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CAPITALIZATION

*Securities: Bonds and stocks (West)


>Corporations are financed by the issuance and sale of corporate securities. A security is a fungible,
negotiable instrument representing financial value. Securities are broadly categorized into debt securities and
equity securities.
ebt securities may be called debentures, bonds, deposits, notes or commercial paper depending on
their maturity and certain other characteristics. !he holder of a debt security is typically entitled to the payment
of principal and interest, together "ith other contractual rights under the terms of the issue, such as the right to
receive certain information. ebt securities are generally issued for a fi#ed term and redeemable by the issuer at
the end of that term.
$ Stoc%s represent the right to participate in earning and the distribution of corporate assets&
o"nership of a business firm. 'onds represent borro"ing by the firm (debt).
> 'onds& A bond is a debt security, in "hich the authorized issuer o"es the holders a debt and,
depending on the terms of the bond, is obliged to pay interest (the coupon) and*or to repay the principal at a
later date, termed maturity. A bond is a formal contract to repay borro"ed money "ith interest at fi#ed intervals.
!hus a bond is li%e a loan& the issuer is the borro"er (debtor), the holder is the lender (creditor), and the coupon
is the interest. 'onds provide the borro"er "ith e#ternal funds to finance long$term investments, or, in the case
of government bonds, to finance current e#penditure. Certificates of deposit (Cs) or commercial paper are
considered to be money mar%et instruments and not bonds. 'onds must be repaid at fi#ed intervals over a period
of time. !ypes of bonds issued are&
$ ebenture bonds& !hose for "hich no specific assets of the corporation are pledged as bac%ing& they
are bac%ed by the general credit rating of the corporation.
$ +ortgage bonds& !hose "hich pledge specific property.
$ Convertible bonds& !hey can be e#changed for a specified number of shares of stoc%.
$ Callable bonds& A bond "hich the issuer has the right to redeem prior to its maturity date. ,hen
issued, the bond "ill e#plain "hen it can be redeemed and "hat the price "ill be. -n most cases, the price "ill
be slightly above the par value for the bond and "ill increase the earlier the bond is called. .enerally, callable
bonds "ill carry something called call protection. !his means that there is some period of time during "hich the
bond cannot be called. !hey are also called redeemable bond, opposite of irredeemable bond or non$callable
bond. !he main cause of a call is a decline in interest rates. -f interest rates have declined since a company first
issued the bonds, it "ill li%ely "ant to refinance this debt at a lo"er rate of interest.
> An equity security is a share of equity interest in an entity such as the capital stoc% of a company, trust
or partnership. !he most common form of equity interest is common stoc%, although preferred equity is also a
form of capital stoc%. !he holder of an equity is a shareholder, o"ning a share, or fractional part of the issuer.
/nli%e debt securities, "hich typically require regular payments (interest) to the holder, equity securities are not
entitled to any payment. -n ban%ruptcy, they share only in the residual interest of the issuer after all obligations
have been paid out to creditors. 0o"ever, equity generally entitles the holder to a pro rata portion of control of
the company. 1quity also en2oys the right to profits and capital gain, "hereas holders of debt securities receive
only interest and repayment of principal.
> !ypes of stoc% issued by corporations include&
- Common stock& -t represents the true o"nership of a corporation. -t provides a proportionate interest
in the corporation regarding (i) control, (ii) earning, and (iii) net assets.
- Preerred stock& !hey have rights or preferences over other classes of stoc%s.
$ Cumu!ati"e #reerred stock: 3referred shares for "hich required dividends not paid in a given year
must be paid in a subsequent year before any common$stoc% dividends can be paid.
$ Partici#atin$ #reerred stock: 3referred shares entitling the o"ner to receive (i) the preferred$stoc%
dividend and (ii) additional dividends after the corporation has paid dividends on common stoc%.
- Con"erti%!e #reerred stock: !hey entitle the o"ner to convert their shares into a specified number of
common shares either in the issuing corporation or in another one.
- &edeema%!e'ca!!a%!e #reerred stock: -t is issued "ith the e#press condition that the issuing
corporation has the right to repurchase the shares as specified.
> -nterest on bonds must al"ays be paid, "hether or not profit has been earned, "hile stoc%s (common)
do not have a fi#ed dividend rate. 'ondholders do not have voice or vote regarding control of the corporation,
"hile stoc%holders can elect its board of directors. 'onds have a maturity date "hile stoc%s do not. !he claim of
bondholders against the property of the corporation must be met before that of stoc%holders.
Securities issued by a company
'onds Stoc%s
ebt security 1quity security
3ayment of principal and interest (coupon) 4"nership rights& to participate in earnings and asset distribution
3ayment of principal at a maturity date 5o payment of principal or interest
ebenture bonds6 mortgage bonds
(bac%ed)
S!4C7
Common stoc% 8epresents true o"nership of a corporation& control, earning, net assets
3referred stoc% 1ntitle to preferences over other classes of stoc%
Cumulative preferred stoc% 3referred stoc% "hich entitles stoc% not paid one year to be paid the ne#t
3articipating preferred stoc% 1ntitle to preferred$stoc% dividends and additional dividends
Convertible preferred stoc% 3referred stoc% convertible into a number of common shares
8edeemable*callable preferred stoc% !he issuing corporation may repurchase the shares
'45S
Convertible bonds 1#changeable for shares of stoc% at the option of the holder
Callable bonds
8edeemable by issuer before maturity date
Call protection& sets a period during "hich a bond cannot be redeemed
*Legal Aspects of Capital
>Concept of Capital& According to company la", capital can be defined as the contribution made by
any person intending to become a member of, or to create, a company and "ho underta%es to bring into it any
item of property, be it tangible or intangible, upon the constitution of the company. A second definition refers to
a fi#ed amount stated in the company9s constitutional documents and in its financial statements.
!here ar different vie"s on the legal nature of capital&
A first vie" sees it as an abstract and static figure representing the monetary valuation of members9
contributions. Arguments against this vie" are (i) that it fails to emphasize the crucial function of capital as
guarantee to creditors6 (ii) that capital doesn9t necessarily equal the value of contributions6 and (iii) that the
temporal relationship bet"een capital and contribution is different& contributions are al"ays made after the
amount of capital has been determined.
A second nominal or abstract vie"& there9s a difference bet"een capital, "hich is a notional sum,
abstract and static, and net "orth :patrimonio neto;, "hich is the difference bet"een the company9s resources
and its debts. !he net "orth fluctuates, as is sub2ect to increases and reductions. Capital may be clearly depicted
by considering its characters of adequacy (to net "orth) or inviolability, designed to preserve the company
members9 position and creditors9 rights.
A third position states that capital is capable of a dual characterization. <rom a nominal approach, it is
seen as an abstract or static figure set out in the company9s constitutional documents and financial statements6
from a real perspective, it is seen as a portion of the net "orth and cannot be disposed of, for protection of
members9 and interested third parties9 interests.
Argentine scholars identify capital "ith its legal concept, i.e. nominal capital& capital is thus related to
an accounting figure.
efinitions of Capital
= Contribution made to become a member of a company, "ith the implied underta%ing of brining an item of property
> <i#ed amount stated in the company?s constitutional documents and financial statements
@ie"s of Capital
= Abstract and static figure representing monetary valuation of members? contributions
> 5otional, abstract, and static sum6 compared to 5et ,orth& difference bet"een resources and debts
A& ual
Characterization
5ominal approach& Abstract or static figure
8eal perspective& 3ortion of the net "orth "hich cannot be disposed of
B& Argentine Scholars Accounting figure
>3rinciples governing the legal concept of capital
!hese are designed to preserve the productive resources ma%ing up the entity9s patrimony for a threefold
purpose& it allo"s its business to carry on activities to satisfy its purposes6 it lets outsiders %no" of the true
magnitude of the company9s assets6 it assures shareholders the preservation of the proportional equivalence
bet"een their shares and the portion of capital they represent (this implies the use of preemptive rights).
