property Insurance
Public policy requires an insurable interest (must own it) in order to purchase insurance. Note that the
substantial economic interest need not exist when the policy is taken out. It only must exist at the time of loss

A general creditor has no insurable interest

Recoverable amount = [Face value of policies ÷ (coinsurance % * FMV of property at time of loss)] * loss

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When there is a total loss, recovery amount/pay out is according to the policy not the coinsurance formula

Subrogation – is the right of the insurer, upon paying the loss, to recover the amount paid from third party who
is at fault (third party started a fire, insurance company paid the damages, then sues third party)