BUSINESS ASSOCIATIONS OUTLINEFALL SEMESTER 2003 ~ PROFESSOR BRIETTA CLARK

I. AGENCY Nature of the Agency Relationship Defn. of principal/agent relationship the fiduciary relationship resulting from the

mutual assent of both parties for the agent to act on behalf of the P towards some endo the analysis of the relationship often settles around whether or not there

has been mutual assent to the relationship Agency exists so corps. and p-ships can function at lower levels (i.e. so you can buy

your car from a salesperson b/c he has authority from dealership to sell you the car) R2nd §13 an agent is a fiduciary w/respect to his P re: matters w/in the scope of

his agency o Defn. of a fiduciary one who owes to others the duties of good faith,

trust, confidence, and candor Agency is clearest in the corporate setting b/c a corporation is a fictitious entity that

can only act thru real people who are its agents; so the corp. will be held to be the principal, and will be liable for the actions of its agents

To show agency, you must have: o manifestation by the principal that the agent will act for him or her, o acceptance by the agent of the undertaking, and o an understanding between the parties that the principal will be in

control of the undertaking.

Master/Servant Relationship where one person has the right to control the physical conduct of the other person; look for day-to-day control, and the master’s control of the way in which the job is performed

Independent Contractor (IC) Relationship where the principal has the right to dictate the results or ends of a particular task, but does not have the right to control how the agent performs the task

some independent contractors are not agents for ex., where the IC operates independently & enters into arm’s lengths transactions w/others no agency exists in this situation

Types of Agent Authority

Actual Authority (Express or Implied) Actual authority exists where the agent reasonably believed, based on P’s

conduct/manifestations, that he was acting on P’s behalf and was subject to his control. (§26)

o Focused on what the agent reasonably believed b/c of P’s conduct

Express authority direct manifestation from P to do act on his behalf Implied actual authority can be circumstantially, but not expressly, proven

o for example, where A was hired to be the president of a corporation by virtue of his title, he has implied authority to hire & fire

o Signs of implied authority Job title, past conduct of the P, nature of the job in the eyes of the

agent, and as perceived by that particular business community Where either form of actual authority exists, P is bound to the contract that A

negotiated, and P CANNOT seek indemnification from A.o P can be sued by a 3rd party for the act, but A can’t b/c agency works to

allow A to act on P’s behalf w/o fear of liability

Mill Street Church of Christ v. Hogan, KY, 1990 Ct. found that Bill had implied authority to hire Sam to help him paint the church, and that therefore Sam was an employee; for implied authority, the focus is on the agent’s understanding of the authority given to him can focus on past conduct of the principal, and the nature of the job here he had hired helpers before, and he discussed w/P the possibility of hiring someone else to help him finish P told him he could hire whoever he wanted the person alleging the authority has the burden of proving that it existed, so the burden was on Bill; as far as Sam was concerned, Bill had hired him many times before; he had no reason to doubt that Bill had the authority to hire him again (but the 3rd party isn’t at issue here); we’re concerned w/Bill, the agent’s, understanding so Sam could sue the Church on this K, but could not sue Bill, and they couldn’t seek indemnification from Bill

Apparent Authority Definition where based on P’s conduct, T reasonably believes that A is P’s agent

o example: P gives agent a job title that usually carries w/it authority to enter into K’s

o focused on what T reasonably believed b/c of P’s conduct refers to the power to bind, not the right to bind that power comes from the

appearance of legitimate authority; this doctrine works to protect 3rd parties who are misled by appearances

where apparent authority exists, P is liable to T, but P can seek indemnification from A if A acted beyond his authority

for apparent authority, consider what occurred at the time the K was entered into Apparent authority and actual authority can coexist Detrimental reliance isn’t required by every jurisdiction; some do require it though,

and often refer to this category as “agency by estoppel” the detrimental reliance requirement though has little practical significance, b/c if there’s no detrimental reliance, then probably no claim will be brought

Because some manifestation from the principal is required, apparent authority can NEVER apply to undisclosed principals

Sometimes P’s inaction can result in apparent authority where P is aware of the assertions made by the agent and does nothing to contradict them; P’s silence amounts to acquiescence

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If apparent authority existed, T cannot sue A on the contract (except if there was fraud or misrepresentation by A, or if A was party to the K)

370 Leasing Corp. v. Ampex Corp., 1976 issue of whether Kays had apparent authority to act as an agent for Ampex; if Kays did exceed his authority, then Ampex could seek indemnification from him; HOLDING Kays had apparent authority to accept offer from 370; it was reasonable for T (370 Leasing) to presume that Kays, a salesman, had the authority to bind the company; (note: the manifestation from the principal was giving Kays the title of sales rep.)

Kidd v. Thomas Edison, Inc., NY, 1917 A female jazz singer reasonably believed that the agent, Fuller, had the authority to enter into the K he did; he exceeded the authority that Edison had given him, but there was apparent authority so the principal is still bound idea behind this is that where P gets another person to do his work for him, P has vouched for the agent’s reliability, and should be bound by the agent’s minor deviations b/c he entrusted him otherwise; perhaps P could seek indemnification from A, but it doesn’t seem that the court would favor that here.

Inherent Authority R2nd §8 a term used to indicate the power of an agent which is not derived from

authority, but solely from the agency relation, and exists for the protection of persons harmed by dealings w/the agent

Cts. often confuse it w/apparent authority; encompasses respondeat superior; and also holds P responsible for some acts of agents which, while unauthorized, are nonetheless quite close to (or incidental to) that which they are authorized to do.

This is a “catch all doctrine” based on fairness where there’s neither actual, nor apparent authority, and yet the agent has the power to bind the principal

Consider the agent’s position, not the 3rd parties position where the agent did something that seemed “usual and proper” for the job, then there is inherent authority

Most common w/undisclosed principal b/c doesn’t fit in w/apparent authority which requires manifestation by P; seems like the ct. wants to punish P for being undisclosed

R2nd of Agency §194 an undisclosed principal is liable for the acts of agents done on his account, if usual or necessary, even if forbidden by the principal

R2nd of Agency §195 an undisclosed principal who entrusts an agent with the management of his business is subject to liability to 3 rd persons w/whom the agent enters into transactions usual to the business, and on the principal’s account although contrary to the directions of the principal

Inherent agency does not apply if the 3rd party knows that the agent is acting w/o authority, or if the agent is not acting in the principal’s interest (like situation where A spends big $$ on a lavish party that has nothing to do w/P)

Watteau v. Fenwick, 1892 Humble was the manager, his name was over the door, but he only had authority from undisclosed P to buy beer and water; he bought other stuff (cigars etc.), contrary to P’s wishes; seller of the cigars sues P on an agency theory, that Humble was acting for P; HOLDING ct. finds that there was inherent authority; Ct.

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doesn’t like the fact that P was undisclosed, that P hid behind his agent; the ct. wants to protect the creditor who acted in good faith and had no reason to suspect it wasn’t dealing w/P; would not be apparent authority b/c there was no manifestation from the principal

Disclosed principal where at the time of the transaction conducted by A, T has notice that the agent is acting for a P, and knows the P’s identity

Partially disclosed principal where T has notice that A is or may be acting for a principal but has no notice of P’s identity unless otherwise agreed, when an agent of a partially disclosed P makes a K

w/another on behalf of that P, the agent is a party to the K (unless the agent discloses that he is acting in a representative capacity, and discloses the identity of his principal)

o so in these situations, A has a duty to T to disclose R2nd of Agency §144 a disclosed or partially disclosed P is liable for K’s made by

an agent acting w/in his authority if made in proper form, and w/the understanding that the Principal is a party

o if there was no understanding that P was a party, then A will be a party to the K, and liable

o also applies to apparent authority (§159) so same the rules apply to unauthorized acts which are apparently authorized

R2nd §161 Unauthorized acts a disclosed or partially disclosed P is liable for acts done on his behalf (if usual or incidental to transactions which the agent is authorized to conduct if), even if forbidden by the P as long as T reasonably believed that the agent was authorized to do these acts, and had no notice that he wasn’t authorized (apparent authority)

Undisclosed principal where T has NO notice that A is acting for a P, the person for who A acts is an undisclosed P T’s state of mind does not matter the assumption is that T thinks that the agent has

authority, but that T has no state of mind about where that authority comes from; inherent authority is the same as apparent except that the manifestation doesn’t have to come from the principal

One of the ct.’s concerns is that the P is trying to actively hide, and the ct. don’t want to let him hide as a way to avoid the liability

for inherent authority to exist, you’ve got to have P controlling the agent, even though he’s undisclosed; control by P is the key!! (otherwise no agency)

Consider the franchisee/franchiser situations look for actual control, b/c while they may be holding themselves out w/the brand name etc., but it’s not clear if there was a principal controlling the operations to be an agent of P, you must be controlled

§186 an undisclosed P is bound by his agent acting w/in the authority given him, but the P won’t be bound by a K which excludes him (so where A is acting on his own for ex.)

§194 a general agent for an undisclosed P subjects his P to liability for acts done on his account, if usual or necessary in such transactions, even if the acts are forbidden by the P

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§195 where an undisclosed P entrusts the management of his business to an agent, he is subject to liability to T’s who the A enters into usual transactions with, even if contrary to P’s directions (Humble case)

where P is partially disclosed, or undisclosed, the agent is liable on the K even if acting on P’s behalf (P liable as well)

NOTE: when you create actual authority in an A/P, a 3rd party’s knowledge of the P-A relationship is irrelevant

Ratification If A initially entered into a contract purportedly on P’s behalf, but w/o actual or

apparent authority, and P subsequently decides to adopt the K, P is bound, as is T. Ratification is the affirming by a person of a prior act which did not bind him but was

done on his account. It requires accepting of the results of the act. Can be express or implied thru acceptance of the results/benefits; note that acceptance

would be found if an agent bought stocks for you against your knowledge, but then you decided to “wait and see” how the stock did

there still has to be a basic agency relationship to have ratification Ratification can occur in partnerships and corporations also (see Prithy Review

example, where the corp. ratifies the action by accepting the results of her entering into 5 year lease agreement)

Botticello v. Stefanovicz, Conn., 1979 H & W own land as tenants in common (each owns ½); H sells land w/o her permission - she had expressly said she wouldn’t sell for below a certain price; being married doesn’t by itself indicate agency existed, nor does being tenants in common; she had always signed all the deeds, mortgages etc., and yet he sells the home w/o her signing it; they was no agency relationship hence ratification couldn’t have been possible; she would have had to do the act on her own P argues that W ratified by her subsequent conduct (receiving payments from the tenant; allowing him to make improvements) but she thought he was just renting, didn’t know T had bought it; but regardless, H never purported to be acting on W’s behalf and that’s necessary for ratification; HOLDING W is not bound, no agency, and no ratification

Liability of Principal for Agent’s Acts Is the principal (P) liable to a 3rd Party (T) for a contract negotiated by the agent (A),

or for a tort committed by an agent? Other questions Is the agent liable to the 3rd party, or to the P (i.e. can P seek

indemnification)? Is the 3rd party bound to a K improperly negotiated by A?

Agent’s Liability to 3rd Parties for Contracts A’s are usually not parties to the K b/c they were negotiating on P’s behalf; but if A

has exceeded his authority, then P can seek indemnification There are narrow exceptions to the “no liability for A” rule (i.e. where A has

committed fraud or misrepresentation, or is party to the K himself) A’s are subject to fiduciary duties to their P’s (i.e. duty of care and loyalty); if A

violates these duties, and P suffers a loss, A can be held liable to P However, if A is a party to the contract, then A can be directly sued on it

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Atlantic Salmon v. Curran, MA, 1992 the principal was partially disclosed; case involves personal liability of an agent who was acting on behalf of a partially disclosed P; HOLDING agent is held liable for breach of salmon K; RULE: where an agent makes a K for a partially disclosed P, the agent is party to the K if he doesn’t reveal who the P is; here the agent had a duty to disclose the identity of the principal the burden was not on T’s to uncover the identity of P; the duty was on the agent to disclose, and where he doesn’t disclose, he is bound, and we can presume he made himself personally liable this case turned on active misrepresentation by the agent which made him liable on the K

Tort Liability of Principal for Agent’s Acts For both tort and K liability, the analysis will turn on P’s control of A but for tort liability, you’ll have to show a greater degree of control over A than you

would have to show in a K action; also in tort situations, ratification doesn’t apply

Humble Oil & Refining Co. v. Martin, TX., 1949 Car parked at a service station was not properly secured, and rolled away, injuring father & 2 daughters; station was owned by Humble Oil; Humble argues no liability b/c station was operated by an ICHOLDING the negligent gas station worker was a servant of Humble’s so respondeat superior applies, and Humble is negligent, and liable for the tort of its agent; ct. disregarded evidence in the franchise K which said that Humble had no power over the employees, and the fact that neither the employees or the franchisor considered Humble the employer; the court finds Humble’s strict control and supervision of the station’s daily operations dispositive; also the clause in the K which required the franchisor to do anything Humble told him to do, and the fact that Humble paid a majority of the operating costs, dictated the hours; they found an agency relationship (i.e. control by P) important to consider the risk; Humble had invested a lot here, and that’s always a sign that they didn’t relinquish full control ct. ignored the fact that the car was being dropped off to be serviced, which wasn’t Humble’s business; all they did was gas, but ct. ignores that probably wanted to get the P’s $$

Hoover v. Sun Oil Company, DE, 1965 negligent employee – smoking cigarette while pumping gas – causes fire; the facts are almost identical to Humble, but the court finds that this was an independent contractor relationship, essentially of landlord-tenant, and that Sun wasn’t responsible for day to day operations, so no liability (there was definitely less control here; a Sun guy came in every week, but that was about it; arguably they could have stopped carrying Sun’s products, but would have probably lost their lease this holding is indicative of the ct’s clearer understanding of the way that gas station franchises work!)

Who is an Agent? Special Concerns for Franchisers & Creditors Franchisers Just because something is a franchise does not insulate it from being an agency

relationship. It the franchise K so regulates the activities of the franchisee that it

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gives the franchiser control that falls within the definition of agency, then the agency relationship arises even if the parties deny that it exists.

Murphy v. Holiday Inns, Inc., VA, 1975 Guest slips at a Holiday Inn; sues the corp., but actually the hotel was owned by Betsey-Len, the franchisee; for agency, we need to find a “continuous subjection to the will of the principal;” here they paid $5000 to become a franchisee, and to get the know-how and brand name, but they ran all the risk of loss; Holiday Inn had no right to profits; HOLDING Holiday Inn, Inc. had no power to control the Betsey-Len motel’s day to day operations; there wasn’t a master-servant/agent relationship. [Remember it doesn’t matter what you say about the relationship; it’s about how you act! What about apparent agency in this case? No, b/c you need control for apparent agency, and that didn’t exist here]

Billops v. Magness Construction Co., DE, 1978 group rented Hilton’s ballroom for a fashion show etc.; dispute about payment; Hilton’s employees harassed and threatened the plaintiffs; P’s want to hold Hilton liable for the torts that occurred in the franchise; the facts showed day-to-day control by Hilton over the franchise; Hilton was allowed to unilaterally terminate the franchise agreement; also the franchise held itself out to be Hilton so apparent authority; P’s also showed they had significantly relied on the name Hilton when they rented the facility, but how is this different than Holiday Inn? b/c Ct. found Hilton retained control thru regulation (however also no right to profits)HOLDING ct. found that agency existed –thru actual and apparent authority

Creditors RULE: a creditor who assumes control of his debtor’s business may become liable as principal for the acts of the debtor in connection with the business. (R of Agency §14)

A. Gay Jenson Farms Co. v. Cargill, Inc., MN, 1981 Cargill is a large, worldwide grain dealer; Cargill heavily financed a grain storage facility that bought grain from local farmers and sold it to Cargill; as part of the loan, Cargill was given right to inspect books; controls were put on who else they could take loans from; at one point, contacted them every day; the farmers knew about the relationship, and made inquires to Cargill instead of to the grain storage facility significant relationship, so you almost couldn’t see difference btwn. the two HOLDING Cargill was more than a “worried creditor;” ct. finds that Cargill had such control and influence over the grain storage facility, that it was more than just a lender, that they were acting to secure a steady supply of grain for themselves; the ct. found actual agency here, Cargill was P (didn’t go for apparent b/c they found actual)

Fiduciary Duties of Agents to Principals

Duty of Loyalty

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an agent must act solely for the benefit of P in all matters connected with agency; as part of the agent relationship, the agent is forbidden from:

o Self-dealing (i.e. can’t be an adverse party)o Usurping business opportunity (i.e. like in Singer)o Competing in the subject matter of agency whilst in the P/A relationship

(Singer)o Using P’s property for personal benefit (Redding)o Deriving secret profits from transactions which would have been P’so Using P’s confidential info. for personal benefit (during or after agency;

Town & Country) fiduciary duties arise during the agency, and end once the relationship is terminated; an agent is allowed to prepare to compete while still in the principal’s employ, but can’t do things like a mass exodus specifically to hurt the P

Reading v. Regam, 1948 solider in the British army was taking illegal kickbacks by virtue of his position in the army; he unjustly enriched himself by virtue of his service to the army; HOLDING violated the duty of loyalty; has to return the profits he made

General Automotive Manufacturing, Co. v. Singer, WI, 1963 Singer was contractually bound to give all his time to his company; he breached his employment K and violated the duty of loyalty b/c he set up a side business, and directed business away from his employer to enrich himself; he violated his duty by failing to disclose the queries that came in; part of what they bargained for when they hired him was his reputation; he is liable for the profits, and has to return themRemedy for breach of fiduciary duty disgorging the profits + any traditional remedies for breach of K etc. an agent can’t compete w/his principal!!! Singer was “usurping a business opportunity” for the company; he had a duty to disclose those opportunities

Duties after the Termination of Agency: “Grabbing & Leaving”

Town & Country House & Home Service, Inc. v. Newbery, NY, 1958 employer is suing former employees who started their own similar “high-impact” cleaning service, very much like the plaintiff’s; D’s worked for him for 3 years, then left, and stole the trade secrets, including names and preferences of customers HOLDING found that D’s had been aspiring to leave P’s business and solicit his customers; they bought the equipment before they left, and they all quit together; all this was in violation of the obligations they owed to P; the crux for the ct. was stealing the customers, nothing else; P will be allowed to enjoin them from further soliciting his customers, or will be entitled to $$ relief for the lost customers

Duty of Care & Skill

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R2d §379 agent is subject to a duty to P to act w/standard care and w/the skill which is standard in the locality for the kind of work he is employed to perform, and also to exercise any special skill that he has

II. SOLE PROPRIETORSHIP Business is owned by one individual; the business and the individual are considered

to be the same person, so the person can be held personally liable Receive a favorable tax treatment (a “pass-through tax”); it means that a partnership

is not considered to be a separate taxable entity, and any losses/gains from it are included on individual returns and taxes are only paid once

No formal filing requirement

III. PARTNERSHIP Partnership is the default rule when a business relationship is formed; it is seen as the

easier option compared to incorporation, b/c of the flexibility involved Defn. an unincorporated association of 2 or more persons carrying on as co-

owners of a business for profito Note that profit sharing isn’t dispositive if it was really a part of wageso When analyzing partnerships, consider what the parties want their

intent, desire for return, risk & control o In a general partnership, each partner is personally liable for the

obligations of the partnership Also receive the favorable tax treatment; no formal filing requirement

Partnership Formation always look first to a written agreement if one exists, but remember that it is not necessarily controlling! Sometimes the circumstances can override what’s in written K.