$-nviolability of capital& +embers9 contributions must be duly ascertained and fairly valued to preserve
the value of capital, in order to protect members and creditors. !he capital amount, duly determined by
valuation of specified considerations, is thus inviolable in the sense that it must be preserved for the purpose of
protecting the company9s creditors and members. -nviolability further constitutes a principle of public policy
incapable of being overridden by private agreement. 0o"ever, capital is actually capable of mutation and may
accordingly be varied as a consequence of valid increases decided by relevant corporate organs and upon strict
compliance "ith mandatory provisions to that effect.
!he inviolability of capital requires valuation of non cash consideration and equivalence bet"een the
value of contribution and nominal value of subscribed capital "hich prevents shares being issued belo" par. !he
intangibility of capital also prevents members from collecting profits accrued during a relevant period "here
losses incurred in previous accounting or economic periods have not yet been absorbed. -nviolability of capital
is also reflected in legal provisions requiring that non cash contributions ("hich must be fully paid in upon
subscription) may only consist of specified property capable of being foreclosed.
$3roductive functions of capital& Capital constitutes the crucial element in the generation of the
productive activity of the business concern (this is the economic potentiality of a business entity). Capital
constitutes a collection of economic assets.
Capital is directly related to the act or series of acts "hich the company proposes to carry on in
accordance "ith its articles (to preserve its guarantee function). Capital must be proportionally related to the
company9s activity in order to ensure proper assumption of economic ris%s and availability of assets in the event
of e#ecution.
!he company9s capital is li%ely to be determined "ith reference to multifarious factors& time,
management strategies, internal corporate policies, e#ternal factors of the mar%et, ris% management and control,
e#ercise of borro"ing po"ers, and investment policies.
$5e" concept of enterprise& -t demands a responsible conduct from the company concerning the
business it conducts, and requiring the entity a fair treatment in respect of its members, the community, and the
environment. !he comple#ity of technology and capital mar%ets demands a moral duty from the entity.
$8egistration authority and control& -n order to prevent undercapitalization, the 8egistrar of business
organizations has po"er to ponder the eligibility of the initially stated capital amount. !he registering authority
fairly intends to %eep the initial proportion bet"een capital and corporate ob2ects for the purpose of preventing
companies from being undercapitalized, thereby defrauding third parties dealing "ith the entity as to the real
magnitude of the company9s assets.
>!ypes of undercapitalization&
(i) 8eal& Company members fail to contribute assets necessary to accomplish the corporate
ob2ects.
(ii) 5ominal& Capital contributions by company o"ners fairly reflect the needed funds to carry
out its ob2ects but any such considerations "ere given by means of a casual title other than a legal title as
contributor.
8easons for undercapitalization are& business ris% avoidance and parent company9s assets
hiding.
!he adequacy of capital, in principle, can only be really pondered "hen the entity is in fact
doing business. !he initial capital figure of a company upon constitution does not certainly reflect its adequacy
to the business to be carried on account of the inherently ris%y nature of commercial transactions. !he control of
legality by the 8egistrar is thus essential to contribute to the accuracy of the presumption of legality of
registered documents.
$.uarantee function of capital& /nder 1nglish la", "henever a creditor is afforded a payment priority
over specified property of the debtor or a third person, a security interest has been created. Consensual security
interests arise by "ay of agreement of the parties6 security interest that arises by operation of la" includes the
common la" lien and a lien arising by operation of la".
!he security function of corporate capital in limited liability structures must be analyzed in relation to
the company9s economic solvency together "ith all relevant legal requirements contributing to its accuracy and
enhancement, such as the transparency and publicity of accounting methods, "hich are crucial factors for
determining the company9s credit and the prevention of real undercapitalization.
4ne advantage of guarantees is that 2udgment processes are avoided.
>!he concept of capital& <rom a pragmatic approach to the concept of capital, there are a productive and
a guarantee function to be born in mind.
According to a modern approach, in addition to the initial static figure determined in the company9s
constitutional documents, capital is formed by the subsequent economic resources capable of becoming part of
the assets (capital increase). !he >>,CDA Argentine Act stated that financial records should be represented in
constant currency& the nominal capital sum is hence yearly ad2usted in order to reflect its real value. /nder
1nglish company la" the amount of the authorized capital is in itself of no importance as an indication of
credit"orthiness because the company9s capital "ill ultimately be determined "ith reference to its paid up
capital (company9s real capital).
<rom a realistic approach, capital must be defined "ith regard to the net economic resources underlying
the formally stated capital amount. Capital is thus li%ely to comprise other items such as revaluation of assets
(integral ad2ustment), share premiums, contributions of creditors that "ill become shares of stoc%, or irrevocable
contributions to capital to be further capitalized upon capital increase.
C45C13! 4< CA3-!AE
3ragmatic Approach !here are a productive and a guarantee function to be born in mind
+odern Approach Capital is formed both by the figure determined in documents and subsequent economic resources
8ealistic Approach Capital must be defined regarding net economic resources underlying the formally stated capital amount
>@aluation of Capital Contributions (property or underta%ings so contributed)& @aluation of capital
contributions is relevant to determine the minimum value of the capital of a company on constitution6 to
determine the share "hereby the contributor shall participate in the business and his consequent rights6 to fi# the
initial limit of shareholder9s liability to"ards the company9s creditors. @aluation ensures the fair value and
consequent adequacy bet"een nominal capital and the aggregate non cash assets representing it. <urther, it
guarantees a fair and equitable equivalence bet"een payment for shares. !here are certain legal requirements
governing contributions to capital&
(i) +onetary valuation (of non$cash consideration)
$/nder 1nglish Ea"& 3ayment for shares can be made in %ind. 1#cept for the case of public
companies under the 1CA >DDF and for Eimited companies under the ACA, the parties9 valuation of non cash
consideration "ill be accepted as conclusive. -t is possible that shares be "atered by agreeing to accept payment
in property "hich is "orth less than the nominal value of the shares& the company "ould be issuing shares at a
discount. 3rivate companies are protected from share "atering by sending the 8egistrar a 8eturn of Allotments
document. !he share "atering ris% is avoided, in the conte#t of 1nglish public companies, by requiring non cash
considerations to be independently valued by a person qualified to be appointed.
$/nder Argentine Ea" (ACA, sections G= to GA)& Assets shall be assessed according to their
mar%et price or by the appraisal of one or more e#pert valuers appointed by the registering authority. !he ACA
provides that valuation of non cash consideration may be challenged by any shareholder alleging it to be
detrimental to him, as "ell as by creditors in cases of equitable insolvency or ban%ruptcy6 2udicial valuation
cannot be challenged. /nder section GA of the ACA, valuation of non$cash consideration for companies "ith a
share capital must be approved by the 8egistrar and shall be ascertained according to mar%et values or by e#pert
valuers.
>/ndervaluation ("here the valued contribution e#ceeds subscribed capital)&
/ndervaluated contributions are admissible under section GA of the ACA. !he shareholder may challenge the
valuation "ithin five years follo"ing the date he gave it. !he shareholder "hose contribution has been
undervalued may require a reduction of its value to one resulting from the valuation if shareholders representing
three quarters of subscribed capital consent to any such reduction.
>4vervaluation& -n case of overvaluation of non$cash consideration the contributor shall
be required to pay the relevant balance. -n EEC9s, under section =GD of the ACA, members are 2ointly and
severally liable to third parties for overvaluation of the contribution representing their share of interest in the
company.
@AE/A!-45 4< CA3-!AE C45!8-'/!-45S
8easons
!o determine the minimum value of the capital of a company
!o determine shares alloted to contributors
!o determine related rights
!o fi# the initial limit of shareholder?s liability
8equirements for
capital contributions
=) +onetary valuation of non$cash consideration
!his avoids shares being "atered*issued at a discount due to overvaluation of
contributions
-n Argentina, valuation is assessed according to the mar%et price or by e#perts?
appraisal
>) Ascertainment
A) Capability of being listed on inventory
B) Susceptibility of being foreclosed
G) ocumentary representation of intangible assets
F) +ust not constitute any underta%ing to do "or% or perform services in the
case of EECs and Argentine companies of persons
H) !he contributor is presumed to transfer property of the assets raised
(ii) Ascertainment
(iii) Capability of being listed on inventory
(iv) Susceptibility of being foreclosed
(v) ocumentary representation of intangible assets (legal rights not constituting claims, legal claims,
collection of legal rights)& -ntangible assets must be represented by documents for the sa%e of their
individualization and conclusive evidence of e#istence. !hey must reflect the legality of the contributor9s
entitlement6 they must be instrumented6 be capable of future gain6 must not constitute the sub2ect matter of a
legal claim6 and represent nominal rights or values.
(vi) -t must not constitute any underta%ing to do "or% or perform services in the case of EECs and
companies of persons (under Argentine company la")
(vii) !he contributor is presumed to transfer property of the assets raised.
>Capital and assets& Capital (notional figure) must be differentiated from contributions representing the
promise of the contributor6 assets it represents6 net "orth ("hich is the dynamic relation bet"een aggregate
assets and aggregate liabilities).
>Accounting implications of capital& -t "ould be true to refer to capital as potential liability of the
company by considering its guarantee function to company9s creditors, or its restitution function (if any) to its
o"ners on distribution of the assets of the company upon the entity being e#tinguished as such.
>Capital constitution& subscribed shares and paid up shares (not yet allotted)6 outstanding shares (held
by shareholders) and treasury shares (acquired by the company).
N()OTIABL( INST&*+(NTS
*C,a#ter -.: Basic conce#ts/ ne$otia%i!it0/ and transera%i!it0
>5egotiable instrument& A signed "riting that contains an unconditional promise or order to pay an
e#act sum of money, either "hen demanded or at an e#act future time.
>Article A of the /CC and its revision& -n =CCD a revised version of Article A "as issued for adoption by
the states.
><unction of instruments& =) As a substitute for money6 >) as an e#tension of credit. -t is essential that
the instrument be easily transferable "ithout danger of being uncollectible so that it operates practically.
>!ypes of negotiable instruments&
$Categories& drafts, chec%s, notes, certificates of deposit (C9s).
$Classifications& orders to pay and promises to pay6 demand instruments (if it (i) states that it is
payable on demand or at sight, or other"ise indicates that it is payable at the "ill of the holder, or (ii) does not
state any time of payment) and time instruments (payable at a future time).
>rafts& A bill of e#change or draft is an unconditional "ritten order that involves three parties. !he
party creating the draft (the dra"er) orders another party (the dra"ee) to pay money, usually to a third party (the
payee). A draft can be both a time draft and a sight draft, such a draft is payable at a stated time after sight.
$!rade acceptances: !he seller of the goods is both the dra"er and the payee. ,hen the draft is
dra"n by a seller on the buyer9s ban% for acceptance, it is called a ban%er9s acceptance.
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>Chec%s (type of draft)& !he "riter of the chec% is the dra"er, the ban% on "hich the chec% is dra"n is
the dra"ee, and the person to "hom the chec% is payable is the payee.
,ith certain types of chec%s, such as cashier9s chec%s, the ban% is both the dra"er and the dra"ee.
A teller9s check is a draft dra"n by one ban% on another ban%.
!raveler9s chec%s require the purchaser9s authorized signature before becoming payable.
>3romissory note& ,ritten promise made by one person (the ma%er of the promise to pay) to another
(usually the payee). -t can be made payable at a definite time or on demand. A note that is secured by personal
property is called a collateral note, because the property pledged as security for the satisfaction of the debt is
called collateral.
>Certificate of deposit& A C is issued "hen a party deposits money "ith a ban%, and the ban% promises
to repay the money, "ith interest, on a certain date. !he ban% is the ma%er of the note, and the depositor is the
payee.
>8equirements for negotiability&
$,ritten form& <ormal "ritten e#pression given certainty. !he "riting must be on a material that
lends itself to permanence. !he "riting must also have portability. -f an instrument is not movable, it obviously
cannot meet the requirement that it be freely transferable.
$Signatures& 'y (i) the ma%er if it is a note or a certificate of deposit6 (ii) the dra"er if it is a
draft or a chec%6 or (iii) an agent representing them. According to the /CC =$>D=(AC), a signature may include
any symbol e#ecuted or adopted by a party "ith present intention to authenticate a "riting. A signature may
be made (i) manually or by means of a device or machine, and (ii) by the use of any name, including a trade or
assumed name, or by a "ord, mar%, or symbol e#ecuted or adopted by a person "ith present intention to
authenticate a "riting. 3arol evidence is admissible to identify the signer.
$/nconditional promise or order to pay& -t must be included in the "riting on the face of a
negotiable instrument. !he promise must be an affirmative (e#press) underta%ing. A C is e#ceptional in this
respect. !he promise or order must be unconditional& it "ill be conditional if it states an e#press condition to
payment, that the promise or order is sub2ect to or governed by another "riting, or that the rights or obligations
"ith respect to the promise or order are stated in another "riting.
><ederal eposit -nsurance Corp. v. <.S.S.S& 3atricia9s and Ea @onne9s guaranties "ere not
negotiable, because the note did not refer to the guaranties and the guaranties did not contain unconditional
promises.
$A fi#ed amount of money must be clearly stated& !o determine the value of the instrument.
<i#ed amount means that the amount must be ascertainable from the face of the instrument. According to the
/CC A$=DB(a), it must be payable in money.
$3ayable on demand or at a definite time (/CC A$=DB(a)(>)). <actors to be born in mind& time of
pay, obligations of secondary parties, statute of limitations, interest to calculate.
>3ayable on demand& -nstruments payable on demand include those that contain the "ords
payable at sight or payable upon presentment. -f no time for payment is specified and the person
responsible for payment must pay on the instrument9s presentment, the instrument is payable on demand (/CC
A$=DJ(a).
>3ayable at a definite time (it cannot be an uncertain future time)& -f it states that it is payable&
(i) on a specified date6 (ii) "ithin a definite period of time after sight or acceptance6 or (iii) on a date or time
readily ascertainable at the time the promise or order is issued. ,hen an instrument is payable on or before a
stated date, it is clearly payable at a definite time, although the ma%er has the option of paying before the stated
maturity date.
>5orthern 'an% v. 3efferoni 3izza Co& ,alter 3effer loaned K=>G,DDD to the 3efferoni 3izza
Company. !he note included a clause that allo"ed the ma%er to renegotiate the terms of repayment at any time
and then e#tend the time for repayment by up to eighty four months :indefinite time;.
!he note "as not negotiable, because under the renegotiation clause, the note "as not payable at
a definite time.
>Acceleration clause& Allo"s a payee or another holder of a time instrument to demand
payment of the entire amount due, "ith interest, if a certain event occurs. /nder the /CC, instruments that
include acceleration clauses are negotiable regardless of the reasons for the accelerations, because (i) the e#act
value of the instrument can be ascertained and (ii) the instrument "ill be payable on a specified date if the event
allo"ing acceleration does not occur.
>1#tension clause& -t allo"s the date of maturity to be e#tended into the future. !he interval of
the e#tension must be specified.