Partners vs. Employees Fenwick v. Unemployment Compensation Comm., NJ, 1945 Ms. Chesire worked for P’s Beauty Shoppe for a few years; she requested more $$ so they drew up a K where they became partners; she would get 20% of the profits at the end of the year; books were open to both parties, but she made no investment, and P still had complete control HOLDING ct. found that they were not partners; found that the intention of the parties (which was to pay her more $$ if he made more $$) overrode the written K between them there was no obligation to share in losses; she had no control of the business; even though they filed partnership tax returns and held themselves out to the employment commission as partners, they really weren’t; the element of co-ownership was lacking

Partners vs. Lenders Martin v. Peyton, NY, 1927 D’s claimed they were creditors of the firm; P’s claim that they were actually partners; the agreement said that they weren’t partners, but you must look beyond it (this was the case w/the old money, where the friends agreed to give $$ to bail out the firm b/c of their friendship w/one man) here the trustees couldn’t bind the firm, although they could veto things they thought were highly speculative, but

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were not involved in the minutia like in Cargill; HOLDING no partnership here; this was an investor/creditor relationship

Partnership by Estoppel (Apparent Partnership) Young v. Jones, SC, 1992 P’s are trying to hold worldwide Price Waterhouse Coopers liable for the negligent actions of a Bahamian company; PW’s logo was on the letterhead of this co.; HOLDING ct. doesn’t find any evidence that they were partners by estoppel; does not find evidence of reasonable reliance by P’s partnership by estoppel: they’ll be estopped from denying it existed

Partnership Agreement P-ships are governed by the Uniform Partnership Act (UPA); but partners can always

agree to their own rules (VERY flexible in this regard – unlike corporations!!); whatever they don’t agree upon will be governed by the UPA (gap-filler)

P-ship agreement can be oral or written; it is the law of the partnership Not all UPA parameters can be varied by the partnership agreement for ex., you

can’t change the fact that all partners are liable to 3rd parties for partnership obligations

Partners owe fiduciary duties to each other But a partner cannot be compelled to remain a partner against his will; every partner

can dissolve the partnership at any time A person can’t be admitted as a partner w/o the consent of the other partners

(although this can be modified in agreement like where in large partnership a committee approves new partners)

A partner can assign their financial interest in the p’ship to a 3rd party The modern view is that corporations can be partners in partnerships; so can trusts,

estates, partnerships, LLC’s etc.

Agency & Partnership Partners are agents of the partnership (§9(1)); each partner has actual and apparent

authority to bind the partnership and incur obligations on behalf of the partnership, as long as the obligations are related to the usual & ordinary business of the p-ship

o Partnership expenses only something incurred thru actual authority

Ace/Spade/Holmes Example 2 person detective p-ship; Spade hires Ace w/o Holmes’ consent If we conclude that Spade’s actions were not usual conduct, then, under §9(1) and (2),

there would be no actual agency, and Ace could NOT sue the p-ship for his salary; if Spade had already paid out, he would have to bear this himself, and it would not be treated as a p-ship expense

But if we conclude that hiring Ace was usual conduct, we still have the issue over whether Spade had authority to hire Ace since Holme’s objected. Go to National Biscuit/Summers analysis.

If jdxt. follows National Biscuit

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o Spade will argue that under §18(e), he has a right to manage the p-ship business, and that under §§9 & 18(b), he had actual authority to act on behalf of the p-ship to hire Ace

And that b/c they were only 2 of them, there’s no way to get a majority to restrict his ability to act re: ordinary business matters (one way to interpret §18h)

o Holmes, though, will argue that under §18(h), his objection to hiring Ace makes the act invalid b/c it has to be decided by a majority, and 1 out of 2 is NOT a majority

o National Biscuit would reject Holmes’ argument b/c it found that an agent’s authority can only be restricted thru majority vote, and Holmes alone did not equal a majority. Holmes’ only way to win here then would be to show that the act was not “carrying on in the usual way” and was thus hiring Ace was not an “ordinary and property” p-ship expense

If Ace did sue the p-ship based on Spade’s apparent authority to create an employment K, then if Spade exceeded his authority, the expense is not a legitimate p-ship expense, and Holmes can seek indemnification from Spade; $$ would go back to the p-ship

If jdxt. does not follow National Biscuit, then a partner’s objection in a deadlock situation could restrict the other partner’s authority; §18(h) is interpreted that once a dispute arises, a majority vote is necessary to authorize the disputed action. (like in Summers)

o Reasoning is that where on partner clearly objects to a particular course of action, it’s not fair to allow the other to ignore their concerns, and force them to bear the expense.

o If Summers applies, and Spade did NOT have actual authority to enter into the K, then the salary isn’t treated as p-ship expense; although Ace can still try to sue on apparent authority grounds

o Does it matter if Holmes’ actually voted or just objected? No, it doesn’t matter formal objections are helpful for record keeping, but not required in p-ships

o If the p-ship is found liable to Ace on the K, but the p-ship is insolvent, can Ace sue Holmes’ personally for the $15K owed him?

§40(d) partners shall contribute the amount necessary to satisfy liabilities (i.e. they’re personally liable for the debts!!)

§18(e) but a partner should only be responsible for liabilities in the same proportion they share profits; if there is some express agreement, that controls; otherwise, liabilities are shared equally, since under §18(a) profits are as well

therefore, Holmes should only be liable for $7500 But §40(d) says that when a partner is insolvent, the other partners

have to pick up the tab so if Spade was insolvent, then Holmes is on the hook for all the rest, since he is the only remaining partner; if there were other partners, they’d be on the hook proportionally for Spade’s share

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NOTE: if Holmes pays the entire thing, he can technically still go after Spade either for contribution (1/2 of the $15K if Spade had actual authority), or for indemnification (the full amount, if Spade didn’t have authority)

Actual vs. Apparent Remember that Ace’s reasonable belief is only relevant where relying on apparent authority; so if Spade had actual authority (as he would have under National Biscuit, as long as his acts were “usual” and “ordinary”), then Holmes objection is irrelevant, and Ace could have sued on actual authority grounds

The actual authority of a partner may be limited or restricted by the agreement

Purported Partnerships (i.e. partnership by estoppel) where someone represents that they are a partner when it is not actually the case, and a 3rd party relies on it, partnership-type liabilities may result a purported partner may also have the authority to bind other purported partners; the person who consents to a partnership in this way is called a partner by estoppel (or “purported partner” under 1994 UPA)

there must have been actual reliance by the 3rd party, since the entire reason for this rule is to protect relying 3rd parties

Joint Ventures the only difference between this and a partnership is that it is set up for a more limited and narrow business purpose joint ventures are generally subject to partnership rules (although some states have set up special rules); the major difference is probably the scope of the actual and apparent authority that each person possesses to bind the venture

Liability in Partnership UPA §15 partners are jointly and severally liable for the p-ships tortious acts

(includes torts where a partner is acting w/in his authority; b/c joint and several liability, a single partner can be on the hook for everything, regardless of whether or not the others are insolvent)

partners are jointly liable for all other debts and obligations of the p-ship (i.e. contractual stuff)

Rights of Partners in Management §9(3) lists acts that require unanimous consent of all the partners to perform (unless otherwise specified):

a) assign the p-ship property in trust for creditors b) disposing of the good-will of the business c) doing any act which would make it impossible to carry on the ordinary business of a p-ship d) confessing a judgment e) submitting a p-ship claim or liability to arbitration or reference

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Fiduciary Duties between Partners A partner is an agent of the p-ship for the purpose of all p-ship business; can bind the

p-ship (§9) partners owe fiduciary duties to each other; a p-ship involves relationships of trust

and confidence and cts. don’t hesitate to enforce duties arising out of this relationshipo this relationship of trust comes from the agency powers that all partners

have, and the concept of cooperative enterprise inherent in the p-shipo the fiduciary duties continue to exist even when dissolution is occurring,

or when the partners are hostile to each othero §21 codifies this duty by requiring that every partner has to account to

the p-ship for any benefit it may receive (i.e. the duty of trust) Partners have the right to inspect the p-ship books (§19) Partners have a duty to render true and full info. to each other on demand (§20) Partners must account to the p-ship any benefit, and hold as trustee for the p-ship any

profits derived w/o the consent of the other partners, and derived from p-ship business or use of the p-ship property (§21 raises the issue of what is a business opp.)

A partner who has been wrongfully excluded from p-ship business & property has a right to an accounting (§22 when is exclusion wrongful? See Lawlis)

Duties owed by Partners to the Partnership Partners owe a duty of care & a duty of loyalty to the p-ship both of these come

from agency; the partners are agents of the p-ship, so they owe this

§18: Rules Determining Rights & Duties of Partners §18a profits and losses get shared equally (losses are sustained by partners according to their share in the profits)§18b p-ship indemnifies all partners for “ordinary and proper” conduct §18e provides that in the absence of an agreement to the contrary, all partners have equal rights in the management and conduct of the partnership business; (ONE PARTNER – ONE VOTE RULE)§18g no person can become a member of the p-ship w/o the consent of the partners (unanimous consent requirement!)§18h any difference arising as to ordinary matters connected with the partnership business may be decided by a majority of the partners (so the majority can deprive the minority partner of authority this § disputed by the cts. in partnerships w/a deadlock between even # of partners see National Biscuit); BUT no act in contravention of any agreement between the partners can be done rightfully w/o the consent of ALL the partners

Capital in Partnerships Capital under p-ship, the amount someone puts up is not determinative of voting

or management power; it’s irrelevant to management rights o However, where one partner puts up all the capital, it could be evidence of

an implied agreement btwn. the partners that the one who put up more capital (i.e. took more risk) would have more management control

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National Biscuit Co. v. Stroud, NC, 1959 Stroud & Freeman had a partnership to sell groceries; there was nothing in their agreement to restrict the power of either; Stroud told a 3rd party that he would personally not be liable for any more bread it sold to the store (he never told Stroud though!!); later Freeman bought more bread from the 3rd party HOLDING the partnership is liable for the bread; Stroud couldn’t restrict Freeman’s actual authority to conduct the normal business of the partnership there’s no way Stroud could have denied Freeman these rights b/c they were only 2 people, and ½ the members of a partnership can’t be a majority; this is the ct.’s interpretation of §18h

Summers v. Dooley, ID, 1971 Summers & Dooley have a 2-man trash collection partnership; Summers approached Dooley about hiring a 3rd person, and Dooley objected; Summers did it anyway, and paid it out of his own pocket; then he sues to get the partnership to pay for it HOLDING the partnership is NOT liable for this expense; a majority of the partners didn’t approve of the plan; it doesn’t matter that Dooley arguably profited from the new guy’s labor; Summers was acting for his own interest and Dooley explicitly objected to what he did, and continued to object to it the entire time this ct.’s interpretation of §18h; that in a 2 man p-ship, it requires a majority of the partners for a dispute over ordinary matters; hence unanimous b/c only 2 people

Partner’s Property Rights in Partnership One of the main motivations behind the UPA was the creation of new property rights

for partnerships; the UPA defined the property rights of a partner in three ways (§24):o Rights in specific partnership property

Rights re: the tangible assets of the p-ship (i.e. cash, RP, accounts receivable etc.)

o Interest in the partnership Ownership interest in the business as a whole distinct from the

ownership of any specific partnership asset o Right to participate in management

Rights in specific partnership property (§25) created a new type of tenancy for property owned by a partnership – “tenants in partnership” i.e. specific partnership property

o The partners have equal rights to possess the property for p-ship purposes, but no right to possess it for other purposes (unless there is consent of the partners)

o A partner’s right in specific partnership property (SPP) is NOT assignable (except if all the partners assign all of the interest)

A partner cannot will away SPP o A creditor of an individual partner cannot seize upon a partner’s SPP in

order to satisfy a nonpartnership claim against an individual partner. Property held in tenancy in p-ship is not subject to claims of

community property etc.

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o Upon death of a partner, his SPP vests in the surviving partners, except where the deceased is the last surviving partner, when it vests in his legal representative. That surviving partner or legal rep. has no right to possess the p-ship property for anything other than a partnership purpose.

**Under §10, any partner can convey property that is held in the name of the p-ship; so just b/c only one partner’s signature is on the deed is NOT enough on its own to invalidate the sale; but that doesn’t mean there won’t be a problem if one partner sells off the p-ship’s property §10(1) & (2) both include the caveat that the sale might be invalidated if the partner signing the deed had no authority to do so; this would turn on whether it’s a usual and ordinary business occurrence in the Spade/Ace example, it doesn’t seem like it is

A Partner’s Interest in the Partnership the right each partner has to receive distributions when and as they are made; it’s similar to the right of a holder of stock against the issuing corporation; it is personal property

o This interest is that of the business in general, and not as ownership over any specific asset; this interest can be assigned

o The partner’s interest in the partnership (unlike in the property) is subject to being seized by individual creditors by the process of “charging an order”

o A partner’s interest in the p-ship is declared to be personal property for all purposes, and can be subject to marital claims or other rights; so even if the sole asset of a p-ship is real estate, the interests in it are personal

o Assigning one’s interest doesn’t by itself dissolve the partnership; nor does it entitle the assignee to interfere in the p-ship, to require an accounting, or inspect the books; it just entitles the assignee to get the profits to which the assigning partner would normally get (§27)

Also the partner who assigned his interest is still a partner, and still has the right to participate in management, and remains liable for obligations, including those that arise after the assignment (although p-ship agreements tend to contract such that once you assign, you are no longer a partner)

If the p-ship dissolves, the assignee can then get an accounting from the date only of the last account agreed to by all partners - §27(2)

Upon a winding up, the assignee gets what would be due the assigning partner

In a term p-ship, the assignee can apply for judicial dissolution of the p-ship; if it’s at will, they can apply for it at any time, but can’t force the dissolution

The right to participate in management since the UPA defines the right to participate in management as a property right, it is immune from seizure by an individual’s creditor, like the SPP above, and can’t be assigned except to a person who is accepted by the remaining partners as a partner that’s the only way an

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assignment of this right, or of the specific property right can be effective, if the others agree that the assignee will become a partner.

Putnam v. Shoaf, TN, 1981 gin-making company; Mrs. Putnam succeeded to her H’s rights; a few years later, she wanted to sever her relationship w/the partnership, which was heavily indebted at the time; she found a buyer – the Shoafs – who agreed to buy and take over personal liability for the p-ship’s $90K debt if she paid in $21K to the partnership before she left; she did so and conveyed her interest, the partnership was dissolved; all she conveyed was her “interest in the partnership” as that’s all she had to convey b/c the property etc. belongs directly to the partnership HOLDING She did NOT have a specific interest in any specific assets of the partnership, either to retain or to convey. All she had was a partner’s interest in the share of the profits, which she intended to convey and did so. She is not entitled to the any judgment that came after her conveyance.