$3ayable to order or to bearer& !o assure an appropriate transfer, the instrument must be payable to order
or to bearer at the time it is issued or first comes into the possession of the holder.
>4rder instruments& !hey are payable to the order of an identified person or to an identified
person or order. !he person specified must be named "ith certainty.
>'earer :person possessing an instrument payable to bearer or indorsed in blan%;
instruments& !hey do not designate a specific payee.
><actors not affecting negotiability& -nterpretation of ambiguous terms (art. A)&
(i) !he fact that an instrument is undated does not affect its negotiability.
(ii) 3ostdating or antedating an instrument does not affect negotiability.
(iii) 0and"ritten terms out"eigh type"ritten and printed terms.
(iv) ,ords out"eigh figures unless the "ords are ambiguous.
(v) ,hen a particular interest rate is not specified but the instrument simply states "ith
interest, the interest rate is the 2udgment rate of interest.
(vi) A notation on a chec% that it is nonnegotiable or not governed by Article A has no effect
on a chec%9s negotiability.
!ransfer
>!ransfer by assignment& A transfer by assignment to an assignee gives the assignee only those rights
that the assignor possessed. Any defenses that can be raised against an assignor can normally be raised against
the assignee.
>!ransfer by negotiation& 5egotiation is the transfer of an instrument in such form that the transferee
becomes a holder. A transfer by negotiation can ma%e it possible for a holder to receive more rights in the
instrument than the prior possessor had.
$5egotiating order instruments& -f the instrument is an order instrument, it is negotiated by
delivery :tradicin; "ith any necessary indorsements :endosos;.
$5egotiating bearer instruments& -f an instrument is payable to bearer, it is negotiated by
delivery.
$Converting order instruments to bearer instruments and vice versa& A chec% originally payable
to cash but subsequently indorsed "ith the "ords 3ay to L must be negotiated as an order instrument, even
though it "as previously a bearer paper. An instrument payable to the order of a named payee and indorsed in
blan% becomes a bearer instrument.
>-ndorsements& An indorsement is a signature "ith or "ithout additional "ords or statements, often
"ritten on the bac% of the instrument itself. -ndorsements can be "ritten on a separate piece of paper (called
allonge).
$'lan% indorsements& -t specifies no particular indorsee and can consist of a mere signature.
$Special indorsements& -t identifies the person to "hom the indorser intends to ma%e the
instrument payable (it identifies the indorsee)
$Mualified indorsements& An indorser "ho does not "ish to be liable on an instrument can use a
qualified indorsement to disclaim this liability (guarantee of payment of the instrument). !he notation "ithout
recourse is commonly used to create a qualified indorsement. !hese indorsements are often used by persons
acting in a representative capacity. !hey can be accompanied by a special indorsement or a blan% indorsement.
$8estrictive indorsements& !hey require indorsees to comply "ith certain instructions regarding
the funds involved.
>-ndorsements prohibiting further indorsement& -f the holder gives value, it has the same legal
effect as a special indorsement.
>Conditional indorsements& 3ayment depends on the occurrence of some event specified in the
indorsement. A person paying or ta%ing for value an instrument can disregard the condition "ithout liability.
>-ndorsements for deposit of collection& -t ma%es the indorsee a collecting agent of the indorser.
!he indorsements 3ay any ban% or ban%er and <or deposit only have the effect of loc%ing the instrument
into the ban% collection process.
>Agency indorsement (trust indorsement :funciona como mandato;)& +ade to persons "ho are
to hold or use the funds for the benefit of the indorser or a third party. !he result of a trust indorsement is that
legal rights in the instrument are transferred to the original indorsee. !he fiduciary restrictions on the instrument
do not reach beyond the original indorsee.
Liability of the Parties
1very party, e#cept a 1ua!iied indorser, "ho signs a ne$otia%!e instrument is either #rimari!0 or
secondari!0 !ia%!e for payment of that instrument "hen it comes due.
38-+A8N E-A'-E-!N& Primar0 !ia%i!it0 is unconditional. A person "ho is #rimari!0 !ia%!e is
absolutely required to pay the instrument6 the !ia%i!it0 is immediate "hen the instrument is signed
or issued and eecti"e "hen the instrument becomes due. 5o action by the ,o!der is required.
+akers and acce#tors are #rimari!0 !ia%!e.
S1C45A8N E-A'-E-!N& Secondar0 !ia%i!it0 is contingent, meaning that the #art0 "ill be !ia%!e
only if the #art0 that is #rimari!0 !ia%!e dishonors the instrument. 3arties that are secondari!0 !ia%!e
promise to pay only if the instrument is properly and timely presented, the instrument is dis,onored,
and time!0 notice of dishonor is given. 2ra3ers and indorsers are secondari!0 !ia%!e.
3roper presentment& Presentment by a holder must be made to the #ro#er #erson, must be made in a
#ro#er manner, and must be time!0. A drat must be presented for acce#tance "here the drat states
so, "here the drat is payable else"here than at the residence or place of business of the dra3ee, and
"here the date of #a0ment depends on #resentment, "here the draft is a foreign bill of e#change
(draft), and "here death or ban%ruptcy of the dra"ee occurs.
ishonor& An instrument is dis,onored "hen #resentment is #ro#er!0 and time!0 made and
required acce#tance or #a0ment is reused or cannot be obtained "ithin the prescribed time. An
instrument is also dis,onored "hen re1uired #resentment is e4cused (as in the case of dead ma%er)
and the instrument is not properly accepted or paid.
3rotest& A #rotest is a certificate of dis,onor that states that a draft "as presented for #a0ment or
acce#tance and has been dis,onored, and the reasons for such dishonor. Protest is no longer required
but may still be used for drats dra"n or payable outside the /S. Indorsers "ho "rite demand and
notice "aived or protest "aived are liable for payment "ithout subsequent #resentment or notice of
dis,onor.
3roper 5otice& <or a party to be held liable on an instrument, it must be properly notiied of the
dis,onor. 5otice may be given in any reasonable manner.
Si$niicance o indorsements& -n addition to being necessary to negotiate order papers, t,e0 create
o%!i$ations on t,e #art o indorsers. !hese obligations come in the form of im#!ied 3arranties and
a contractua! #romise to #a0 su%se1uent ,o!ders o t,e instrument5
Warranties o indorsers
An indorser 3,o recei"es consideration or an instrument makes i"e 3arranties to su%se1uent
,o!ders:
6) T,e indorser ,as $ood tit!e to instrument. (did not steal it or came into possession in
an unla"ful manner).
-) A!! si$natures are $enuine or aut,ori7ed.
8) T,e instrument ,as not %een materia!!0 a!tered
9) No deense o an0 #art0 a$ainst t,e indorser is $ood a$ainst t,e instrument5 A
1ua!iied indorser does not make t,is 3arrant05
:) T,e indorser ,as no kno3!ed$e o t,e %ankru#tc0 o t,e maker5
(@er en pOg. >= Contract of indorsers)
Accomodation #arties: 4ne "ho signs an instrument in any capacity for the purpose of lending his or
her name to another party to the instrument . !hus, an accommodation party "ho signs on the front of
a promissory note belo" the signature of the ma%er assumes the same liability as the ma%er. 4ne "ho
signs on the bac% of the instrument assumes the same liability as an indorser.
An accommodation party is not liable to the party accommodated. !he party accommodated is liable
to the accommodation party if the latter pays the instrument.
+u!ti#!e #a0ees and missin$ indorsements
I an instrument is #a0a%!e to eit,er o t3o #a0ees/ as in ;Pa0 to t,e order o 4 or 0<, the
indorsement of only one of the payees is necessary to negotiate the instrument. ;Pa0 to t,e order o 4
AN2 0<, the indorsement of both payees is necessary to negotiate it.
=or$ed or unaut,ori7ed indorsements
An unauthorized signature or indorsement is one made "ithout actual, implied or apparent authority.
,ith three e#ceptions, and unless ratified, an unauthorized or forged signature does not serve as the
signature of the person "hose name is signed. -t has no effect. -n addition, 3,en an instrument is
#aid on a or$ed indorsement/ t,e tort o con"ersion takes #!ace. Conversion is the "rongful
e#ercise of dominion and control over another9s personal property.
!he three e#ceptions, designed primarily to promote negotiability&
-mposters& ,hen an instrument is issued to an imposter on the false belief that the imposter is the
payee, the indorsement by any person in the name of the payee is treated as an effective indorsement.
!he rule places the loss on the one "ho is in the best position to prevent it. (the ma%er or dra"er)
5o interest intended& ,hen the ma%er or dra"er of an instrument intends the payee to have no interest
in the instrument, an indorsement by any person in the name of the payee is effective.
3added payrolls& ,hen an agent or employee of the ma%er or dra"er pads the payroll by supplying the
employer "ith fictitious names, an indorsement by any person in the name of each fictitious payee is
effective. !his rule places the burden of preventing this type of fraud on the party "ho is in the best
position to prevent it P either the dra"er or the ma%er.
>+iscellaneous -ndorsement 3roblems&
$!he payee or indorsee "hose name is misspelled can indorse "ith the misspelled name, the correct
name, or both. !he usual practice is to indorse "ith the name as it appears on the instrument and follo" it by the
correct name.
$-f an instrument is made payable to t"o or more persons 2ointly, all of the payees9 indorsements are
necessary for negotiation. -f an instrument payable to t"o or more persons does not clearly indicate "hether it is
payable in the alternative or payable 2ointly, then the instrument is payable to the persons alternatively.
>.eneral +otors Acceptance Corp. v. Abington Casualty -nsurance Co& Abington issued an
insurance policy to Azevedo to cover his Qeep. .+AC held a security interest in Azevedo9s Qeep. !he car "as
damaged and Abington issued a chec% payable 2ointly to the order of Azevedo and .+AC. ,here there are
copayees, a negotiable instrument cannot be discharged by the actions of only one payee. /CC A$==D(d)
e#pressly prohibits the discharge of an instrument e#cept by all the payees.
$Chec%s& also payable to legal entities (authorized representatives shall negotiate them) and public
officers.
*C,a#ter ->: ?o!der in 2ue Course and 2eenses:
>A holder normally is sub2ect to the same defenses that could be asserted against the transferor. A
0older in ue Course (0C) is a holder "ho ta%es the instrument free of most of the defenses and claims to
"hich the transferor "as sub2ect.
>8equirements for 0C status&
$<irst requirement& !a%ing for value& An 0C must have given value for the instrument :/CC A$AD>(a)
(>)(i), A$ADA;. Something of value must have been given in e#change of the instrument6 a holder "ho receives
the instrument as a gift or inherits it is an ordinary one. A holder ta%es the instrument for value only to the e#tent
that the promise has been performed (he must give value before and not after receiving the instrument).
/nder /CC A$ADA(a), a holder can ta%e an instrument for value in one of five "ays&
(i) 'y performing the promise for "hich the instrument "as issued or transferred.
(ii) 'y acquiring a security interest or another lien in the instrument.
(iii) 'y ta%ing an instrument in payment of, or as security for, an antecedent claim.
(iv) 'y giving a negotiable instrument as payment ("hich instrument has value "hen being issued, not
"hen the underlying obligation is finally paid).
(v) 'y giving an irrevocable commitment as payment.
RChec% deposits and "ithdra"als& A commercial ban% can become an 0C "hen honoring other ban%s9
chec%s for its o"n customers, "hen such chec%s are not paid by these other ban%s. AS7 S!1@15S$<-8S!
5A!-45AE 'A57 1LA+3E1
RSpecial situations& A holder may ta%e an instrument for value but still not be accorded 0C status.
/nder /CC A$AD>(c), a holder has his rights limited to those of an ordinary holder in the follo"ing situations&
(i) 3urchase at a 2udicial sale or acquisition by ta%ing under legal process6 (ii) Acquisition "hen ta%ing over an
estate6 (iii) 3urchase as part of a bul% transfer.
$Second requirement& !a%ing in good faith (honesty in fact and observance of reasonable commercial
standards of fair dealing). !he purchaser$holder must have acted honestly in the process of acquiring the
instrument. -t is not necessary that the transferor act in good faith.
RAdamar of 5e" Qersey, -nc. v. Chase Eincoln <irst 'an%, 5.A& !homas stole t"o chec%s and used
them in a casino (Adamar). Adamar too% them in good faith but the ban% prevented payment. !he court held
that the casino satisfied the requirement and "as entitled to payment.>
$!hird requirement& !a%ing it "ithout notice that it is a defective instrument (in the event it is). 5otice
of a defect is given "hen the holder has actual %no"ledge of the defect or receiving it or having reason to %no"
of the defect. !he holder must also have received the notice at a time and in a manner that gives a reasonable
opportunity to act on it :/CC A$AD>(f);.
R3ossible defects include&
(i) !hat the instrument is overdue&
a. emand instruments& !a%ing the instrument %no"ing that demand has been made or
that it has been made at an unreasonable (CD days after the chec%9s date) length of time after its date.
b. !ime instruments& !a%ing the instrument after its e#pressed due date. 4nly business
days must be counted.
-f a debt is to be paid in installments or through a series of notes, the ma%er9s default on
any one installment or on any one note of the series "ill constitute notice of the instrument being overdue.
(ii) !hat it has been dishonored& 3ayer refuses to pay. !a%ing an instrument "hich has been
dishonored and %no"ing it is being in notice.
(iii) An uncured default "ith respect to another instrument issued as part of the same series.
(iv) !he instrument contains an unauthorized signature or has been altered.
(v) !here is a defense against the instrument or a claim thereto& !hey must be apparent on the
face of the instrument.
a. -ncomplete instruments& Eac%ing an element of negotiability. +inor omissions do
not affect the validity of the instrument. !hose incomplete instruments "hich have then been completed in an
unauthorized manner "ithout the holder %no"ing are still enforceable by the 0C.
b. -rregular instruments& @isible evidence of forgery of a ma%er9s or dra"er9s signature,
or alterations to material elements of negotiable instruments "ill disqualify a purchaser from 0C status.
c. @oidable obligations& -f the holder %no"s that the obligation under the instrument is
voidable, he cannot be a 0C. 7no"ledge of one defense precludes a holder from asserting 0C status in
regard to all other defenses. 7no"ledge that a fiduciary has "rongfully negotiated an instrument is sufficient
notice of a claim against the instrument to preclude 0C status.
(vi) -t is so irregular or incomplete as to call into question it authenticity.
>0older through an 0C& A holder "ho acquires 0C rights by deriving his title from an 0C, under
the Shelter 3rinciple (unless the transferee is engaged in fraud or illegality) :/CC A$>DA(b);. Eimitations to
the shelter principle include persons "ho formerly held instruments and "ant to reacquire them from 0Cs.
>/niversal defenses (real defenses)& !hese are valid against all holders.
$<orgery& -t cannot bind the person "hose name is used unless that person ratifies the signature
or is precluded (for its negligence) from denying it. !his defense can also be raised by a principal "hen one of
his agents e#ceeds their authority.
$<raud in the e#ecution (inception)& A person is deceived into signing a negotiable instrument.
!his defense cannot be raised if a reasonable inquiry "ould have revealed the nature and terms of the
instrument.