Fiduciary Duties & Rights in Partnerships

Meinhard v. Salmon, NY, 1928 hotel lease between 2 men; Meinhard sues Salmon for not informing him about option to buy the property they had been renting; when Meinhard finds out he demands that the lease be held by their joint venture, Salmon refuses, so Meinhard sues; Salmon got this offer to buy b/c of the partnership, it should have gone to both men but it didn’t; it doesn’t matter that Salmon can argue the partnership wouldn’t have been able to financially swing it; Salmon was also the manager, and so Meinhard relied on him heavily to apprise him of business opps., and things like the lease expiring if this had been another property, then it would have probably been fine since this was a one project joint venture (i.e. it wouldn’t have been considered a p-ship opportunity); but this was an opp. it was for the same property they were operating in!HOLDING judgment for Meinhard b/c Salmon breached his fiduciary duty; his interest in the lease should be the same as what his interest in the p-ship was; Ct. found that this was a “partnership opportunity” opinion written by J. Cardozo; the new UPA has tried to pull back on the case’s holding of such a high duty btwn. partners

Grabbing & Leaving

Meehan v. Shaughnessy, Mass, 1989 Meehan & his friends decide to create their own law firm; the original firm sued the ex-partners for violation of fiduciary duties to p-shipHOLDING these partners did breach a fiduciary duty by planning and working for months to take cases w/them to their new firm; they unfairly acquired these clients, the ct. holds, b/c they prepared to do so, maintained secrecy about which ones they were going to take, and this gave them an advantage over their former partnership b/c it was happening behind their back Partners have obligation to render on demand true and full information of all things

affecting the partnership whereas here they openly lied when confronted

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The ct. did not find them guilty though on the accusations of improperly handling their cases for their personal benefit or for secretly competing

Expulsion from the Partnership

Lawlis v. Kightlinger & Gray, IN, 1990 Lawlis was a senior partner and an alcoholic; they gave him many chances; Lawlis argues that the partnership was dissolved, and that his expulsion was wrongful b/c it wasn’t authorized by 2/3 of the senior partners HOLDING Ct. was in the right to expel him from the firm; ct. finds that they were very generous w/him, and that they had a “no cause expulsion clause” in their partnership agreement and they exercised it; if the ct. was to find otherwise, then they would be imposing a “for cause” requirement on the parties which was not their intent

Day v. Sidley & Austin, F. Supp., 1977 Day was a senior partner, but not part of the executive committee that managed the daily business of the law firm; merger occurred w/another firm; he was booted out of his Washington DC office and was unhappy; he sued for humiliation, loss of income, says that the firm actively misrepresented the result of the merger and hid that they’d been shopping around for it for a long timeHOLDING the law firm’s motion for summary judgment granted; P suffered from a bruised ego and little else He had no right to remain the D.C. chair, and he wasn’t reasonable to think that

things wouldn’t change after the merger; Then he argues that the merger was so fundamental that it required unanimous vote,

which they didn’t have but their partnership agreement didn’t require it and that overrides the UPA provision to the contrary

Also breach of fiduciary duty for starting merger negotiations w/o consent of the other partners; but those duties are about concealing profits, competing etc. not about this in order to show breach of fiduciary duty, the partners would have had to have done something that harms a partner or causes loss in exchange for personal benefit.

Partnership Dissolution & Fiduciary Duties

The Right to Dissolve defn. of dissolution: change in the relation of the partners caused by any partner ceasing to be associated in the carrying on of the business (§29) on dissolution the p-ship is not terminated, but continues until the winding up of p-ship affairs is completed (§30) Default rule is that p-ships are at-will, and each partner has the legal right to:

a) withdraw from p-ship by express will at any time, and b) compel a winding up of the assets except as otherwise agreed (§37) refers to formal continuation agreements, and p-ships which are for specified terms or undertakings

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in a term p-ship, though, a partner always has the power (but not necessarily the right) to dissolve the p-ship; this power cannot be eliminated by agreement; it exists even when its exercise will breach an agreement; if you don’t have the right to dissolve though, it would be a “wrongful” rather than “rightful” dissolution

formal continuation agreement clause in the partnership K which says that in the event a partner chooses to withdraw, that partner cannot compel the winding up, and that the remaining partners have the right to continue the business

Term/Definite Partnerships a partner can always leave a partnership at any time, but depending on when it’s done, it may be “wrongful” to do so b/c if you leave before the expiration of the term of the p-ship, then you’ll be considered in breach of the partnership, and you won’t have the right to force a wind up

Causes of Dissolution (§31)(1) Without violating the agreement between the partners: (i.e. events that trigger automatic dissolution)

By termination of the definite term specified in the agreement (end of term) By express will of any partner when it’s an at-will p-ship By express will of all the partners who have not assigned their interests By expulsion of any partner from the business in accordance w/such power

conferred by agreement btwn. partners (Lawlis)(2) In violation of the agreement in a term p-ship by the express will of any partner at any time (3) By any event which makes it unlawful for the business of the p-ship to be carried on or for the members to carry it on in p-ship(4) By the death of any partner(5) By the bankruptcy of any partner or the p-ship(6) By decree of the court (§32)

ct. decree granted where: a) a partner has been declared a lunatic, or is declared incapable of performing his part of the K; b) a partner is guilty of conduct which prejudicially affects carrying on the p-ship business c) a partner willfully or persistently breaches the p-ship agreement, or conducts himself in way that makes it not reasonably practicable to carry on the business p-ship w/him d) the business can only be carried on at a loss e) other circumstances render dissolution equitable

Legal effect of Dissolution Legally the partnership is over, but economically it continues; one or more of the partners is gone

Owen v. Cohen, CA, 1941 oral agreement to open bowling alley; no written K so UPA controls; the 2 partners started disagreeing, ct. orders dissolution; issue on appeal did the evidence warrant dissolution? D argues that the discord between them was petty,

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P argues it was severe; here there was a build-up of small incidents which led to a major discord, where D was trying to undermine P’s ability to get a fair share of the $$ HOLDING under UPA §32, the ct. can order dissolution when one partner seeks it, and the ct. finds that a partner has been “guilty of such conduct as prejudicially affects the carrying on of the business” the ct. found this here, but this is very rare for a ct. to order this b/c cts. don’t usually like to get involved in business matters! P went to the ct. b/c the relationship was so hostile that the p-ship was unable to function **also, it wasn’t clear here if this was a term partnership or an at will partnership; if it was at will, then P could have had the right to dissolve and force a winding up; if it was term (even thru an implied term, like the time when P’s loan was paid off), then they couldn’t force a winding up until the term expired if it was term, then Cohen couldn’t compel a winding up b/c the term wouldn’t have expired, which means he wouldn’t have his loan paid back right away, although he would eventually get it b/c he would have become be a creditor

Collins v. Lewis, TX, 1955 cafeteria business where Lewis managed the business, brought the lease, the experience etc., and Collins provided all financing; all the revenue, except Lewis’s salary, would go to repay Collins; but the costs were way above the projected, and eventually it opens, and operates at a loss; Collins wants out HOLDING no judicial dissolution; ct. agrees w/jury that Lewis was a competent manager; it was a partnership at term b/c of a 30-year lease, so Collins couldn’t just withdraw; if he did, he would be in breach and liable to the partnership for damages; although he’d be able to cut his losses since he was the one funding the business but he’d gain nothing from it the ct. didn’t find any of the circumstances met for a ct. ordered dissolution they had created their own K, so the UPA didn’t totally control

Page v. Page, CA, 1961 linen supply business w/oral K; P seeks declaration that it was an at will partnership; HOLDING ct. finds it was at will, was not for a definite term UPA provides for partnership dissolution at the express will of any partner, as long as

there is no definite term; D argues that it was a term p-ship b/c they testified that they expected to meet current expenses from current income, and to recoup their investment if it was successful; he argues that this was enough to create a term partnership in Owen v. Cohen where the ct. held that when a partner advances a sum of money with the understanding that it was a loan and is to be repaid as soon as possible from profits, that the partnership is for the term reasonably required to repay the loan but there, the evidence supported that conclusion

Here it was just a common hope that the earnings would pay off the expenses; all partnerships are usually entered into with the hope that they will be profitable, but that doesn’t make them all partnerships for a term, nor does it obligate them to continue until all of the losses have been recovered.

D argues that P is acting in bad faith, wants to dissolve it for personal gain ct. does not find that; but that doesn’t matter anyway for determining if at will or term

Also D is protected by the fiduciary duties owed by his co-partners; the UPA says the dissolution must be in good faith a partner at will can’t “freeze out” a co-partner and

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appropriate the business for his own use; you can’t dissolve unless you fully compensate the other partners

The Consequences of Dissolution The right to a force a wind up does NOT have to be taken ; often the withdrawing

partner will just leave and allow the remaining partners to continue the business, and create a new partnership among themselves in order to continue it in the same form

o In this situation, UPA gives a favorable formula to equate interest (§42)o Note thought that this power to compel the wind up can create a huge

bargaining chip for the person who wants out so that’s why the UPA allows continuation agreements in §37

Authority to manage the p-ship during winding up §37 says that the partners who have not wrongfully dissolved have the right to manage the winding up

Prentiss v. Sheffel, AZ, 1973 can 2 majority partners in a 3-man “at will” partnership purchase the partnership assets at a judicially supervised dissolution sale? D claims his partnership rights were violated b/c he was excluded from management and affairs. P’s argue that D didn’t live up to his share of the bargain, didn’t contribute his share of operating losses etc.; HOLDING P’s are allowed to bid on the partnership’s assets (here a shopping center): the p-ship was at will and was properly dissolved; no indication that there was any bad will in the D’s desire to dissolve

Legal Effect of Winding Up (§§37, 38, 40) The partnership’s assets are liquidated, and then liabilities are satisfied from the

proceedso liabilities are first satisfied from p-ship property; but contributions from

partners may be necessary if $$ from the liquidation can’t cover the liabilities

o If after all liabilities are paid out, there is a surplus, then it is used to return capital to the partners, and divide up the profits

o Order of payouts: Those owed to creditors other than partners Those owed to partners other than for capital and profits (i.e. loans

the partner gave the p-ship) Those owed to partners for capital Those owed to partners for profits

Legal Effect of Termination The winding up is complete, and the partnership is legally, and economically over.

Wrongful Dissolution

At-Will

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In an at-will p-ship, P’s are legally entitled to withdraw at any time, and force a winding up of the assets

A wrongful dissolution in an at will p-ship is one in breach of an agreement, or b/c of misconduct or other breach of fiduciary duty

o Each P can still force a winding up of the assets though (§§37, 38(2)(a)(I)) o The nonbreaching P’s are also entitled to sue for damages for breach

(§38(2)(a)(II))Term The end of the specified term or definite undertaking automatically dissolves the P-

ship; each partner can force the winding up of the assets If a partner withdraws before the end of the specified term, he can do so, but then he

is in breach of the agreement, and a wrongful partner The Rightful P’s can:

i. Force a winding up under §§37,38(2)(a)(I), ORii. Continue the business for the agreed upon term, §38(2)(b)

1. in this situation, they can still use the p-ship’s property, and can delay payment to the wrongful P

they have to either secure the payment by bond approved by the ct., or pay to the wrongful partner the value of his interest in the p-ship, less any damages, and indemnify him against future liabilities

2. they also have the right to sue the wrongful P for damages for breach, §38(2)(c)(I)

The Wrongful P’s situation i. If the business is NOT continued, then he has the right to a

winding up, less any damages due to breach, §38(2)(c)(I)ii. If the business is continued, the wrongful P only has the right to

the value of his interest in the p-ship (not including good will), less any damages (or payment secured by bond), and gets released from any existing liabilities, §38(2)(c)(II)

Expulsion P’s are entitled to expel a partner in accordance w/terms in their p-ship agreement The expelled P is only entitled to the net amount due under the p-ship agreement; he

is not entitled to force a winding up Usually the term would discharge him from all p-ship liabilities If a partner is expelled by other partners who are acting in bad faith or in breach of

fiduciary duties, he is entitled to the above rights, and can sue for damages for breach

Possible Alterations in the P-Ship Agreement Something other than equal management rights and profit/loss rights

o Ex. management depending on amount invested; profit depending on amount invested

Limit on the actual authority of a partner

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o Ex. one partner acts as the “managing partner”; or the creation of a committee to make certain decisions

Continuation agreements Fixed salaries (i.e. guaranteed payments) There are certain items, though, that can’t be contracted around:

o Personal liability to 3rd parties the p-ship agreement cannot immunize specific partners from liability w/o the express consent of the creditor

o Partners access to books and records o Reduction of the duty of care, or eliminating the obligation of good faith

and fair dealingo Restriction on the right of a partner to withdraw (you can though restrict a

withdrawing partner’s ability to demand a winding up)

Liability of New Partners (§17) New partner is liable for p-ship liabilities arising before his admission, except that

this liability shall only be satisfied out of p-ship property o This can be trickier than it looks though, as far as determining what

“arising before” means

Capital Accounts of Partners Determine how partners will share the ownership interest of assets, and how assets

will be distributed upon liquidation o The accounts are not supposed to correspond to the value in the p-ship, but

rather reflect the relative claims of the partners to the assets of the p-ship UPA (1914) gives no guidance on what they should be like; the one from 1994 gives

much more so o 1994 says that a partner’s account is: his initial capital contribution +

additional contributions + allocations of profit to the partner – distributions of cash or property to the partner – allocations of losses to the partner

Capital accounts can be positive or negative; negative accounts reflect $$ owed by the partner to the p-ship

Tax Situation for P-Ships Pass-through tax, so the profits/losses go right on a personal Schedule C filing; the

partnership itself is not taxed as an entity also the losses can be used to reduce tax liability

IV. CORPORATIONS Requires many filing formalities; is much more complex, and usually more expensive

to set up, than a partnership Absolves the parties involved of personal liability (one of the key factors when

deciding to incorporate!)

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A corporation is treated as a fictitious legal person, separate and apart from its owners (i.e. a corp. can sue and be sued; can buy property etc.)

Subject to a double-tax once at the corporate level, and again at the individual SH level when assets are distributed to SH’s

Management structure the Bd. of Directors (SH’s elect the Bd., the Bd. usually selects the officers, some of whom often may also sit on the Bd.)

A. Corporate Formation, Limited Liability & Corporate Governance

Limited Liability & Other Benefits of Incorporation Considered one of the biggest benefits of the corporate form investors (SH’s) can

limit their liability to the amount they invest; they risk nothing else except that Promotes capital formation SH’s willing to risk more b/c can control risk Promotes diversity of investment i.e. investing in many co.’s b/c of controlled risk Reduces management costs SH less likely to want to monitor and control

corporation; also they won’t care about investigating other SH’s before they invest, b/c they don’t have to worry about another SH becoming insolvent, and being liable for their debt (like in p-ship)

Promotes transferability of shares b/c doesn’t affect corp.’s identity and legal status; also where the corp. is public, they have an open market for the shares

Allows market prices to more accurately reflect firm value (b/c not at the mercy of partners who might force a winding up, hidden debt etc.)

Piercing the Corporate Veil If the veil gets pierced, it doesn’t mean that the corporate form has changed; it’s only

pierced in relation to this debt Enterprise liability doesn’t requiring piercing a co; that’s where you find that 2 or

more companies are really one in the same; this involves criminal liability (i.e. fraud, lack of minimum insurance) it’s a horizontal action, you’re not going up to try to get a SH

It’s almost impossible to get the corporate veil pierced, and even if you can, it’s still hard to get to the SH’s

o It is even MORE impossible to pierce a public corporations b/c of the unity of interest prong the only way to go after public corp.’s is really thru the federal securities laws

o Piercing the veil really only happens w/closely held corporations, and most often w/sole SH’s

Elements ~ o Unity of Interest btwn. SH & the Corp. (i.e. thru failure to observe

corporate formalities; undercapitalization; intermingling of funds)o Would promote injustice if the ct. didn’t pierceo Assumption of the Risk (Optional 3rd Prong reserved for sophisticated

creditors like banks etc.)

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Reverse piercing where P is able to pierce thru the corporate veil and get to the SH, but it’s not enough to satisfy the claim, so if the SH owns other companies in the same way, then P can reverse pierce his other co.’s, showing that all the corp.’s are all owned in the same fashion

o A little different than enterprise liability b/c that is where there is no difference between 2 companies; that is not necessarily the case here

Sea-Land Services Inc. v. Pepper Source, 7th. Cir., 1991 Pepper Source, co. owned by Marchese, didn’t pay SeaLand on a K to ship peppers; Marchese also owned 4 other businesses; P wanted to pierce Pepper Source’s corporate veil, and then reverse pierce Marchese’s 4 other companies; allege they are all alter-egos of Marchese; To pierce the corporate veil, the ct. required a 1) Unity of interest (i.e. failure to observe corporate formalities; undercapitalization; intermingling funds); 2) would promote injustice. At first the ct. finds the first prong met, but not the second; P had to show that honoring the separate existence of these companies would “sanction a fraud or promote injustice”, and that it wasn’t enough that SeaLand wouldn’t get paid on their K; there has to be something akin to fraud, deception, or a compelling public interest ON REMAND Marchese was found guilty of tax evasion, and that was enough fraud to meet the 2nd prong, so they pierced the corporate veil

Walkovszky v. Carlton, NY, 1966 injured pedestrian suing SH of cab company; Carlton, D, is a SH in 10 cab co.’s, each of which owns 2 cabs, and had the lowest insurance required by state law; all the co.’s are operated out of same building HOLDING case dismissed; P didn’t state a case for piercing thru to D No allegations that he was using the co. in an individual capacity (no unity of interest) The corporate form can’t be disregarded just b/c the corp. has insufficient funds to

cover losses; any rights P has are for negligence of the driver, and holding co. liable under respondeat superior

P’s arguing fraud, but it’s not fraudulent to take out the state minimum in insurance that’s an issue to be taken up w/the legislature; plus it was a BJ to hold this amount of insurance, and that’s not something the ct.’s like to second guess

Kinney Shoe Corp. v. Polan, 4th Cir., 1991 one man owned 2 companies; entered into lease, and then he subleased part of it to his skeleton co.; the skeleton defaulted on the sublease payments; HOLDING corporate veil should be pierced The 2 prong test is satisfied there was such unity of interest that there was no

separate personalities between Polan and the co. (the one payment the co. made was from his own bank account); and an inequitable result would occur if the veil wasn’t pierced; the co. was grossly undercapitalized; didn’t adhere to any of the corporate formalities of filing, meetings etc.; found that he created Industrial, which had no assets, to protect all of his own assets

TC didn’t pierce b/c they said the “3rd prong” hadn’t been met; this is where D will be found to have assumed the risk b/c they should have done a credit check etc., and so they’ll be held to have had the knowledge that a reasonable credit check would have

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revealed; if it would have disclosed undercapitalization, then the party will be held to have assumed the risk

The Appeals Ct. doesn’t agree w/applying the 3rd prong in this case that prong is reserved for sophisticated creditors, like banks or large lenders, who are in the position to investigation, and where they could make provisions if the person didn’t have adequate capital the third prong is permissive, not mandatory; this factual situation doesn’t call for applying the 3rd prong

“nothing in, nothing out, no protection”

Corporate Governance: Roles of Managers & Shareholder Voting

Kidsco Inc. v. Dinsmore, DE, 1995 Kidsco Inc. wants to conduct a hostile takeover of TLC; TLC’s bylaws were just

amended to require that special meetings be called 60 – 90 days before the meeting SH of Kidsco and TLC, who favor the hostile takeover, are seeking an injunction

invalidating the amendment HOLDING Kidsco had no “vested right” to a special meeting, the amendment to

the bylaws was valid §109 provides that once stock has been issued, the power to adopt, amend, repeal

bylaws shall be in the SH’s entitled to vote, except if the certificate of incorporation confers otherwise. (as was the case here the certificate expressly and legitimately authorized directors to amend this w/o SH approval)

When a corp.’s CoI puts all SH’s on notice that the bylaws can be amended at any time, then no vested rights exist to prohibit an amendment

Auer v. Dressel, NY Corp.’s bylaws say that “it is the duty of the president to call a special meeting whenever requested in writing to do so by voting SH’s holding a majority of capital stock” such a request is made and he refuses to call the meeting HOLDING the meeting must be called, regardless of the fact that the issues were futile, b/c none of the proposals suggested could be legally voted on

Certificate of Incorporation (CoI) §102 Contents of the CoI the CoI is a document issued by a state authority

which grants a corp. its legal existence, and the right to function as a corp. Required elements:

o Name (w/corp. tag)o Addresso Purpose of business

Can be narrowly or broadly stated; if narrow, corporate business outside it can be a violation of the ultra vires doctrine

o Shares + par value o Name & address of incorporators

Optional elements:

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o Provisions for management and conduct of affairs of corp. (including giving SH’s more power)

o Right for SH’s to purchase additional shares o Provisions for larger voting requirement than is in the Codeo Provision limiting corp.’s duration to a specified date (otherwise corp. has

perpetual existence)o Provision imposing personal liability for corp.’s debts on SHo Provision eliminating or limiting a director’s personal liability for breach

of fiduciary duty, as long as it doesn’t eliminate certain areas (i.e. breaches of loyalty, good faith, intentional misconduct, self-dealing -- §102b7)

§102(b)(1) any provision which is required or permitted to be stated in the bylaws can instead be stated in the CoI

The certification of incorporation and the bylaws CANNOT contradict each other where there is a conflict, the certificate trumps!