R<ederal eposit -nsurance Corp. v. Culver& !he 8e#ford State 'an% loaned KGD,DDD to 7alliel.
Culven received only KAD,DDD from him. !he ban% made Culven sign a note for the "hole amount and told him
he "as only signing a receipt. ,hen the ban% failed, the -nsurance Corp. bought the note and sued Culven.
efendant "as negligent in relying on the ban%9s representative9s assurance that the note "as only a receipt.
$+aterial alteration& !hey include any change in the contract terms bet"een t"o parties&
completing an instrument, adding "ords or numbers, changes, cutting off part of the pages, adding a clause. !o
correct "rong information in total amounts does not imply an alteration. -f the alteration is readily apparent,
then obviously the holder has notice of some defect or defense and therefore cannot be an 0C.
$ischarge in ban%ruptcy& !he purpose of ban%ruptcy is to settle finally all of the insolvent
party9s debts.
$+inority (infancy), according to state la".
$-llegality& ,hen the la" declares that an instrument is void because it has been e#ecuted in
connection "ith illegal conduct.
$+ental incapacity& Any instrument issued by a person ad2udicated mentally incompetent is null
and void (voidance ab initio).
$1#treme duress (immediate threat of force or violence).
>3ersonal defenses& /sed to avoid payment to an ordinary holder of a negotiable instrument.
$'reach of contract or breach of "arranty.
$Eac% or failure of consideration.
$<raud in the inducement (ordinary fraud)& A person "ho issues a negotiable instrument based
on false statements by the other party "ill be able to avoid payment on that instrument.
$-llegality& !he statute provides that an illegal transaction is voidable, the defense is personal.
R7edzie and =DA
rd
Street Currency 1#change, -nc. v. 0odge& <rentess "as not a licensed
plumber and received a chec% from 0odge. 'ut he did not do his 2ob6 he did cash the chec% at 7edzie, although
0odge stopped payment. -llinois9s la"s do not ma%e the contract "ith the unlicensed plumber void& hence the
illegality defense cannot be raised.>
$+ental incapacity& -f a ma%er or dra"er issues a negotiable instrument "hile mentally
incompetent but before a formal court hearing has declared them to be so, the instrument is voidable.
$ischarge by payment or cancellation.
$/nauthorized completion of an incomplete instrument.
$5ondelivery of the instrument.
$4rdinary duress or undue influence rendering the contract voidable.
><ederal limitations on 0C rights& !o protect consumers, the <ederal !rade Commission (<!C) in
=CHF issued 8ule BAA, "hich effectively abolished the 0C doctrine in consumer credit transactions.
$8equirements of <!C rule BAA (relating to consumers9 credit transactions)& Attempts to prevent a
situation in "hich a consumer is required to ma%e payment for a defective product to a third party. !he rule
applies to any seller of goods or services "ho ta%es or receives a consumer credit contract. /nder rule BAA, these
parties must include in the consumer credit contract a provision. -f such provision is not there, a consumer may
remain unprotected.
$1ffect of the rule (0C becomes a contract assignee)& <!C 8ule BAA allo"s a consumer "ho is party to
a consumer credit transaction to bring any defense he has against the seller of a product against a subsequent
holder as "ell. !here is a reduction of transferability& any 0C of the instrument is placed in the position of a
contract assignee.
B*SIN(SS O&)ANIZATIONS: A&)(NTINA
Ar$entine !a3 on %usiness or$ani7ations and ot,er !e$a! entities
!o form a business organization (sociedad comercial) in Argentina it is necessary to comply "ith one of the
legal types recognized by the Argentine Companies Act =CGGD*H> (ACA). /nder sec. =, a rigid system is
established& ShabrO sociedad comercial cuando dos o mOs personas en forma organizada, conorme a uno de !os
ti#os #re"istos en esta !e0, se obliguen a realizar aportes para aplicarlos a la producciTn o intercambio de
bienes o servicios participando de los beneficios y soportando las pUrdidas9 (ACA, sec. =). !o form a business
organization under the ACA you need to comply "ith one of these types.
!his contrasts "ith the Anglo$American system "hen "e analyze a similar definition of one type of business
organization, namely 3artnerships& @an association o t3o or more #ersons to carr0 on as co-o3ners (Aoint
tenants) o a %usiness or #roitB (/3A). !his definition proves a much more fle#ible system as regards the
creation of business organizations and their recognition by the state.
,hether a 3artnership is considered a legal entity or not is traditionally a matter of debate, especially under /7
la" "hich lac%s a formal statutory provision stating such nature. /nder the 8/3A in the /SA, legal personality
is formally recognized to such business organizations.
/nder provisions of the Argentine Civil Code (ACC) other legal entities may be formed besides business
organizations*associations. !hese are the follo"ing&
48.A5-VA!-45S
Eegal entities of a private nature
Sociedades
3artnerships governed by the Ar Civil Code (Sociedades civiles)
'usiness organizations
Associations
-ncorporated associations
/nincorporated associations
<undaciones
Eegal entities of a public nature
!he State
-ndependent agencies (entidades autOrquicas)
!he Catholic Church
Eegal entities of a public nature are governed by public administrative la" "hile legal entities of a private
nature are governed by private la" and deals basically "ith private persons.
All of these, provided they comply "ith certain requirements that "e9ll mention later in each case, are regarded
as legal entities. !his basically entails secondary liability of the members, as the organization as such is
considered primarily liable.
Some of these "ill have authorization of the state, "hich basically entails limited liability of the members.
Eet9s see each particular case&
Sociedades Ci"i!es (sec. =FBJ ACC et seq.)
3artnerships governed by the ACC have the follo"ing characteristics&
=. As they are legal entities, its members have secondary liability (responsabilidad subsidiaria, los
miembros gozan del Sbeneficio de e#cusiTn9, this means that personal liability only arises after the
2udgement creditor has e#ecuted the partnership9s assets) and unlimited, 2oint liability6 they are liable on
an equal basis for the entity debts irrespective of the proportion of their original contributions (this fact
that they ans"er only "ith their SporciTn viril9, as stated in sec. =HBH ACC, differentiates Ssociedades
civiles9 from Ssociedades comerciales9 that also have unlimited liability).
>. !hey are for$profit entities.
A. !o be regarded as legal entities they need to be constituted by Sescritura pWblica9 (under sec. ==JB,
subsec. A, ACC) :public deed;. 4ther"ise, they "ill be regarded as Ssociedades civiles irregulares9
("hich are also Ssociedades de hecho9) deprived of legal personality (that9s "hy they are not included in
the chart). !he liability of the members in this case "ill be primary and unlimited.
Asociaciones 0 undaciones con autori7aciCn de! estado #ara uncionar (sec. AA ACC)
espite the differences bet"een Sfundaciones9 ("hich can be constituted by one person, and even by a
testamentary provision) and -ncorporated Associations, they both en2oy the same characteristics&
=. As they are legal entities, its members have secondary liability. 'ut as they have been Sincorporated9, or
authorized by the state, their members also en2oy limited liability.
>. !hey are non$profit entities. Certain lucrative purposes, ho"ever, are almost al"ays present (e.g. <-<A,
A<A).
Sim#!es asociaciones ci"i!es o re!i$iosas (sec. BF ACC)
!hese are /nincorporated Associations "ith the follo"ing characteristics&
=. Eiability of the members is e#actly as that established for Ssociedades civiles9. Sec. BF ACC provides
that the rules that govern Ssociedades civiles9 "ill also apply to this type of association by default.
>. <or it to be considered a Ssimple asociaciTn9, and thus en2oy secondary liability of its members it is
necessary that Sla constituciTn y designaciTn de autoridades se acredite por escritura pWblica o
instrumento privado de autenticidad certificada por escribano pWblico9. 4ther"ise, they "ill not be
regarded as legal entities and its members "ill be primarily and unlimitedly liable upon there not
e#isting legal personality of the entity (for this reason they are not included in the chart).
,e can conclude that there are t"o types of legal entities that do not require authorization by the state&
Ssociedades civiles9 and Ssimples asociaciones9.
<or some scholars, the lac% of authorization by the state renders the organization a Ssu2eto de derecho9 but not a
Spersona 2urXdica9. /nder la" =HH==, such distinction becomes outdated and denies the personality that the
ACC, as amended, vests upon Ssociedades civiles9 and Ssimples asociaciones9. :!his is "hat +arcelo said but
"hich doesn9t seem to apply to Ssimples asociaciones9. Sec BF ACC clearly states their nature as Ssu2etos de
derecho9 as opposed to Spersonas 2urXdicas9. -n any case, - thin% the difference is more linguistic than practical;.

.oing bac% to 'usiness 4rganizations (Sociedades Comerciales) there may be other hybrid situations to
consider, namely Ssociedades no constituidas regularmente9 (under title -@ of the ACA). !hese include t"o
cases&
Sociedad de ,ec,o
!hese organizations lac% instrumentality despite the fact that they comply "ith most features required for a
Ssociedad9 to be such (for e#ample, the members evidence Saffectio societatis9, the "ill to associate and share
efforts, profits and losses). !he members conduct business as if they "ere in fact associated in some manner.
!he Ssociedades civiles irregulares9 mentioned above are the same as these Ssociedades de hecho9.
Sociedad Irre$u!ar
!hese organizations do comply "ith one of the legal types recognised by the ACA. !hey also comply "ith all
the steps to"ards instrumentality but lac% the final filing thereof before the registering authority.
5either SSociedades de hecho9 nor SSociedades -rregulares9 are legal entities (they couldn9t be included in the
chart).
'oth terms "ill evidence difficulties in translation as they are not e#actly the same as Spartnerships by estoppel9
or Sde facto corporations9.
YArgentine 'usiness and Civil 4rganizationsY
$ !he Argentine legal system in the matter of business and civil organizations is governed by the
Argentine Companies Act =CGGD and the Argentine Civil Code. !he Argentine Companies Act establishes a rigid
system by virtue of "hich one must choose one of the legal types of business organization in order to create one.
(!his opposes to the Anglo$American system, "hich proves to be much more fle#ible as regards the creation
and recognition of business organizations.)
!he Argentine Civil Code also rules over other legal entities, "hich are&
$ Eegal entities of a public nature (governed by public administrative la")&
$ !he State
$ -ndependent agencies
$ !he Catholic Church
$ Eegal entities of a private nature (governed by private la")&
$ Sociedades Civiles (partnerships)& As they are legal entities (for "hich they must be
organized by public deed), its members en2oy secondary, but unlimited, 2oint liability. !hey are for$profit
entities.
$ Asociaciones y <undaciones con AutorizaciTn del 1stado para <uncionar& !hey are
non$profit entities. -ts members have secondary, limited liability.
$ Simples asociaciones civiles y religiosas& -ts members bear secondary, limited, 2oint
liability (only if it organized by public deed). !he lac% of authorization by the state renders the organization a
Ssu2eto de derecho9 but not a Spersona 2urXdica9.
$ /nder the Argentine Companies Act, "hen there is a problem in the organization of the business
organization a Zsociedad no constituida regularmenteZ is said to e#ist. !hey can be either&
$ Sociedades de hecho& !hey lac% an intrument evidencing their e#istence.
$ Sociedades irregulares& !hey lac% the filing of their instruments "ith the government office.
5either one nor the other are legal entities.

1thics (Company Ea")
Y1thics can be defined as the study of "hat constitutes right or "rong behavior. 'usiness ethics focuses on "hat
constitutes right or "rong behavior in the business "orld and on ho" moral and ethical principles are applied by
businesspersons to situations that arise in their daily activities in the "or%place.
>4ne of the most effective "ays of setting a tone of ethical behavior "ithin an organization is to create an
ethical code of conduct. A "ell$"ritten code of ethics e#plicitly states a company9s ethical priorities. 4ther
components of ethics programs include a corporation9s ethics committee, ethical training programs, and internal
audits to monitor compliance "ith applicable la"s and the company9s standards of ethical conduct.
>!he Sarbanes$4#ley Act of >DD>& -t requires that companies set up confidential systems so that employees and
others may raise red flags about suspected illegal or unethical auditing and accounting practices. ,eb$based
reporting systems "ere set up. !hrough them, employees can contact 1thics point, "ith "hich they may report
suspicious accounting practices, se#ual harassment, and other possibly unethical behavior.
>!he 1nron Case& According to the rules of the <inancial Accounting Standards 'oard, energy traders could
include in current earnings profits that they anticipated on energy contracts. 0erein lay the beginning of a type
of accounting fudging that increased over time as the company struggled to improve its reported current
earnings. 'y >DDD, GD[ of 1nron9s K=.Bbn of reported preta# profits consisted of anticipated future earnings on
energy contracts. 'ecause 1nron9s managers received bonuses on "hether they met earning goals, they had an
incentive to inflate the anticipated earnings on such contracts. -n this "ay, 1nron9s stoc% prices "ere really high,
but 1nron "asn9t paying high ta#es.
4ff$the$boo% transactions& 1nron also created a comple# net"or% of subsidiaries that enabled it to move
losses from the core company to the subsidiaries, "hich did not sho" up in 1nron9s boo%s. ,hen these "ere
created, 1nron transferred assets to them, assigning a value to the assets that "as much greater that their actual
mar%et value.
Self$dealing& 1nron9s C14 frequently did business "ith companies o"ned by his children.
RA company is guilty of coo%ing the boo%s "hen it %no"ingly includes incorrect information on its
financial statements Pmanipulating e#penses and earnings to improve their earnings per share of stoc% (13S).>
R,ith off$balance sheet accounting, a company didn9t have to include certain assets and liabilities in its
balance sheet.>
RSpecial purpose entities (S31)& 5e"ly created companies specifically created for certain purposes.>
>Sarbanes$4#ley Act& !he legislation establishes ne" or improved standards for all /S public company boards,
management, and public accounting firms. 8egarding auditors of public company financial statements the act
requires auditor independence. !he act further establishes a ne" controlling agency& the 3ublic Company
Accounting 4versight 'oard (3CA4') "hich is in charge of overseeing, regulating, and inspecting firms in
their roles as auditors of public companies.
>Section BDB directs the S1C to adopt rules requiring each annual report of a company to contain an internal
control report "hich shall include a statement of management9s responsibility on financial reporting as "ell as
an assessment of the effectiveness of said internal control structure as of the end of the most recent fiscal year. -t
further requires the company9s auditor to attest and report on the adequacy of the company9s internal control
over financial reporting. .ood internal controls may help companies deter fraudulent financial or accounting
practices.
>!he bill "as enacted as a reaction to a number of ma2or corporate and accounting scandals including those
affecting 1nron, !yco -nternational, Adelphia, 3eregrine Systems and ,orldCom.
SarbanesP4#ley contains == titles that describe specific mandates and requirements for financial reporting. !itle
- consists of nine sections and establishes the 3ublic Company Accounting 4versight 'oard, to provide
independent oversight of public accounting firms providing audit services (ZauditorsZ). -t also creates a central
oversight board tas%ed "ith registering auditors, defining the specific processes and procedures for compliance
audits.
!itle -- consists of nine sections and establishes standards for e#ternal auditor independence, to limit conflicts of
interest. !itle --- consists of eight sections and mandates that senior e#ecutives ta%e individual responsibility for
the accuracy and completeness of corporate financial reports.