Amendment to the CoI §242b: First the Bd. of Directors adopts a resolution setting forth the amendment to the CoI proposed, and then it is voted on by the SH’s at the annual meeting, or at a specially called meeting; if the majority of the outstanding stock entitled to vote in favor, the amendment passes (True Majority)

Bylaws defn the rules or administrative provisions adopted by a corp. for internal

governance; often includes titles and general duties of corporate officers Under §109(b), the bylaws can include any provision relating to the business of the

corp., as long as it is consistent w/law and w/the CoI Validity of Bylaws

o the original bylaws may be adopted, amended, or repealed by the initial directors (if named in the CoI), or by Bd. of directors before co. has received payment for stock

o After corp. has received payment for stock, (meaning there are now SH’s!), the SH’s have the power to adopt, amend, or repeal bylaws, unless the CoI confers the power to do this on the Bd. of Directors.

But just b/c this power has been conferred upon the directors does NOT divest the SH’s of this power

Uses normal SH voting procedure (doesn’t require true majority)

Shareholders’ Rights Generally, SH’s have the right to vote for the election of directors at annual (§211b)

or specially called meetings; they also have the rights to vote on certain other “fundamental matters”

o Usually those include mergers, amendments to the CoI, a sale of substantially all the corp,’s assets, and liquidation

SH’s are not agents, nor principals, and they can’t act on behalf of the corp. Their right to vote is much like a citizen in a representative democracy Generally, “one share, one vote” although this can be modified by provisions in

the CoI, giving certain classes of stock greater or lesser voting rights

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General Rule SH’s don’t manage the corp., but this can be changed in the CoI

the FUNDAMENTAL MATTERS SH’s must vote on: o §109 amend the bylaws (if stock has already been sold; see above)

just majority of the quorum, not a true majority o §242b: amendments to the CoI; if the majority of the outstanding stock

entitled to vote in favor, the amendment passes o §251(b)(c) mergers; directors have a duty to act in an informed and

deliberate manner when approving a merger resolution for SH voting; then a true majority of the outstanding stock entitled to vote must approve

meaning a TRUE MAJORITY not a majority of the quorum o §271 sale, lease or exchange of assets requires vote by the majority

of the outstanding stock entitled to vote thereon o §275 dissolution requires vote by the majority of the outstanding

stock entitled to vote thereono in all these fundamental matters, it is the Bd. that first considers and drafts

the resolution o Removal of directors – requires true majority of the shares entitled to vote

§220 INSPECTING THE BOOKS any SH, upon written demand & w/a proper purpose, can inspect the corp. books during business hours and make copies

o a proper purpose is something reasonably related to the person’s interest as a SH

o If the corp. refuses, the person can appeal to the Ct. to compel the corp. to comply w/the request

SH Quorum a quorum is the minimum number of SH’s who must be present for the body to

transact business, or vote §216 provides that a majority of shares entitled to vote is necessary for a quorum,

unless the CoI states otherwise (so 51% of the outstanding shares who can vote)o in DE, the CoI can’t ever set a quorum for less than 1/3 of the shares

Unless otherwise stated, in all matters other than election of directors, the affirmative vote of the majority of the quorum shall be the act of the SH’s (§216(2))

o But remember, §216 is “subject to this chapter in respect of the vote that shall be required for a specified action” meaning that this § is subject to any other part of the code which might have specified differently

o Like in §252(b)(c) which expressly provides for a true majority to approve a merger; a true majority is the majority of outstanding shares entitled to vote!!!

o True majority also required in certain other fundamental matters, like amending the CoI (§242b), the sale of assets (§271), and dissolution (§275)

Election of directors requires a plurality of the vote of the shares entitled to vote (so whoever receives the highest amount of votes from the quorum is elected)

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o If a SH controls 51% of the stock, under straight voting, he will always be able to elect whoever he wants b/c he’ll be able to vote 51% for that person; he’ll be the controlling SH; a person w/51% of the vote would qualify as a quorum on his own!

Special SH Meetings §211(d) allows the CoI or the bylaws to designate the power to call special meetings

of the SH’s to the bd. of directors or other persons o it could be designated in the CEO, or in a SH w/at least 10% (Auer)o but this power doesn’t have to be given

If a controlling SH wanted to call a special meeting, but didn’t have the above powers to do so, he has other options §228 gives a loophole that allows SH’s to act in lieu of a special meeting as long as they have 1) a proper purpose, and 2) have the minimum # of SH’s who would be required to authorize the action they want to take consent in writing to the action

o In the case of a 51% SH, he’d have that required amount, and could take the action he wanted, like remove the Bd. and replace it w/his own Bd.

o Would it be a proper purpose though? Yes, b/c §141k provides that any and all directors can be removed by a majority of the SH’s w/or w/o cause; there are exceptions for cumulative voting & staggered boards

o This is considered a loophole that can be used by hostile bidders

Voting by Proxy Very often SH’s just approve whatever management recommends, esp. if the corp. is

doing well, or they don’t vote at all; so whoever controls the Bd. can often get the SH’s to go along w/what they vote election of Bd. of Directors just requires a plurality of the quorum voting

§212e a duly executed proxy is irrevocable if it states as such, and is coupled w/an interest sufficient to support an irrevocable power (b/c the person you’re giving your proxy to must have some interest in the corp. to insure they’ll care about voting)

Straight Voting The default if a SH has 4 shares to vote, they vote 4 shares on each election; so for

candidate 1, they vote 4 times etc. allows someone w/a majority of the shares to control the Bd.

Cumulative Voting Purpose to ensure representation of minority SH’s on the Bd. of Directors; they

probably won’t get enough for control, but they’ll get somethingo It un-bundles the shares; so if a SH has 4 shares, and there are 4 elections,

he has 16 shares to work with, and can vote them all on one person Under §214, cumulative voting can only be provided for in the CoI Cumulative voting only applies to electing directors!! A director elected by cumulative voting cannot be removed in the usual manner

Board of Directors’ Duties

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§141a Have the legal power and duty to manage the affairs of the firm, including hiring/monitoring the officers (the officers manage under the “direction” of the Bd.)

o But this power to manage can be changed in the CoI §141b the Number of Bd. members shall be fixed in the bylaws, unless it is fixed

in the CoI; directors don’t have to also be SH’s, unless the CoI or bylaws require thato Directors can resign at any time o Quorum a majority of the total # of directors constitutes a quorum,

unless the CoI or bylaws requires a greater amount (§141b) The bylaws can provide that a # less than the majority constitutes a

quorum, but it can’t be less than 1/3 of the total directors, except if a Bd. of 1 is authorized, in which case 1 director will constitute a quorum

o The vote of the majority of the directors present will be the act of the Bd., unless the CoI or bylaws requires a higher amount

§141c Bd. can designate a committee; to the extent provided in the committee resolution, a committee can exercise all the power of the Bd., BUT a committee cannot amend the CoI (although a committee can issue shares, dividends), and can recommend to SH’s the sale of substantially all the assets, or recommend dissolution of the corp., or amendment to the bylaws

o but unless provided for in the resolution, bylaws or CoI, no committee will have the authority to declare a dividend, issue stock etc.

§141d Directors can by CoI or initial bylaw, or bylaw adopted by SH’s, be divided into classes (allows for a staggered board) ex. where directors amended the bylaws to allow a staggered bd. (which is not a valid way to do this), but then it was ratified by SH vote at the annual meeting so it would probably stand up in ct.

o if the person wanting to do it was a majority SH, he could also use his majority SH power to amend the bylaws

o to avoid the majority SH’s ability to do this, the Bd. who enacted the original staggered bd. bylaw, could have put in a “supermajority” vote requirement to get it altered

o the staggered bd. can be divided into 1, 2 or 3 classes §141e Directors are protected when they rely in good faith on corp. records, expert

testimony, committees of the Bd. etc., as long as those people have been selected w/reasonable care by or on behalf of the corp.

o often used to defend business judgment but it is not absolute protection; the use of an expert has to be in good faith, and you can’t delegate all your responsibilities as a Bd. to him

o Issue w/the P’s complaint in Eisner was that they didn’t allege the particular facts of the process the Bd. used w/the expert; just made broad generalizations about his press statements after the fact

§141f allows for decisions w/out holding a meeting as long as they consent §141g can hold meetings and have offices outside of Delaware §144h unless otherwise state in CoI or bylaws, they fix compensation of directors §141i allows for participation in meeting over conference call (directors CANNOT

use proxies!!)

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§141k Removal of directors: any director or the entire bd. can be removed, w/or w/o cause, by the vote of the majority of the shares entitled to vote, except:

o if the Bd. is staggered under §141d, then removal is only allowed for cause (unless the CoI provides otherwise) very difficult to prove cause

o if the corp. has cumulative voting if it took 11% of the SH’s to elect one of the directors, then that director can’t be removed w/o cause if there are at least 11% who voted to keep the director in b/c otherwise the majority could just get rid of the minority directors

only applies where less than the whole bd. is going to be removed; they can remove an entire cumulative vote the normal way

Directors are NOT full time employees; although some officers will invariably be elected to the Bd. (i.e. the CEO)

Individual directors have no authority to bind the corp.; their power is only as a collective, as a delegated committee, or as an agent thereof

o The officers perform/supervise the day-to-day managerial functions Directors are subject to fiduciary duties owed to the corp.; these are basically the

same type of duties that an agent owes to his Principal The “Business Judgment Rule” (BJR) largely immunizes managerial decisions from

judicial review or SH challenge o However, there is a balance in corp. law between this broad delegation of

authority and a system to maintain accountability to SH’s

Vacancies on Board §223(a)(d) allows vacancies to be filled by a majority of the directors (although

less than a quorum) can be altered in the CoI or the bylaws

Officers Officers and other employees are agents of the corp.; their authority comes from

delegation by the Bd. Apparent authority can also exist by virtue of certain titles etc.; if the officer acted

beyond his scope, the corp. can seek indemnity from him Corporate code usually calls for a President, a Secretary, a Treasurer, and one or more

VP’s Any number of offices can be held by the same person, unless the CoI or bylaws

provide otherwise §142 officer titles and duties are stated in the bylaws; they can resign at any time

w/written notice §142e in the absence of bylaws to the contrary, officer vacancies will be filled thru

bd. of directors Officers owe the same duties of care and loyalty as directors

Tax Situation for Corporations Double tax b/c earnings are taxed once at the corporate level, and then again on SH’s

when dividends are distributed (note: this is bad for SH’s, b/c the more the co. is taxed, the less $$ it has, and the less they get)

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The losses are only usable by the corporation; unlike in partnership, where they can be noted as a loss on partners’ returns

B. Fiduciary Duties & Shareholder Litigation(See the CHART!!!)

Derivative Suits suits by a beneficiary of a fiduciary to enforce a right belonging to that fiduciary (i.e. a suit asserted by a SH on the corp.’s behalf against a 3rd party, usually a corporate officer or director) any remedy that comes out of such a suit goes back to the corp., b/c the alleged harm was to the corp. in derivative suits where the SH’s are suing the directors, the directors are personally liable for this --- b/c it’s against the corp., and they pay it to them (otherwise it would be coming out of the corp. in order to go back in – makes no sense) to be able to sue derivatively, you have to have been a SH at the time of the breach, and at the time of breach

VG was not a derivative, but direct – they had already sold their stocks at a low price, but could still sue directly

Deferring to the Business Judgment Rule Cts. defer to it b/c they recognize that investing is risky, and that SH’s shouldn’t be

able to use the cts. for protection just b/c they lost $$ o A ct. will not second-guess a business decision as long as it was made in

good faith, was reasonably informed, and had a rational basis While directors are not allowed to overtly waste the SH’s assets, they do have a lot of

discretion over business decisions o The directors owe the corp. & SH’s a duty of care, and duty of loyalty

BJR is an offspring of §141a, that the affairs of the corp. are managed by the Bd.; the party attacking a Bd.’s decision has to rebut this presumption

In breach of fiduciary duty suits, the SH has to show LOSS to the corporation in addition to the breach, otherwise there aren’t any damages

Illegality & fraud do overcome the BJR; ct.’s usually don’t want to deal w/this though when a co. decides to violate the law b/c, for ex., the fine for doing it is worth it; the ct.’s do seem to focus on the monetary benefit to SH’s, which infuriates some scholars who argue it condones breaking the law

Kamin v. American Express Co., NY, 1976 SH derivative action, alleging that certain dividends are a waste of corporate assets; that they should have sold something else to get a tax break; HOLDING motion dismissed; P’s failed to make an actionable complaint; BJR trumps! mere errors of judgment are not enough for the ct. to interfere; there was a suggestion that this action increased the directors’ salaries, but all actions have effects on earnings, so they will be presumed to have been acting in good faith (esp. b/c there were only 4 directors whose compensation was tied to earnings)

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to have breach of fiduciary duty, the ct. holds that you’ve got to have some kind of nonfeasance, malfeasance, illegality or fraud

Shlensky v. Wrigley, Ill, 1968 SH derivative suit, alleging negligence and mismanagement b/c all other teams in the

league hold night games, and that b/c the Chicago Cubs don’t, they’re losing revenue HOLDING dismissed! P never showed damage to the corp. (a necessary

element – don’t forget it!), or that night games actually would increase revenue There was no showing of fraud, illegality, or conflict of interest; this is not to say that

this has to exist, but unless D’s actions border on this kind of activity, then the ct. should not interfere

“failure to follow the crowd” is not negligence

A.P. Smith Mfg. Co. v. Barlow, NJ, 1953 SH’s arguing that the co. wasted money by giving donations to Princeton; the SH’s

say that the CoI doesn’t authorize the contribution, and that the Bd. didn’t have any express or implied authority to make it

HOLDING the donation is allowed; P’s did not suggest that it was made w/o forethought, or that it was made to further someone’s personal interest; rather it was modest, and w/in limits imposed by a NJ statute; there’s a statute requiring SH approval if in excess of 1% of capital stock, or if over 25% of SH’s complain neither of those situations exist here

Public policy also supported the charitable giving

Limits on the BJR

TEST FOR WASTE to find waste, you have to have “something so one-sided that no business person of ordinary, sound judgment could conclude that the interests of the corp. were adequately considered;” a very high burden – almost impossible for P to win on

RARE Successful Waste Claim Dodge v. Ford Motor Co., Mich., 1919 One of the RARE exceptions where the ct. did not give deference to the BJR, and

where a D lost on a WASTE claim (b/c his actions were found to be irrational, and not for the corp. purpose)

Ford announced that no more special dividends would be paid, that he would reinvest them all in the business, and would use them to build a new plant, and that the price of the car would be reduced (he had social goals in mind to pay a living wage, and to allow more people to drive)

Dodge Bros. owed 10% of the stock; they sued, alleging waste based on the dividend policy, and the building of the new plant

HOLDING the Dodge Bros. won; the ct. ordered that dividends be paid The year when Ford refused to issue dividends had been his most prosperous year; so

his action seems to be a refusal to do what the circumstances called for

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Testimony from Ford that damaged him he talked about awful profits, and how his goal was to do good for society, and incidentally to make profits, b/c he was desperate to not look like a robber baron the ct. found that this was contrary to the corp.’s mission, which is to make $$ for the SH’s

However, the ct. didn’t interfere w/the expansion of the plant; deferred to BJR there

Procedural Due Care Violations: Failure to Make Informed Decisions

BJR & Ordinary Business Matters Brehm v. Eisner, DE, 2000 Derivative suit SH’s argue that the Bd. breached its fiduciary duty when it

approved Michael Ovitz’s employment K (which was extravagant & included a no fault termination clause), and that the directors were NOT disinterested and independent

Ovitz was friend of Eisner; didn’t have experience working for this kind of co.; K was negotiated personally by Eisner

P’s allege that the Bd. did not properly inform himself about Ovitz’s severance package; the Bd. had been advised by an executive compensation specialist, and he admitted he did not use good judgment; Old Bd. charged w/not exercising due care

New Bd. rubber stamps his no fault termination so he could get the big package; for that P charges the new Bd. w/waste

HOLDING Deferred to the BJR; found that the Bd. didn’t have to know every single fact, and that they’re responsibility is to consider the facts reasonably available; defer to §141e of the DE code, that they can rely on experts; P’s didn’t allege that they didn’t listen to him, that he wasn’t selected w/due care etc.; just b/c the expert later said that he didn’t do a good job isn’t dispositive; they relied on his public recanting in press statements REMAND the ct. did allow P’s to inspect the books though, and on remand found a Bd. who turned a blind eye, had barely considered Ovitz’s hiring, and didn’t show due care; waived the demand requirement

Francis v. United Jersey Bank, NJ, 1981 Creditors are suing Mrs. Pritchard’s personal estate to recover the $$ they are owed She inherited 48% of insurance brokerage co. from her late H; her sons owned the

rest, and drew from the co. for personal uses; by the time she died, they had taken $12M in loans, $$ which was supposed to be held in trusts for clients

She didn’t monitor the sons or take her responsibilities seriously, although she had been forewarned; she had a drinking problem; Ct. rejected argument that her behavior should be excused b/c she was old, grief-stricken, alcoholic, overtaken by sons

Do directors have fiduciary duties to creditors? Usually not, but here it was an unusual situation where they were holding $$ in trusts for the creditors

HOLDING Mrs. Pritchard is personally liable to the creditors

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Directors have a duty to keep themselves informed; they cannot just say they didn’t know what was going on; they have to be familiar w/finances, and if they discover illegal activity, they have a duty to object, and if nothing is done, to resign

This co. was more like a bank b/c they were holding millions of $$’s; there was an implied trust and fiduciary duty to guard this money for these 3rd parties

Tort liability her negligence only results in personal liability if it was the proximate cause of the loss; the ct. found her inaction was a substantial factor in the loss

Duties in Fundamental Matters Smith v. Van Gorkom, DE Sup. Ct., 1985 Class action by SH’s against Bd. members for breach of fiduciary duty/failure to take

due care (not a derivative suit b/c alleges voting rights violations, proxy fraud) TransUnion was not living up to its economic potential, which made it ripe for a

takeover; VanGorkam (VG), the CEO and Chair of the Bd., thinks they should consider selling or merging

VG meets on his own w/Pritzker, a corporate takeover specialist; they run #’s on a cash-out merger at $55/share; VG suggested the figure w/out trying others

VG calls meeting of senior management, gives them no documentation, they think $55 is too low; wanted management buy-out; he immediately meets w/the Bd., gives 20 minute presentation, but never showed how he got to the $55 figure

Bd. meeting lasted for 2 hours; merger approved as long as TU had right to accept better offer, and that it could share its proprietary info. w/other bidders; no one read the final K before they delivered it to Pritzker these documents were ultimately different than what VG had said, put constraints on ability to negotiate a better deal the way it was set up w/Pritzker, no other co. wanted to bid unless Pritzker deal was out (it was a “lock up” deal!); the market never had an actual chance to really bid, which means the share price wasn’t tested against the market (Market tests aren’t necessary to show duty in tender offer situations but they help)

SH’s then approve the merger but this wasn’t effectual to ratify b/c the SH’s weren’t fully informed; the proxy was faulty

HOLDING VIOLATION OF PROCEDURAL DUE CARE – Judgment for the P’s for the fair value of their TU shares; the Bd.’s decision to approve the cash-out merger was not the product of an informed business judgment; the Bd’s efforts to amend the merger agreement were ineffectual (legally & factually), and the proxy did not disclose all the relevant facts; therefore, there was a breach of fiduciary duties to the SH (thru failure to take due care)

The Bd. was grossly negligent when they approved the sale at that price, w/o inquiring how they came up w/the figure, and w/o facing a crisis, or having any prior notice; they relied almost chiefly on what VG said; no members of management were there and no written documents;

§141e doesn’t apply b/c they didn’t rely on any reports, just this oral stuff; for a “report” to enjoy protection under §141, it can’t be blindly relied upon the ct. felt this board was “captured” by VG – giving him complete deference

Rebuttal to the Bd.’s arguments doesn’t matter that the buy-out # was at a much higher rate than what the shares were trading at; they knew it traded at less than it was

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worth, and they had never even considered selling before; as far as being able to accept other offers, they were barred from actively soliciting them!

Did the Bd. later ratify? No, they still were not fully informed; still never saw anything in writing; and the way they amended it was never even approved, and no one looked at the written K! And there was fishy stuff going on w/the other 2 co.’s interested in buying seemed like VG pressured them; he wanted his friend Pritzker to get it

REMAND case settled for $23M; VG paid more than the others; Pritzker paid as well; if they had found that $55 was the actual price then they would have gotten nothing, b/c as a tort, you have to have loss/damage!

Merger Terminology

Leveraged buy-out purchase of a firm (generally thru its shares) financed by a small amount of equity, and taking on a large amount of debt; often after the purchase, the assets of the firm are sold to pay off the debt (She says we won’t need to know this --- it gets rid of the SH’s) we won’t be tested on this

Management buy-out firm's existing management buys the firm, often thru a leveraged buy-out

Merger 2 firms are combined into a single firm; distinct from a takeover where one co. buys the shares of the other and becomes its parent; in a merger, the 2 become one firm, w/one group of SH’s owning the newly combined firms

Cash-out merger merger in which the SH’s of one firm get cash for their shares and don’t become SH’s of the new firm

Proprietary information the private info. that firm’s don’t have to publish about themselves, and which would be valuable to someone wanting to bid on the firm

Tender Offer an offer of cash or securities to the SH’s of a corp. in exchange for their shares at a premium over the market prices; no SH vote is required since technically it’s not a corporate transaction, but one of individual SH’s; tender offers require a public announcement that the shares will be purchased

typically a way for someone to acquire a lot of shares, and take over the Bd. (like in Wallstreet – Gekko did this w/BlueStar)

Effects of VG: Statutory Limits on Directors’ Liability As VG shows, on a successful breach of fiduciary duty claim, a director can be held

personally liable; often insurance will cover the costs, but if not, they’re on the hook; however, ct.’s are hesitant when awarding this as they don’t want to discourage people from sitting on Bds.

After VG, people were very nervous about personal liability of directors in response, DE enacted DE Code §102(b)(7):

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o Allows a corp. in their CoI to eliminate the personal liability of directors for breaches in certain contexts

o Does not however take away shareholders right to sue for injunctive relief; just protects the directors from monetary damages

o Limits cannot eliminate a director’s duty of loyalty, cannot allow waste, intentional violation of the law

BJR & NonfeasanceIn re Caremark International Inc. Derivative Litigation, DE, 1996 Health care co. where employees were guilty of Medicare fraud; they agreed to settle

for over $250M w/some of the P’s; SH’s are now suing, arguing that the settlement wasn’t fair to the corp. and its SH’s

The Directors had a duty to attempt in good faith to know what’s going on w/the co.; they settled & agreed to permanent audit committee; to find a breach by the directors, P’s would have to prove that they knew or should have known about the illegal activity, and that they took no steps to remedy it, and this resulted in SH loss

HOLDING the Ct. approves the settlement; in consideration of the weakness in P’s claim, a settlement assuring an auditing system will exist in the future to deter these big payouts is adequate + it gave them attorney’s fees; so there was a favorable holding for the SH’s, but really this decision isn’t as big as it seems; they still deferred to the BJR, and implied that once a Bd. starts a monitoring system, the ct. won’t inquire much further; Judge found there was a “very low probability” that the ct. would find the directors breached fiduciary duties; the co. settled b/c they probably just wanted to squash it

Self-Dealing

Duty of Loyalty: Directors & Officers Conflicts of Interests Self-dealing tends to be easier to show than failure to take due care, or waste; b/c

where there is a conflict of interest, it automatically shifts the burden onto D to show ratification or that it was fair

§144 defines a conflict of interest as a transaction involving an interested director (where they’re either a director of another corp. they’re transacting w/or they have a financial interest) but says that these will not be void just b/c of this, that they can be “cleansed” thru 1) bd. ratification; 2) SH ratification; 3) fairness of the transaction

Classic conflict of interest where directors are deciding their own compensation Bd. Ratification under §144(a)(1)

o If there are 9 directors, and 4 are “outside” the transaction, then for proper ratification, the interested directors can be there to make the quorum, and even vote, but their vote won’t count towards proper ratification

o For proper ratification a majority of the votes of disinterested directors (even if they don’t equal a quorum but you still need to have a quorum present, not necessarily voting, but present)

o Also needs to be full disclosure of what’s going on, and it must be done in good faith (i.e. it doesn’t count if it’s not in the best interests of the corp.)

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What if the 5 interested directors didn’t want to participate at all; didn’t even want to show up to make the quorum? We would still need to have a quorum, which would be at least 5 (a majority of the 9); one way to avoid this issue is to create a committee of the 4 disinterested and have them ratify (§141c2 allows this)

Bayer v. Beran, NY, 1944 Derivative suit: SH’s allege the Bd. was negligent, wasteful in embarking on a radio

ad. program costing $1M, and that it was a breach of the duty of loyalty, b/c it was really to benefit the wife of the President of the co. (and one of the Bd. members)

While it’s not improper to employ family members, it deserves a higher degree of scrutiny; here the decision was done after much review and consulting; it’s ridiculous that they would spend $1M just so the wife could earn $24K but what about furthering her career?

HOLDING no self-dealing; no breach of the duty of loyalty; evidence doesn’t show it was done to further her career it was a standard K, she didn’t appear more than any other artist on the program; she was already an established singer

Yes, this was a conflict of interest, but it was a fair K (this was the first case to allow for fairness to cleanse a conflict of interest, even in the face of no Bd. or SH ratification)

Lewis v. S.L. & E., Inc., 2nd Cir., 1980 tire dealership in Rochester; another co. owned by the same man; that co. holds the lease to the dealership, and nothing else; sons take over as directors The sons never consider raising the rent, they never enter new lease when lease

expires; they disregarded that there were other SH’s of this co. who were not family A conflict of interest existed b/c they were on both bds. of the companies transacting;

burden shifts to the D’s to prove proper ratification or fairness HOLDING breach of fiduciary duty to the SH’s; D’s did not meet their burden

Self-Dealing Compensation for Directors & Officers Cohen v. Ayers, 7th Cir., 1979 Derivative SH suit; challenging employee stock option plan, argues it was waste, and

a gift of corporate assets; The fair market value of the shares kept declining, making the options worthless to

the employees; so the co. kept re-issuing them at higher rates HOLDING there was some conflict of issue on the re-issue, but then the burden

shifts, and it turns out there was valid SH ratification; P could not prove waste waste arises when the corp. gives something of value w/o adequate consideration; not the case here, reduction of option price to meet declining stock value is not waste per se, and may be necessary to maintain the original value of what was given

Self-Dealing: Corporate Opportunity Doctrine

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Corporate opportunity doctrine part of the broad fiduciary duties assumed by corporate officers and directors; it’s an agreement to place the interests of the corp. above one’s own interests

The law does not require that one has to formally present every opportunity to the Bd. In deciding if it is a corporate opportunity, a ct. will consider:

o if the corp. is financially able to take on the opportunity o if it’s in their line of business; ando if they have a reasonable interest in this, and a reasonable expectancy that

their directors would apprise them of such opportunities If the opportunity was not one for that corp., then there’s no duty of loyalty issue!

Broz v. Cellular Information Systems, Inc., DE, 1996 Broz was Pres. and sole SH of RFBC; he was also a director of CIS Broz became aware of a deal for a Michigan cellular license; a brokerage firm

contacted him to see if RFBC would be interested; they did not contact CIS, the broker told him that CIS wasn’t interested; eventually RFBC gets the license

CIS SH’s file derivative suit, claiming Broz usurped a corporate opportunity As a director, Broz was allowed to analyze if this was an opportunity that belonged to

CIS; based on their financial status, and that they weren’t taking on any more cellular holdings, he concluded it wasn’t; he could have covered his bases by formal disclosure, but he didn’t have to

HOLDING he did not breach his fiduciary duties to CIS; ct. found no corporate opportunity here ct. found it esp. dispositive that he had talked to some of the directors informally about it, and they told him CIS wouldn’t be interested

The Duty of Loyalty & Controlling Shareholders SH’s do not have fiduciary duties to one another; but practically there are situations

where SH’s control the co. by virtue of how much they own In such situations, ct.’s have found that the controlling SH is really acting like a

manager, and owes fiduciary duties to the other SH’s and to the corp. (the same way a director does)

Sinclair Oil Corp. v. Levien, DE, 1971 Sinclair is a holding co.; owns 97% of Sinven’s stock (controlling SH); clear that

Sinclair owes Sinven a fiduciary duty Sinclair caused Sinven to issue excessive dividends, b/c they were the primary

recipient of them; P argues that this prevented Sinven from expanding; However, b/c Sinven never got anything that the minority SH’s didn’t also get, then it wasn’t self-dealing

P never proved that Sinclair usurped any corporate opportunities either However, they did find self-dealing in a K between Sinven and another of Sinclair’s

subsidiaries; where the subsidiary lagged in payments, and didn’t comply w/the minimums set in the K; this was self-dealing b/c Sinclair got the products to the detriment of Sinven’s SH’s

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Conflict of interest is found - Sinclair has to prove intrinsic fairness, since no ratification; Sinclair did not meet this burden, there was nothing fair about this breach of K!

HOLDING in relation to the K, there was a breach of fiduciary duties; Sinclair is accountable for damages

NOTE that the lower ct. found self-dealing on all counts, not just the K

Zahn v. Transamerica Corp., 3rd Cir., 1947 Zahn, holds Class A stock of A-F; he’s suing TransAmerica (TA) on behalf of all

SH’s similarly situated; says that TA forced A-F to redeem its class A shares at a certain price, instead of being part of the liquidation that occurred the next year

TA owned 71% of A-F’s B stock (voting stock; gets lower dividends, and 1/3 of assets on liquidation), and 66 % of its A stock (junior preferred stock – has higher dividends, but no voting rights; but would get 2/3 of assets upon liquidation); so TA is controlling SH

A-F owed $6M worth of tobacco, which was disclosed on their books; but unbeknownst to the public, it was actually worth $20M; TA was aware of this

Zahn is alleging that TA had a plan to take the value of the tobacco for itself, by “calling the A stock,” then liquidating, and thus getting most of the assets for themselves

When they called it, the A SH’s had the option to take cash, or to exchange it for B; they couldn’t keep the A stock (A was entitled to twice as great dividends as B); the SH’s here cashed out (didn’t convert to B probably b/c they thought corp. was poor)

Controlling SH’s owe a fiduciary duty to minority SH’s; Zahn argues that the Bd. of directors breached by favoring TA, that really the bd. was the instrument of TA

HOLDING Held TA accountable to the Class A SH’s; found they were liable in tort for both fraud and deceit; the Ct. found that disinterested bd. would have disclosed the actual worth of the tobacco; the damages were what they would have gotten if they had converted their shares to class B prior to liquidation (b/c they didn’t have the full info., they were unable to properly evaluate whether they should redeem or convert to B)

Direct suit ; breach of fiduciary duty of loyalty; direct b/c they suffered distinct harm compared to the other SH’s

In the cases w/different classes of stock, look to what the parties expected out of it – directors will have a duty to meet that which was written in the share agreement, which may involve favoring one class on certain things; breach of that occurred here

Cleansing through Fairness

Elements to consider for fairness of transaction ~ Timing, initiation, negotiation, structure of the transaction, disclosure to and

approval by the directors and/or shareholders Examples getting a fair price, making $$ for the corp. etc.

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Fliegler v. Lawrence, DE, 1976 SH derivative action brought by Agua Mines against the directors and officers of USAC Pres. of Agua, acting on his own, gets a lease to a property; he offers it to Agua, but

the Bd. rejects it; Pres. sells it to USAC, a closely held corp., formed for this purpose K gave Agua long term option to acquire USAC if they wanted;

They exercised this option and paid $800K of shares for it; P sues, alleging waste HOLDING D’s were able to prove the intrinsic fairness of the transaction

(property was valuable, and they got cash they needed) It was an interested transaction, so D’s tried to prove that the Bd. ratified, but it

wasn’t approved by a majority of the disinterested SH’s; but they were able to cleanse it on fairness

SH Ratification of Interested Transactions In Re Wheelabrator Technologies, Inc. Shareholders Litigation 2 companies, Waste & WTI; Waste owns 22% of WTI’s stock, and elects 4 directors

to serve on WTI’s bd.; eventually the 2 companies merged; arranged a deal for the SH’s of both company

this was an interested transaction, but the plan was considered at length; WTI’s disinterested directors approved the merger, and then the SH’s approved it

P’s argue that the proxy was misleading and didn’t disclose all the facts no, the SH’s were fully informed, and therefore properly ratified; then P’s argue breach of duty of care but that’s moot b/c the fully informed, disinterested SH’s ratified

More on Shareholder Derivative Suits If the suit is successful, the corp. has to pay the shareholder’s legal expenses, b/c the

shareholder has benefited all the other shareholders as a group If unsuccessful, they cannot recover costs/legal fees! And the corp.

could sue them and force them to pay its legal fees as well Once the transaction has been litigated, other SH’s cannot sue on the same issue Often seen as nuisance suits (or “strike suits”) brought just to get a small recovery

often the party in interest would be P’s attorney, who would look for a SH to bring this suit so he could get attorney’s fees; incentive for collusive settlements w/the corp. is high b/c the costs are passed on to the corp.