!itle -@ requires internal controls for assuring the accuracy of financial reports and disclosures, and mandates
both audits and reports on those controls.
!itles @ is designed to help restore investor confidence in the reporting of securities analysts. -t defines the
codes of conduct for securities analysts. !itle @- defines the S1C?s authority to censure or bar securities
professionals from practice.
!itle @-- requires the Comptroller .eneral and the S1C to perform various studies and report their findings.
Sarbanes$4#ley required the disclosure of all material off$balance sheet items. -t also required an S1C study and
report to better understand the e#tent of usage of such instruments and "hether accounting principles adequately
addressed these instruments.
Section BDB requires management and the e#ternal auditor to report on the adequacy of the company?s internal
control over financial reporting (-C<8). /nder this section, management is required to produce an Zinternal
control reportZ as part of each annual 1#change Act report.
security
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An equity security is a share of equity interest in an entity such as the capital stock of a
company, trust or partnership. The most common form of equity interest is common
stock, although preferred equity is also a form of capital stock. The holder of an equity is
a shareholder, owning a share, or fractional part of the issuer. nlike debt securities,
which typically require regular payments !interest" to the holder, equity securities are not
entitled to any payment. #n bankruptcy, they share only in the residual interest of the
issuer after all obligations ha$e been paid out to creditors. %owe$er, equity generally
entitles the holder to a pro rata portion of control of the company. &quity also en'oys the
right to pro(ts and capital gain, whereas holders of debt securities recei$e only interest
and repayment of principal.
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). #temi*ed catalog or list of tangible goods or property, or the intangible attributes or
qualities.
+. ,alue of materials and goods held by a (rm !)" to support production !raw materials,
sub-assemblies, work in process", !+" for support acti$ities !repair, maintenance,
consumables", or !." for sale or customer ser$ice !merchandise, (nished goods, spare
parts". #t is often the largest item in the current assets category, and must be accurately
counted and $alued at the end of each accounting period to determine a (rm/s pro(t or
loss. 0irms whose in$entory items ha$e a large unit cost generally keep a day to day
record of changes in in$entory !called perpetual in$entory method" to ensure accurate
and on-going control. 0irms with in$entory items of small unit cost generally update their
in$entory records at the end of an accounting period or when (nancial statements are
prepared !called periodic in$entory method". The $alue of an in$entory depends on the
$aluation method used, such as (rst-in, (rst-out !0#01" method or last-in, (rst-out !L#01"
method. 2AAP require that in$entory should be $alued on the basis of either its cost
price or its current market price whiche$er is lower of the two to pre$ent o$erstating of
assets and earning due to sharp increase in the in$entory/s $alue in in3ationary periods.
The optimum le$el of in$entory for a (rm is determined by in$entory analysis. 4alled also
stock in trade, or 'ust stock.
5hat 6oes #n$entory 7ean8
The raw materials, work-in-process goods and completely (nished goods that are
considered to be the portion of a business/s assets that are ready or will be ready for
sale. #n$entory represents one of the most important assets that most businesses
possess, because the turno$er of in$entory represents one of the primary sources of
re$enue generation and subsequent earnings for the company/s shareholders9owners.
#n$estopedia e:plains #n$entory
Possessing a high amount of in$entory for long periods of time is not usually good for a
business because of in$entory storage, obsolescence and spoilage costs. %owe$er,
possessing too little in$entory isn/t good either, because the business runs the risk of
losing out on potential sales and potential market share as well.
#n$entory management forecasts and strategies, such as a 'ust-in-time in$entory system,
can help minimi*e in$entory costs because goods are created or recei$ed as in$entory
only when needed.
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5hat 6oes ;arbanes-1:ley Act 1f +<<+ - ;1= 7ean8
An act passed by .;. 4ongress in +<<+ to protect in$estors from the possibility of
fraudulent accounting acti$ities by corporations. The ;arbanes-1:ley Act !;1="
mandated strict reforms to impro$e (nancial disclosures from corporations and pre$ent
accounting fraud. ;1= was enacted in response to the accounting scandals in the early
+<<<s. ;candals such as &nron, Tyco, and 5orld4om shook in$estor con(dence in
(nancial statements and required an o$erhaul of regulatory standards. #n$estopedia
e:plains ;arbanes-1:ley Act 1f +<<+ - ;1=
The rules and enforcement policies outlined by the ;1= Act amend or supplement
e:isting legislation dealing with security regulations. The two key pro$isions of the
;arbanes-1:ley Act are:
). ;ection .<+: A mandate that requires senior management to certify the accuracy of
the reported (nancial statement
+. ;ection ><>: A requirement that management and auditors establish internal controls
and reporting methods on the adequacy of those controls. ;ection ><> had $ery costly
implications for publicly traded companies as it is e:pensi$e to establish and maintain
the required internal controls.
The ;arbanes-1:ley Act
The ;arbanes-1:ley Act of +<<+ is mandatory. ALL organi*ations, large and small, 7;T
comply.
This website is intended to assist and guide. #t pro$ides information, and identi(es
resources, to help ensure successful audit, and management. 5hether you are entirely
new to the ;arbanes-1:ley legislation, or whether you ha$e an established strategy, this
portal should hopefully pro$e to be of substantial $alue
#ntroduction
The legislation came into force in +<<+ and introduced ma'or changes to the regulation
of (nancial practice and corporate go$ernance. ?amed after ;enator Paul ;arbanes and
@epresentati$e 7ichael 1:ley, who were its main architects, it also set a number of
deadlines for compliance.
The ;arbanes-1:ley Act is arranged into ele$en titles. As far as compliance is concerned,
the most important sections within these are often considered to be .<+, ><), ><>, ><A,
B<+ and A<C.
An o$er-arching public company accounting board was also established by the act, which
was introduced amidst a host of publicity.
;arbanes-1:ley 4ompliance
4ompliance with the legislation need not be a daunting task. Like e$ery other regulatory
requirement, it should be addressed methodically, $ia proper analysis and study.
Also like other regulatory requirements, some sections of the act are more pertinent to
compliance than others. To assist those seeking to meet the demands of this act, the
following pages co$er the key ;arbanes-1:ley sections:
;arbanes-1:ley Act ;ection .<+
This section is of course listed under Title ### of the act, and pertains to /4orporate
@esponsibility for 0inancial @eports/.
;ummary of ;ection .<+
Periodic statutory (nancial reports are to include certi(cations that:
D The signing oEcers ha$e re$iewed the report
D The report does not contain any material untrue statements or material omission or be
considered misleading
D The (nancial statements and related information fairly present the (nancial condition
and the results in all material respects
D The signing oEcers are responsible for internal controls and ha$e e$aluated these
internal controls within the pre$ious ninety days and ha$e reported on their (ndings
D A list of all de(ciencies in the internal controls and information on any fraud that
in$ol$es employees who are in$ol$ed with internal acti$ities
D Any signi(cant changes in internal controls or related factors that could ha$e a
negati$e impact on the internal controls
1rgani*ations may not attempt to a$oid these requirements by reincorporating their
acti$ities or transferring their acti$ities outside of the nited ;tates
;arbanes-1:ley Act ;ection ><>
This section is listed under Title #, of the act !&nhanced 0inancial 6isclosures", and
pertains to /7anagement Assessment of #nternal 4ontrols/.
;ummary of ;ection ><>
#ssuers are required to publish information in their annual reports concerning the scope
and adequacy of the internal control structure and procedures for (nancial reporting. This
statement shall also assess the eFecti$eness of such internal controls and procedures.
The registered accounting (rm shall, in the same report, attest to and report on the
assessment on the eFecti$eness of the internal control structure and procedures for
(nancial reporting.