Also if D’s are personally liable, they get indemnified in a settlement, but not in an adverse ruling (they’ll have to personally bear whatever cost insurance doesn’t cover, if they have it)

In a settlement, the corp. pays the fees of both the individual D’s, and the P’s

Barriers have now been put up to these strike suits like a bond requirement where P has to put up a bond to cover D’s expenses in case P loses (required in NY, not in DE); also judicial approval of settlements is now required, so judges can evaluate if the suit was just about paying off the lawyers

often laws saying that only P’s who owned shares contemporaneous w/ the wrongdoing can sue

The Corp. is joined as a D in these suits b/c it failed to assert the claim itself!

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The Demand Requirement Demand is only required for derivative suits The demand requirement comes from case law since under §141a directors

manage the corp., then it’s the directors’ decision to decide if the corporation should engage in a lawsuit (since a derivative suit is on behalf of the corp.)

When a demand is made by a SH, the Bd. has several options: Take corrective actions, enter into a settlement w/the D, and avoid

the lawsuit Bring the action itself Permit P to proceed in its place Reject the action as not w/in the corp.’s best interest

If Bd. rejects, then the issue is whether the rejection was wrongful

When a ct. considers if a demand was properly refused by the Bd., they do NOT look at the underlying transaction at issue, but rather at the process the Bd. went thru to decide whether or not to pursue the litigation

It’s difficult for a P to make a wrongful refusal complaint esp. b/c the fact that P submitted the demand to the Bd. in the first place shows he thought they were fair enough to make a decision

Procedurally, a P who wants to start a derivative action has to first either make a demand to the Bd. to bring the action, or show that the demand was excused

Demand Excused P’s usually don’t make demands, and instead argue that the demand was excused

under DE law if you make a demand, and it is rejected by the Bd., then the Bd.’s decision to reject is entitled to the presumption of the BJR

o Note that in a demand refused case, the P is not allowed discovery When is demand excused?

o It used to be that it was excused if the complaint alleged misconduct by any of the Bd’s members;

o The law has shifted though since the mid-1970’s, P have had to allege that a majority of the bd. personally benefited from the transaction

If it was the case, the ct. would probably not expect the Bd. to reverse itself or evaluate the proposed lawsuit impartially b/c one shareholder objected

But if a majority was NOT involved, then demand might be required, unless P could show evidence that the decision was corrupt or reckless

Even if demand is excused, P can still be barred from proceeding this is where the special litigation committee comes in

Requirement to make a demand can be excused where: (from Aronson)o There is a reasonable doubt that the Bd. is capable of making an

independent decision to assert the claim, b/c of the following: The majority of the Bd. has a financial interest

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The majority is incapable of acting independently b/c of domination or control, or

The underlying transaction was not a valid exercise of BJ If a SH cannot show the above, then must make a demand on the Bd. to bring the suit It’s important that the demand process be meaningful hence a SH has a right to

prompt notice of the Bd.’s decision

Grimes v. Donald, DE Sup Ct., 1996 Derivative action by SH Grimes – he alleges that the Bd. breached its fiduciary

duties (failure to exercise due care; waste) Grimes takes issue w/CEO’s employment K and termination package Grimes demanded the Bd. get rid of the K; the Bd. refused Grimes claims that since Donald will be let go, and receive a generous package if the

Bd. interferes w/his management, then that inhibits the Bd. from exercising their duties under §141a Ct. disagrees; it’s a BJ to delegate duties, this doesn’t mean they abdicated (renounced) their duties

Here Grimes made a demand to the Bd.; then he tried to claim it was excused, but that doesn’t work once you make a demand, you’re waiving you’re right to contest the independence of the Bd. Grimes didn’t make a solid case for why the BJR should be overcome; he just argued that they didn’t sue, so obviously they were wrong; he should have included particularized allegations that raise a reasonable doubt about the Bd.’s decision to refuse being one of good BJ

HOLDING the demand for a derivative suit fails; also Grimes couldn’t try to bring a direct action b/c he suffered no personal harm

Special Litigation Committee (SLC’s) members are appointed by the board these committees almost ALWAYS decide that the derivative suit should be

dismissed Courts have differed about these committees in NY, they’ve applied the BJR and

not examined the committee’s decision; in DE, they let the TC decide whether or not to look into their decision

Came on the scene in the 1970’s; at first the ct.’s always deferred to the BJR, despite the taint of the Bd. appointing the committee members (like Auerbach)

Obviously there’s considerable risk that special litigation committees will be affected by bias towards the members of the Board (since appointed by Bd.)

What usually happens is that after P alleges demand excused, the Bd. will create these independent litigation committees

If the SLC makes a determination that it’s in the best interest to terminate litigation, then the Bd. will make a motion based on that committee to dismiss

Under §141(c), the Bd. has the authority to designate a smaller committee the most likely result is that the SLC makes a recommendation to terminate the litigation

Then Delaware changed everything w/the “demand-excused cases” that where demand was found to be futile, the ct. will listen to the SLC, but w/suspicion b/c of the taint

2 STEP TEST for CT. to ANALYZE SLC’S MOTION TO DISMISS: (from Zapata)

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o Procedural Inquiry Ct. considers: 1) independence of the SLC; 2) the reasonableness of the investigation conducted (i.e. support

for their conclusion/diligence used in making the decision); and 3) the good faith of the committee

Corp. (D) has the burden of proving the SLC’s independence; only limited discovery is allowed

Burden on D here is actually pretty high; different from everything we’ve seen before re: BJR D will help their case by showing use of experts, legal/economic counsel etc.

If the ct. is satisfied that the SLC was reasonable and independent, they move to the next step; if these elements are not met, then the derivative suit can proceed

o Substantive Inquiry Ct. balances the claims expressed by the SH w/the co.’s best interests as expressed by the SLC (Ct. gets to actually apply it’s own BJ!!)

The Ct. is permitted to use its own business judgment to determine if the SLC’s motion to dismiss the claim should be granted

This step is here for situations where step 1 might be met, but the SLC’s actions don’t satisfy a spirit of fairness

This is a far more intrusive inquiry than even the fairness test applied to self-dealing

o In DE, the 2-step Zapata test only applies to SLC recommendations where demand has been excused.

Auerbach v. Bennett, NY, 1979 A report showed evidence of bribery in companies working abroad; GT&E ordered

an internal investigation to see if it was guilty of the same thing; the investigation revealed that it was a part of it, to the tune of $11M in kickbacks and bribes; also revealed that some of the directors were personally involved

SH commences derivative action against the directors, the auditor, alleging breach of fiduciary duties Bd. then creates an SLC, which comprised 3 disinterested directors who had joined after the bribery SLC determined that the directors had not profited personally, and that the suit should be dismissed b/c it would not be in the best interest of the co. to proceed, and b/c the publicity would be damaging

HOLDING the ct. applies the BJR and defers to the SLC’s judgment The BJR doesn’t totally shield the SLC members it inquires if they were fully

disinterested and independent, and were in a position where they could make an unprejudicial exercise of judgment here there’s nothing to raise a triable dispute of fact about their independence or disinterest

But the BJR does embrace the SLC as long it balanced ethical, legal, commercial, promotional, public relations concerns

Zapata Corp. v. Maldonado, DE, 1981

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SH derivative suit, alleging breach of fiduciary by officers and directors of Zapata; the SH argued that demand was excused b/c all the co.’s directors were named as D’s, and had allegedly participated in the action

In response, Bd. creates an SLC composed of 2 independent directors; the SLC concludes that all actions should be dismissed

The Bd. can’t allow a derivative suit to be dismissed if doing so would violate their fiduciary duties, regardless of what the SLC says

Issue is that if the SH decides that making demand would be futile, we don’t want to just allow Bd.’s to get rid of the suit anyway thru committees; but on the other hand we want to avoid destructive strike suits

HOLDING after applying the 2-step test, they overruled lower ct.’s finding that the suit should proceed; remand, finding SLC’s judgment was proper under the test

In re Oracle Corp. Derivative Litigation SH derivative suit, formed to investigate inside trading; SLC created, made up of new

directors who had joined after the quarter when the alleged misconduct occurred – both Stanford professors

They used legal advisers, they were paid the going rate for consultants, interviewed over 70 witnesses, very extensive report produced

Conclusion SLC recommends not proceeding w/the derivative suit SLC has the burden of convincing the ct. that its members were independent, that it

acted in good faith, and that they had a reasonable basis for conclusions (Zapata test) P argues the Bd. is not independent b/c of the connection w/Stanford & director’s

donations to it; also one of the D’s was a professor there HOLDING SLC’s motion to terminate the suit is denied b/c the SLC was NOT

independent! Failed on independent prong The SLC’s report was undermined b/c they seemed to avoid the topic of the Stanford

connection; makes it look like they’re hiding something; the ct. didn’t care that Stanford had rejected one of the D’s children from admittance

Direct SH Claim vs. Derivative SH Claim Getting around the Procedural Requirements? For a direct claim, the SH has to allege more than an injury resulting from a wrong to

the corp.; must show suffering that is separate, distinct, and personal from that suffered by other SH’s

o Must consider the nature of the wrong, and the remedy sought o Look for something that is harming someone personally, rather than

harming all SH’s in the same way Classic derivative suits basic breach of fiduciary duty suits, where alleged that the

directors did something to lose corp. $$; if successful $$ will go back to the corp. Sometimes they can be more like hybrids, esp. where you have a minority SH, and

the $$ would go directly to them; or where the bd. is so small and corrupt that the ct. doesn’t award the $$ to them b/c it would go back to the bad guys, so instead gives it to the SH who was out the money

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Classic direct claims Undermining of voting rights (thru proxy fraud etc.); Allegations of improper payment for shares; any other personal claim where remedy goes to SH

Sometimes P’s will try to frame a complaint as a direct complaint in order to avoid the demand requirement

Just b/c the value of the shares went down, you do not have a direct or derivative suit – that’s the risk of investing!

Legislative Actions to Discourage “Strike” Derivative SuitsCohen v. Beneficial Industrial Loan Corp., US, 1949 SH derivative suit, brought in fed. court Issue does the fed. court ruling on a diversity action (by virtue of diversity) have to

apply a statue of the forum state (NJ) that makes an unsuccessful P pay for D’s attny. fees, and requires P to put up a bond to insure this? Yes.

The NJ legislature created this to ward off strike suits, and the statute must be applied HOLDING the fed. court has to apply the statute (case shows these are valid)

Eisenberg v. Flying Tiger Line, Inc., F.2d, 1971 HOLDING finds P’s action was not derivative, but rather personal, and so a direct

suit; he is not required to put up the security required by law for derivative suits His suit was personal b/c he was personally deprived of the right to vote b/c of the

co.’s reorganization

C. Federal Law: Securities Fraud & Insider Trading Securities Exchange Act of 1934 the Act is not self-executing, only comes into

being thru fed. rules created by Congress Congress has done thru creating rules & creating the SEC

Liability under these rules affects not just managers and directors, but also consultants, accountants, underwriters etc.

Rule 10b-5 is the primary federal rule used to fight inside trading 1975 case confirmed that R10b-5 only applies to purchasers and sellers of securities;

found that it didn’t apply to someone who claimed to have been misled by a prospectus, and then didn’t buy; he took no action, so had no cause of action

Scienter a state of mind of an “intent to deceive, manipulate, or defraud” R10b-5 is in addition to everything else we’ve discussed; possible to have a 10b-5

claim and a duty of loyalty claim R10b-5 is about creating a level playing field, but only where a fiduciary duty exists;

these are the policy reasons creating a level playing field in the market, and holding directors accountable when they violate their fiduciary duties to SH’s

o people can have different info. or insights and trade on those merits, and that is no violation

10b-5 actions are either brought by the SEC or by a private party (not derivative) Private 10b-5 action P has to prove:

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o that D made a material representation or omission in connection w/the purchase or sale of a security

o that P relied on that omission/misrepresentation o D had scienter (a mental state of an intent to deceive/defraud)o causation

Private actions under 10b-5 requires additional elements than a claim brought by the SEC

o The SEC just has to show the basic jurisdictional requirement, that it’s the kind of thing an investor would have relied on)

o A private party, though, tget damages, has to show that they did in fact buy or sell based on that statement, and show causation (i.e. actually experienced damages)

In order to avoid liability, the insider w/the material info. must either a) abstain from trading, or b) disclose the info. to the public

Under 10b-5, it doesn’t matter if you can prove that the inside information really didn’t influence you; as long as you do it, then you violate

Under 1994 case, Ct. held that the scope of 10b-5 is controlled by the statute – and that where the text of the rule is not complete, must look to how the 1934 Congress would have resolved the issue

Jurisdictional element “by use of any means or instrumentality of ISC, or the mails, or any national security exchange” address this quickly; easy to meet

Securities Fraud ViolationsBasic Inc. v. Levinson, US, 1988 Chemical manufacturing co. for steel industry issues public statement saying it isn’t

considering merger; P sells their stock after this; shortly later the co. stops trading their shares and mergers by accepting a tender offer

Bring suit against Bd., arguing it issued misleading public statements in violation of Rule 10b-5; injury alleged: that they sold at artificially depressed prices, in a market that had been influenced by and relied upon the Bd.’s misleading statements

HOLDING found the Bd. violated R10b-5 by failing to disclose material info. D tries to argue that they have to keep certain info. private, that the merger wasn’t at

the point yet to disclose the test to know when you have to disclose is not a bright line one, it’s mushy the ct. will consider how serious the talks were, if there were Bd. resolutions offering them, the beginnings of formalized discussions

“Fraud on the market” idea that stock price is determined by available material info.; that people rely on the integrity of the market, and any misleading statements will defraud purchasers of stock, even if they don’t actually rely on the statement the Ct. approves of this standard; they’re not going to require P to prove reliance; instead the reliance is presumed

in order to rebut the presumption, D’s would have to show some fact that proved P actually didn’t rely, or that the market knew about the talks etc., or showing that P would have traded anyway

P has to show that the breach caused some harm Strong dissent that didn’t like the use of the fraud on the market theory b/c thought it

economics were replacing legal theories; also the fact that everyone in the class is

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presumed to have relied, even though there was indication that many people just outright didn’t believe the statements about the merger

Insider TradingGoodwin v. Agassiz, MA, 1933 SH sold stock in Cliff Mining Co.; brings direct suit against the director and the

President of the corp.; alleges they had material knowledge about the value of the stock that P did not have, and they traded on it

D’s believed in a theory that they would find copper in this area; it wasn’t proven, but they put stake into this idea, and thought the stock would go up if true

They closed one mine, P read it in the paper, and sold his shares; then D’s bought them P argues he would not have sold if he had known what the geologist thought

HOLDING P cannot prevail on the suit; fraud is not presumed where directors buy stock from a SH, it must be proven; there was nothing to show fraud or conspiracy; the copper thing was a theory, not proven (so it wasn’t material info then)

There would have been no advantage for them to disclose the copper theory b/c if it hadn’t turned out to be correct, then they could have gotten sued if people relied on that statement

SEC v. Texas Gulf Sulfur Co., US, 1969 TGS drilling in Canada, finds area w/high mineral content; they decided to buy the

land, but didn’t want to drive up the price, so they kept it quiet TGS employees & their tippees buy TG significant amount of stock; during this time

there were rumors in NY papers about possible ore strike; TGS tried to quell the rumors by issuing 3 press releases saying there was no ore to be found, even though at the time they knew they had a huge strike on their hands

The press releases had an effect on trading, some traded their shares; then before they issue another release saying they had found ore, insiders (employees, geologists, consultants) are doing more trading; stock price had increased from $17 to $58 in less than 6 months

SEC brings a civil enforcement action Inside trading trading on the basis of material, nonpublic information; spirit

of the rule is to prevent people who have access, either directly or indirectly, to inside info. that is only supposed to exist for a corporate purpose, not for personal gain

What makes information material?? Here the biggest indication is that the people who knew this info. did heavy trading! That’s an indication that it was material b/c it influenced them so much

A duty to disclose or to abstain from trading only arises where the info. is “reasonably certain to have a substantial effect on the market price of the share if disclosed”

o Therefore, insiders are not always forbidden from trading in their company (b/c its only when they have this material info.)

o The Basic test: whether a reasonable person would attach importance to the info. in determining his choice of action

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o That includes disclosing something that might affect the stock, like the possibility of a merger

o SPECULATIVE EVENT to determine if need to disclose you must BALANCE the following:

Magnitude (or Significance) of the Event The probability/likelihood that it’s going to occur

HOLDING the info. about the ore strike would have been valuable to a reasonable investor; since they traded on this info., w/o disclosing it, they are liable under 10b-5

o It wouldn’t have been a problem if they didn’t trade; that’s the issue the insiders can’t benefit from info. that the public doesn’t have

o Geologist & consultants are also guilty; they were “temporary insiders” Other claim that the press release put out violated R10b05(b) “making untrue

statement of material fact”**the misstatement/omission stuff was added to the Rule after judicial interpretation

10b-5 Violations by Outsiders 10b-5 doesn’t specifically talk about insiders, so there’s really nothing explicit which

says you have to have a fiduciary duty to SH’s to violate 10b-5 Hence liability of outsiders under the tipper/tippee & misappropriation theories

Tipper/Tippee (Rule 10b5-1) Elements of Tipping ~

o Tipper breaches fiduciary duty (i.e. discloses for improper purpose)o Tippee knows or should know that disclosing this info. is a breach o Tippee trades b/c of this info., or causes others to trade

Remember that in any case where the tippee is held liable, the tipper will also be liable; it’s not just the disclosure alone though the tippee has to take action on the info. he got tipped to

Essentially where you’re facilitating a breach by your tipper; they’re giving you the info. for their personal benefit and you know it and they know it!

To not be liable the tippee has to abstain from trading (or disclose but that’s impractical b/c he doesn’t have the tools to disclose, nor is he supposed to know the info. in the first place)

Just being careless w/info. isn't enough to trigger tipper/tippee; it might violate a duty of care though (i.e. leaving a memo around; talking loudly on the phone in store)

Chiarella v. United States, US, 1980 The print shop case; he was able to tell which co. was the target co. of a tender offer;

he bought up shares in the target co. He was fired, and agreed to disgorge his profit; but the Sup. Ct. held that he didn’t

violate R10b-5 b/c he wasn’t an “insider” of the co. whose shares he had traded (the “target co.”); since he had no fiduciary relationship w/that co., who was just a potential victim of the other co.’s tender offer, then ct. found there was no relationship of trust between Chiarella and the SH’s of the target co.; he had no duty to disclose or abstain

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Dirks v. Securities & Exchange Commission, US, 1983 Dirks got material info. from insiders who wanted him to investigate fraud at Equity

Insurance; he did and found it, but also disclosed it to his clients, some of whom traded on it

HOLDING Dirks had no duty to this company; there was no expectation from the source that he was supposed to keep it confidential, in fact the source told him to investigate! The tipper also got no financial benefit from disclosing it to Dirk, he just wanted to expose the fraud (there must be an improper purpose)

SEC asserted the position that the tippee “inherits” the fiduciary duty of the tipper, and that the former employee of Equity breached, and thus Dirks breached the Ct. disagrees w/this; says that this would severely restrict the role of market analysts recipients of inside info. do not invariably acquire a duty to disclose or abstain

This turns on if the insider is breaching a fiduciary duty it depends a lot on the purpose of the disclosure; absent any personal gain, there’s no breach of duty to the SH; and subsequently, absent any breach by the insider, then there is no derivative breach by the tippee

Here there’s no indication that the employee was doing anything for financial gain; so see above holding

Misappropriation (R10b5-2) Where the outsider misappropriates info. in breach of a duty of trust/confidence

this turns on whether or not there was as relationship of trust/confidence So you’re violating a duty to your source; they didn’t mean for you to tell anyone! Familial relationship triggers a relationship of trust/confidence (R10b5-2(b)(2))

o That presumption can be rebutted by the person who got the information showing that there was no duty of trust or confidence w/respect to the info., by showing either they didn’t know or shouldn’t have known that the person expected them to keep it confidential; or b/c of the parties history, pattern etc. pretty hard to prove in the family context

Only the outsider will be liable b/c the focus is on the outsider who breached his relationship w/the insider

United States v. O’Hagan, US, 1997 O’Hagan is partner in law firm; firm is representing GrandMet, who’s making a

tender offer for Pillsbury; the possible merger was confidential O’Hagan purchases significant stop of Pillsbury b/c of the info., made himself the

largest single SH; once the merger was announced, the price jumped, and he sold, making $4.3M

Under Chiarella, O’Hagan had no duty to the target co.; his only duty was to his law firm, and GrandMet

HOLDING found he misappropriated the info., thus violating R10b-5 Misappropriation is where a person commits fraud “in connection with” a securities

transaction, and thereby violates R10b-5, by misappropriating confidential information for securities trading purposes, in breach of a duty owed to the source of the info. it’s a catch-all; serves to get the corporate outsider who isn’t breaching to

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the co. he’s trading in, but to the source of the info. O’Hagan breached duty owed to his law firm, and its client when he traded on the nonpublic info.; he pretended loyalty to his fiduciary and then secretly trades

To be absolved of liability, he would have had to disclose to the law firm and GrandMet and request permission to trade; b/c then there would be no deceptive device

o Note that he could still be liable under state law for breach of duty of loyalty; and if he only disclosed to 1 of the 2, then he’d still be liable under misappropriation

o Under this law, Chiarella would have been found guilty! Misappropriation was developed in a response to Chiarella and cases like it.

Rule 10b5-1(c)(1)(a) says that proof of a “plan” of when to sell shares can rebut the presumption that you were “trading on the basis of inside info.” like the Martha Stewart case; she’s arguing she had a pre-arranged plan w/her broker to trade below $60

10b5-1 almost not dealt w/by the SEC; D tries to show that they didn’t trade on the basis of the info.; but the SEC got into some trouble w/a few courts, so they issued this rule to create the presumption that when someone who is aware of that info. and trades on it, is presumed to have traded on the basis of but they do provide for some affirmative defenses, to protect things like where you’ve already got a K; they’re very strict though; in practice though, once an investigation starts, the incentive to settle is strong, b/c of the strong presumption

§16b Short Swing Profits the SEA’s prophylactic rule against insider trading the rule says that officers, directors, and 10% SH’s have to pay to the co. any profits

they make w/in 6 month period from buying and selling the firm’s stock o if you’re only getting losses, then it doesn’t matter (so if you sell lower

than you bought)o officers & directors refers to an officer that performs a policy function;

they are subject to §16b if they occupy the position either at the time of the purchase, or at the time of the sale (unlike the SH’s, that have to be 10% at both purchase and sale)

It’s both over and under inclusive it penalizes insiders for trades unrelated to nonpublic info., and doesn’t encompass many trades made on nonpublic info.

o Over-inclusive b/c it’s strict liability; the SEC doesn’t care if they’ve traded on the basis of inside info., or what their intent was regardless they have to disgorge $$

o Under-inclusive you can do stuff to avoid §16b (of course you might still be liable under R10b-5)

This § results in lots of paperwork to be filed w/the SEC! Recovery goes to the corp., and the suit can be brought by either the corp. or a SH in

a derivative suit

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Liability is predicated on the matching of any purchase w/any sale, regardless of the order of the 2, during a 6 month period where the sale price is higher than the purchase price

SH 10% status must exist “immediately before” both transactions so in Reliance, they weren’t 10% before the matching sale; and in Foremost, they weren’t before the matching purchase

§16b only applies to companies that are traded on a national exchange have assets of at least $5M, and 500 or more SH’s

Deputization where Co. X asks one of its officers to serve on the Bd. of Y, and then Co. X profits on Y w/in a 6 month period, then X may be liable under §16b, b/c it “deputized” the officer idea is that they’ve made an officer become an insider and they’re presumed to have used info. that the officer brought it from Y’s Bd.

Reliance Electric Co. v. Emerson Electric Co., US, 1972 Emerson Electric owned 13.2% of Reliance Electric; he sold all of that stock in 2

sales, both of which occurred in a 6 month period of purchasing the stock; on the first sale, he brought his holdings below 10%

HOLDING he’s only liable to disgorge on the 1st sale; by the time of the 2nd sale, he was not a 10% owner anymore in fact, this is recommended as a legitimate way to avoid §16b liability!

Foremost-McKesson, Inc. v. Provident Securities Co., US, 1976 The purchase here that they’re wanting to match is what made them a 10% owner; so

it doesn’t matter that they sold w/in 6 mo.’s b/c you have to be a 10% owner (a presumed “insider”) at the time you bought, and sold b/c the idea is that they want to avoid people being an insider and then buying and selling b/c of it if you weren’t an insider when you bought, then you shouldn’t be categorized as such

Other Prophylactic (i.e. preventative) SEC Rules Rule F-D where if an insider discloses material info. to an analyst, they have to

disclose to the public, and if they slip and give up material inside info, then they also have to disclose that publicly; this rule is important b/c insiders are always talking to stock analysts, and that’s ok as long as you’re just getting general info.

§14e-3 saw in O’Hagan where if there have been substantial steps taken by someone to commence a tender offer, if any other person finds out about it from an insider, and has good reason to believe it’s true, it would be fraudulent to trade on the info.; it’s broader than R10b-5 b/c it doesn’t require a breach of a fiduciary duty, but narrower b/c it only deals w/tender offer (so anyone who knows they have material info. they’ve acquired from the target or the acquiring co. will be liable, even if no duty breached)

o this is to disallow the scenario where word creeps out and people start trading like crazy (b/c there are so many involved the transaction attorneys, printers, etc.)

o this rule helps to plug up the holes in those scenarios

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o so in this case if you’re in Starbucks, and you hear someone on their cell phone talking about a tender offer, and you think it’s probably legitimate, and then you run and trade on it, you could be in trouble under §14e-3

o the catch-all for the tender offer context o Clark thinks there could be a private right of action here - she’s not sure

Regulation of Proxy Contests: Federal & State Law

Proxy Contests: Strategy & Reimbursement

beneficial owners where a person buys stock but doesn’t bother to have their broker register them w/the company; the broker then has the SH rights, the actual SH doesn’t get them (although presumably the broker owes a duty to vote as they want)

Levin v. Metro-Goldwyn-Mayer (MGM), Inc., F. Supp., 1967 SH action against 5 MGM bd. members -- the SH’s suing are officers, or significant

SH’s, and they want control of the Bd.; the 2 battling groups want to nominate a slate of directors for the meeting

P’s charge that D’s are wrongly getting the corp. to pay for the proxy battle – hiring a PR firm, paying attny’s, a proxy solicitation co. etc.

HOLDING management is not using illegal or unfair means; P’s request to stop the solicitation of proxies (injunctive relief) should be denied

Management is allowed to fully inform the SH’s, and to reasonably use corporate funds to fight a proxy challenge, as long as the expenses are reasonable, and as long as the fight is over policy issues, not personality driven the ct. didn’t find that the $$ spent was excessive, or that any fed. laws were violated

Reimbursement of Costs

Rosenfeld v. Fairchild Engine & Airplane Corp., NY, 1955 SH derivative action by SH who owns 25% of shares; P argues that $$ spent to

reimburse both sides in a proxy fight was wrongly paid out that the group that lost (which was the management at the time) shouldn’t have been compensated

HOLDING P’s complaint should be dismissed; management is allowed to act in good faith in defense of their corporate policies also if the new bd. makes the decision to reimburse them for the cost, as well as the new bd., then that’s w/in their power (as long as they get SH approval; and as long it was not for personal reasons, and reasonable expense here the ct. found reasonableness even where they used corporate planes, limos etc.)

However if it is shown that the $$ was spent for personal power, private gain, then the ct. will not allow the reimbursement

Where the incumbent managers lose, and they had out of pocket expenses, the new Bd. will decide whether to reimburse them, and SH approval will be required

Federal Regulation of Proxy Solicitation: Anti-Fraud Provisions

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Corporate democracy depends on SH’s having full §14a of SEA prohibits solicitation of proxies in violation of SEC rules

o solicitation of proxies is defined broadly though; 1966 case where minority SH was deemed to have solicited proxies even though he just inquired to other SH’s about getting the proxy lists

o but that’s been amended so it only falls under it if they actually solicit proxies

R14a-3,4,5,11 requires those who solicit to furnish each SH w/a proxy statement, where they disclose anything that would be relevant to a SH making a decision (i.e. management includes annual report; disclose conflict of interests)

o When there’s no contest & its just management’s recommendations, then the rules require particularly extensive disclosure

Rule 14a-16 parties have to files copies of the material they disclosed w/the SEC Rule 14a-7 when an insurgent group contests management thru proxy (must do so

thru written notice), management can either mail the group’s material to the SH’s directly and charge the group, or give them the list (they usually don’t like to give the list out!!)

Proxy contests have traditionally been unpopular, b/c if you tried one and lost, you bore the cost of doing it; and if you won, you’re only SH’s so your increased profitability is small for that reason, they couple proxy fights w/tender offers, so they buy up all the shares and vote themselves in

o But they’re becoming more popular w/all the scandals; SH’s are standing up and getting involved

Proxy Fraud J.I. Case Co. v. Borak, US, 1964 SH allegation of misleading proxy; §27 of the SEA gives private parties the right to

bring suit for proxy fraud violations under §14a; it gives fed. DC’s jdxt. over all suits in equity and at law D’s argue that Congress made no specific reference to a private right under §14a (which they don’t), and that even if they did, it should only be for derivative suits, and for prospective relief

The purpose of §14a is to protect investors, which implies that whatever judicial relief is necessary will be available to the ct.

Private actions and derivative suits are necessary for proxy fraud cases the SEC doesn’t have time to analyze every single proxy that comes before it

It isn’t limited to prospective relief, b/c that would frustrate the whole purpose of it being a fed. statute; they should be able to get damages!

HOLDING fed. court have the power to grant all necessary relief they didn’t make a holding on the topic, just said that the fed. ct. could give the remedy, and remanded it down to the DC

This decision was famous, and conclusory ct. found an implied right to bring a private action, that the law implies a remedy where there’s a wrong

§27 gives DC’s jdxct. over actions to enforce liability or duty created; according to the E&E, the ct. really took allowances here, that the statute was silent on it

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NOTE: this implied remedy theory has since been rejected by the Sup. Ct. however, the right to a private right of action for proxy fraud is entrenched and not going anywhere

b/c of Borak, SH’s can sue under fed. law, and they avoid having to bring a fiduciary challenge, and thus the BJR etc. Under Borak, a private proxy fraud action can be brought by a SH whose vote was solicited (either direct or derivatively)

Rule 14a-9 Rule against false/misleading statements in Proxies Rule 14a-9 – Any solicitation that is false or misleading with respect to any material fact, or that omits a material fact necessary to make statements in the solicitation not false or misleading, is prohibited

Mills v. Electric Auto-Lite Co., US, 1970 Merger btwn. Auto-Lite and Co. X; P’s were SH’s of Auto-Lite P’s alleged a misleading proxy b/c it said that Auto-Lite recommended the merger

w/Co. X, but really the Auto-Lite bd. was controlled by Co. X; they owned over ½ Auto-Lite’s stock

P’s could have challenged this on duty of loyalty (self-dealing), due care, waste etc., but SH’s ratified etc., and the BJR, so P’s wanted to go federal

Ct. held that it is enough to show that the alleged misstatements were material; thus excusing actual reliance, and eliminating it as an element in proxy fraud

Also concluded that transaction causation existed b/c a proxy solicitation of minority SH’s holding 46% was essential to getting the 2/3 necessary for merger approval; causation is another element in §14a-9 (a necessary element so what if they didn’t need their votes to pass the merger? Cts. are split on this); they’d still have fiduciary

HOLDING the issue here was not the substance of the claim, but whether P’s had alleged sufficient facts for a cause of action; Sup. Ct. finds that they did!!

Where the misstatement or omission in a proxy is “material” that finding leads to a conclusion that the defect was of such character that it would be found important by a reasonable SH who was deciding how to vote. (requirement in R14a-9, insures the action won’t be trivial)

Reliance is NOT necessary when it’s material, then the SH has shown enough of a causal relationship between the violation and injury;

D tries to argue that the merger was fair and that this should supersede but this isn’t what the fed. law is about; it’s about protecting SH’s merger is only relevant for figuring damages

Seinfeld v. Bartz, ND Of Cal., 2002 SH derivative suit; P alleges the proxy was misleading b/c it didn’t include the value

of stock option grants given to directors, and that by not using the Black-Scholes method of calculation, they were violating fed. anti-fraud statute (didn’t show an over $1M increase in stock options)

4 other cases have rejected the idea that using Black-Scholes is necessary

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HOLDING based on persuasive case law, and lack of rebuttal by P, ct. finds that using this method of calculation is not a material omission for purpose of R14a-9 Clark said that this is up for debate, that in light of recent cases, this might be found to have been material

Federal Regulation: Shareholder Proposals

When a co. doesn’t want to include a SH proposal in their proxy, the co. bears the burden of showing why it should be excluded

When a co. receives a SH proposal they want excluded from the proxy, they have to file a notice w/the SEC; if they find the corp. is in the right, they issue a “no action letter” but if they don’t agree, they notify the co. that they’ll bring an enforcement action if the proposal isn’t included

Recently SH’s have been bringing proposals based on sex, race discrimination etc., and the SEC has said they should get in, not issues of ordinary business decisions

A proposal probably won’t be allowed in if it is binding, b/c then it starts looking like the SH’s are managing the business, against the corp. law (usually management is the one running the show and giving the SH’s what to vote on)

o Ability to bring SH proposal isn’t expressly allowed from the code, but comes from the idea that directors manage the business, not SH’s; the law around these proposals has been judicially developed thru cases

Lovenheim v. Iroquois Brands, Ltd., F. Supp., 1985 The goose feeding case; Rule 14a-8, says that a SH who notifies the issuer of the proxy of his intent will have

the action put forth HOLDING Ct. said P’s motion to get this in the proxy should be granted, b/c it is

“otherwise significantly related” to the corp.’s business b/c of the ethical/social significance ct. has held that this exception shouldn’t hinge solely on economic grounds

Ct. rejects all of D’s arguments doesn’t matter that it accounts for less than 5% of the earnings b/c that exception doesn’t apply if “otherwise significantly related”

D then contends that since P admits the resolution will likely fail that it shouldn’t be included misstates what the proxy rule is all about, since it’s supposed to insure SH access to proxies regardless of passage; ct. also finds it won’t cause them undue harm all their claims about SH reaction are purely speculative; talks about how SH’s should have uncluttered proxies, and that businesses should be free from “harassment”!! this is absolutely contrary to §14

NY City Employees’ Retirement System v. Dole Food Co., SDNY, 1992 This pension fund was a SH in the co.; they wanted them to include a proposal for

Dole to form a committee to study health care proposals being considered in US Dole writes to SEC and says it will exclude it b/c it concerned an “ordinary business

operation” and it would be “beyond their power to effectuate” SEC agrees, then SH’s sue

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Corp. has the burden of showing the proposal fits w/in an exception HOLDING P’s have met their showing; the proposal has to be included Ct. disagrees b/c it’s related to an issue of large social significance, big part of their

revenue goes to pay for health care, so not part of ordinary business, and more than 5% (although Dole didn’t provide any of those figures)

“beyond their power to effectuate” Dole doesn’t show that the point of this proposal is lobbying; it’s just forming a committee, which they have the power to do!

Austin v. Consolidated Edison Co. of NY, Inc., SDNY, 1992 P’s want the co. to put a non-binding resolution in the proxy endorsing the idea that

D’s employees should be allowed to retire after 30 years of work, regardless of age HOLDING Ct. agrees that this is an ordinary business matter, and that it addresses

a personal claim (b/c these SH’s are union reps. for Edison’s union) plus they have collective bargaining to address this issue (which is not to say this is dispositive, but just that it makes it look like something that doesn’t need SH voting)

They try to liken it to high CEO salaries ct. says it’s a real stretch; that this issue hasn’t captured the public’s attention the way that has

Rule 14a-8 Procedures Any shareholder who has owned 1% or $2,000 worth of a public company’s shares for at least one year may submit a proposal. a proposal can be excluded by the Bd. if is “not a proper subject” 14a-18(i)(1):

Relevance Where proposal doesn’t relate to the company’s business, b/c it accounts for less than 5% of revenues (i.e. a “small stakes matter”), and is not “otherwise significantly related to the co.’s business” R14a-8(i)(5)

Not part of co’s ordinary business operations Election – Proposals relating to the election of directors/officers Direct conflict – Proposals that “directly conflict” with management proposals

(means the Bd. doesn’t have to include it; it can still be brought if the SH brings it on their own)

Duplicative - Proposals that duplicate another shareholder proposal that will be included

Recidivist – Proposals that are recidivist and failed in the past. Violation of law Personal grievance Out of power – Proposals dealing with matters beyond corporation’s power to

effectuate Mootness – If co. is already doing what shareholders want.

Shareholder Inspection Rights There’s nothing in the proxy rules requiring the corp. to give SH’s the SH list, but

there are rights like this under state law so that’s where these battles are fought (see DE §220 on SH’s right to inspection under this law you can inspect the SH

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list as long as you have a proper purpose; no requirement for minimum ownership time or amount like in NY)

Under §220, a “proper purpose” is a purpose reasonably related to the person’s interest as a SH

§220c if the corp. refuse to permit the inspection, or doesn’t reply w/in 5 days, then the SH can go to the Ct. to compel the inspection; the Ct. has to discretion about whether to require the SH to pay for the lists, or to just compel the corp.

also once the corp. rejects or refuses to comply w/the request for the SH list, the BOP is on the corp. to show why they shouldn’t be allowed to see the list; however, for other corporate records, like inspecting the books, the SH bears the burden of showing they have a proper purpose

o reasoning: lists are a more basic right; also easier for the corp. to give them than to allow full inspection of books and records

Crane Co. v. Anaconda Co., NY, 1976 Tender offer proposed by Crane for Anaconda; Anaconda opposes it Crane requests SH lists from Anaconda; they owned no stock at the time, and

Anaconda said no; but then they did get the majority of the stock, and requested again according to NY common law right to inspect the books; Anaconda refused, but said they’d mail Crane’s prospectus to Anaconda’s SH’s at Crane’s expense

HOLDING Anaconda failed to meet its burden of proof; Crane was a qualified SH under NY law, had not sold a SH list w/in the last 5 years; the Ct. compels the inspection of the books, and giving the SH lists; Anaconda argues that they shouldn’t get it b/c it wasn’t related to Anaconda’s business, and it was hostile to the corp. Ct. disagrees; a tender offer is common and it’s not improper for Crane to want to solicit proxies

State ex rel. Pillsbury v. Honeywell, Inc., Minn, 1971 P’s want to compel Honeywell to produce its SH list, and all corporate records

dealing w/weapons and munitions manufacturing P was an anti-Vietnam activist, and was upset to learn that Honeywell made bombs He bought some shares just so he could have a voice over these issues; under DE

statute, the SH must have a proper purpose to inspect corporate records HOLDING applying DE law, this request was for an improper and indefinite

purpose ct.’s have tended to find that where someone buys stock just for one purpose, that this person can’t be found to have the right of inspection; his concerns were irrespective of economic benefit etc., and had nothing to do w/him being a SH

Inside Director where you’re both a member of the Bd. of Directors and an officer or SH; outside directors are neither

Internal Affairs Doctrine the state law granting incorporation; spells out the traditional relationships between SH, directors, officers etc.; a state ct. is bound to accept the governing rules of whichever state the corp. is incorporated in

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V. CLOSELY-HELD CORPORATIONS

Overview In closely-held corps., usually the directors are controlling SH’s, or people selected

by them; they are responsive to the wishes of these SH’s therefore the SH’s, and not the directors, will be calling the shots

Bd. of Directors usually acts like a rubber stamp in these situations (except for situations where SH’s are at odds w/each other, and here voting rights etc. can become important)

Close Corporations Less than 30 SH’s (according to DE code) Closely-Held Corporations less than 100 SH’s These corps. tend to be much more like a partnership, trying to squeeze into corporate

governance o b/c they are so much more like p-ships, where the partners have a duty of

good faith to each other, close corp. DE code has made it so that SH’s in close corps. have a duty of good faith to one another (exception to rule in normal corporations)

Shareholder Agreements Vote Pooling Agreements

Other ways to alter voting control besides voting agreements to issue different classes of stock, and designate how many seats on a bd. each class gets

Or totally divorce voting rights from stock preferred class, where they get more money instead of voting rights (unless no dividends are issued for certain # of quarters, in which case they can vote)

Bottom line SH agreements (i.e. “pooling agreements”) are allowed; common K law governs them, but to make sure they’re enforceable though be sure to get an irrevocable proxy or a voting trust

o §212b proxies are allowed but they can’t be acted upon after 3 years from date of creation, unless otherwise stated

o §212e proxy is irrevocable if its states it is, and if its coupled w/an interest sufficient to support an irrevocable power; can be an interest in the stock or the corp. in general (must give specific instructions to proxy it’s an irrevocable separation of the voting from the rest of the share)

Ct.’s usually have a harder time w/these K’s where they require the appointment of particular people as officers or employees, since that theoretically deprives management of one of its most important roles

o The modern view is that such agreements are enforceable, at least for closely held corps., as long as they’re signed by all the SH’s

VOTING TRUST authorized by corporate law in most states; where the SH’s who want to act together turn their shares over to a trustee, who then votes for them in accordance w/the document; often used by families as a way to prevent coalition formation w/minority SH’s that might shift power out of the family

Ringling Bros. Barnum & Bailey Combined Shows v. Ringling, DE, 1947

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Small co. w/1000 outstanding shares held by 3 SH’s; they used cumulative voting to elect the 7 bd. of directors

2 SH’s make agreement where they were going to vote jointly, and if they failed to agree, they would submit the dispute to an arbitrator and his decision would be binding on them; by doing this they could be sure to elect 5 of the directors;

the 2 women had a falling out, allegiances switched the arbitrator made his determination

SH’s do not have fiduciary duties to each other or the co.; so it’s not illegal for them to create voting agreements to further their own interests; and ct. found they both knew exactly what they were doing when they entered it

Arbitrator ct. concludes that they didn’t mean to give him power to vote, just that his decision would be binding on one another ct. finds that by him voting personally, he exercised a power he didn’t have, and they throw his votes out no decision of the arbitrator could be enforced if the parties were unwilling; so after his decision is given, something more is required at least one has to determine the plan will go into effect

HOLDING the “vote pooling agreement” was valid; and that one of the women breached the agreement by voting a different way than suggested by the arbitrator, when the other voted as he said the ct. is allowed the reject the votes of a SH if they violate the rights of another person, as they did here

Shareholder Agreements Controlling Director’s Business Judgment

Clark v. Dodge, NY, 1936 2 sole SH’s of 2 drug companies – one owning 75% of each co., and the other owning

25% of both; Clark managed both co.’s, and knew the secret formulas; they entered into a written SH agreement which provided that Clark would continue

as manager as long as he was “faithful, competent etc.”, and that he’d give the formula to Dodge’s son, and to give Dodge ¼ of the profits, that no unreasonable salaries would be paid out, and that when Clark died, he’d give everything to Dodge’s wife and kids (as long as he had no one)

Clark alleges that Dodge breached this K by not using his control over the stock to keep Clark as the director/general manager, and that he allowed excessive salaries to be given could any of these be structured as breach of fiduciary duties? They’re mostly v. personal so would probably be breach of K, maybe waste b/c of the salaries but that would be almost impossible

Issue for the ct: is the K void as against public policy? Dodge argues the agreement infringed on his duty as a director to manage the corp.;

that SH’s aren’t supposed to manage the corp! but the ct. finds that if the K doesn’t harm anyone, there’s no reason for holding it illegally

HOLDING the agreement was legal b/c they were the only 2 SH’s; it wasn’t harmful to anyone else, and if anything was arguably beneficial

Ct. granted specific performance of the K.

Galler v. Galler, Ill, 1964

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Brothers w/a pharmacy; each owned ½ of the shares; they did have a minority SH (an employee) for about 15 years; eventually they bought back the stock from him

Brothers had a SH agreement for financial protection of their families; required that they vote for each other and their wives, and gave guaranteed annual dividend as long as certain profits met

One brother died, all kinds of weird issues w/how the remaining one treated the other wife

Ct. found that certainly the way D treated P-wife was inequitable, but there was no public detriment, and there was no objecting minority interest

There was no termination date provided in the K but the ct. finds that it was ok b/c only operative when one partner was living; this was a straight contractual voting agreement, not a voting trust; there was no fraud here, and no prejudice to public policy or minority interests, so nothing to render it unenforceable

Found the annual dividend was ok it was normal for what they were making, and only based on profits; the ct. totally disregarded the minority SH here b/c he had been bought out by the time they made this K

HOLDING agreement is fine; any $$ D’s got in excess has to be accounted for The ct. here was willing to uphold the agreement, although they did scrutinize it

closely what else could they have done? Written pension plans; employment K’s w/guaranteed salaries; buy-out agreements, so where a SH wants out of a closely held corp., he knows he’ll be able to sell his shares

ABUSE OF CONTROL – FREEZE OUTS Professor Clark’s Marcela & Tony nursing business example; they were trying to

freeze out the minority SH In freeze outs, you can often have a# of the different fiduciary duty breaches

happening at once (i.e. self-dealing, breach of due care, waste)

Wilkes v. Springside Nursing Home, Inc., MA, 1976 4 men have incorporated nursing home; they all invested in it, and made agreement

that they’d all be directors Discord between the men develops; 3 of them don’t reelect Wilkes as a director or an

officer; so he’s a SH, but what can he do w/this? They’re “freezing him out” of the co.; he can’t really get rid of his shares b/c there’s no market for them

In close corps., cts. are esp. wary where employment is denied, b/c it’s often the reason why the person invested in the first place typically the earnings of a close corp. are distributed thru salaries, bonuses, and retirement benefits not dividend payouts like a big public corp.;

The ct. recognizes that in a close corp. the majority has a duty to deal w/the minority w/good faith and loyalty but they don’t want to apply this blindly; the majority still has the right to look out for its own interests, as long as balanced against minor interest Legitimate Business Purpose: ct. has to consider if they have one for the actions against the minor; if so, ct. will give it discretion

BUT, minor SH can still show that the major’s objective could have been achieved thru another course of action which would have been less harmful to minor interest

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BALANCE It’s the ct.’s role to weigh the legitimate business purpose, if any, against the practicability of a less harmful alternative

HOLDING majority does not show a legitimate business purpose for severing Wilkes from the payroll, or for refusing to reelect him as a salaried officer; they didn’t show he had engaged in misconduct, or couldn’t perform, or was trying to hurt the co. it was a “freeze out”; also ultimate plan was to pressure Wilkes into selling his share to the corp. at a price below the share value

The duty of good faith and loyalty owed required majors to at least consider that their actions were in disregard to the longstanding policy that they’re all supposed to be directors, and that employment w/the corp. and stockownership went hand in hand; their actions of cutting off his salary assured that he’d receive no return at all from the corp., and the 15 years he had put into it

Damages new issue for the court; he’ll get whatever salary he would have gotten if he had remained as an officer and director

Ingle v. Glamore Motor Sales, Inc., NY, 1989 Car dealership; sole SH allows employee Ingle to buy some shares; brings 2 sons in;

the 4 then sign agreement w/a “repurchase option” that co. could buy back the shares if he ever ceased to be an employee for any reason eventually the 3 try to “freeze out” Ingle; don’t reelect him to Bd., and fire him as manager of dealership

Exercise repurchase option and buy back his shares; P sues argues that as minor SH in close-corp., he is entitled to a fiduciary-rooted protection against being fired. Says this should overrule the fact that his employment K was at will, and that is precluded his termination w/o cause, despite the express provisions of the agreement.

HOLDING the termination and repurchase was valid Strong dissent that this was unfair, that the term in the K allowed them to get rid of a

25% owner; that this wasn’t just an ordinary employment K as the ct. treated it

Sugarman v. Sugarman, 1st Cir., 1986 Family-owned paper business; one SH, Leonard, owns 61%; other group owns 21%;

P’s sue, arguing Leonard is trying to freeze them out, and that he’s breaching fiduciary duty owed to them by paying himself and his family excessive salaries

HOLDING Leonard breached his fiduciary duty to the minors; ct. awards P’s 21% of the improper payments that Leonard and his dad had received

Ct. found that the excessive salary was part of a freeze out strategy (you work to take $$ out of the corp. for yourself, so less dividends issued)

Also major SH’s have an independent duty to exercise complete candor w/minority SH’s when they negotiate stock transfers; they must disclose all material facts; if they breach this duty, and low ball the minority, offering substantially inadequate price, then minor can seek damages based on the difference

in a close corp., you don’t even have to sell to seek the damages; even if you get an inadequate offer from a majority but doesn’t accept it, you can still seek damages if SH can prove that the offer was part of a plan to freeze out minority SH’s from the corp. here there was a freeze out plan; Leonard took actions so that the P’s wouldn’t get any financial benefit from the co.; also compelling that dividends had never been paid out, and that they wanted to work there and hadn’t been hired, or had

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been improperly discharged every element of freeze out plan doesn’t have to exist, here there were sufficient indications, esp. the low ball offer

STATUTORY DISSOLUTION & COURTS’ EQUITABLE POWERS State statutes often exist that allow the minority SH in a closely to petition the cts. for

ct.-ordered dissolution, or the use of general equitable powers of the courts almost like in partnerships, where you can petition ct. to dissolve

Like CA Code §1800 an involuntary dissolution statute allows the minority SH to come to the court and seek an involuntary dissolution; only certain people can take advantage of it, here she would qualify under a(2) as a 33.3% owner

Minor has to show under b(4) broad grounds for seeking involuntary dissolution (pervasive fraud, abuse of authority, persistent unfairness to a SH similar to a breach of fiduciary duty)

Often if it looks like you’ll get a dissolution from the ct., the other SH’s will offer a good buy out offer

Under §1804, and many other state statutes, the ct. can instead of ordering dissolution, use its equitable powers and order a buy out at a specific price

CT’s step in and apply these statutes, even where not oppressive or fraudulent conduct, but where in a closely held situation, a SH’s reasonable expectations aren’t being met --- so where the conduct is unfair, not necessarily oppressive b/c cts. know that in a close corp., it’s unfair to expect minority SH’s to bargain for their expectations, so sometimes the ct. has to step in

Alaska Plastics, Inc. v. Coppock, AK, 1980 3 partners in plastic co.; during divorce proceedings, one man gives his ex-wife some

stock; never tell her about SH meetings, never issue dividends, then low-ball her w/an offer to buy her out; one of their buildings burns to the ground and they had no insurance; she sues in this kind of situation, the best she could hope for was to get them to buy her shares a fair price; this could happen as follows:

o a provision in the CoI or bylaws that provides for purchase of shares by the corp., contingent on some event, like death of SH or transfer

o SH can petition the ct. for involuntary dissolution of the corp (AK statute allows it)

liquidation is an extreme remedy; it’s allowed only where the acts of directors are illegal, oppressive, or fraudulent, or where assets are being wasted or misapplied; all debts have to be paid, and the remainder is distributed to the SH’s

o Upon a significant change in the corp. structure, like a merger, the SH can demand a statutory right of appraisal

this statutory method is available in 2 circumstances under AK law: after merger or consolidation; or upon sale of substantially all the co.’s assets here the ct. does not find this applicable, regardless of the Valley Plastics thing

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o A purchase might be justified as an equitable remedy upon finding breach of fiduciary duty between directors and SH’s

Here none of them apply they offered her 2 prices and she didn’t accept either; also dismissed her waste claims based on trips for wives, and lack of insurance, b/c deferred to BJR

HOLDING on remand, TC entered judgment for her for $32K; found that there was findings of oppressive or fraudulent conduct sufficient to force the buy out; it took the less drastic route of creating equitable relief (last option – breach of duty)

VI. ALTERNATIVE BUSINESS FORMS

Remember that in any of the limited liability forms, where you’ve got few SH’s, and a new business, creditors will often demand a personal guarantee which means you are personally liable anyway regardless of the business form!!

To Review, see the example from the book w/Bernie, Jessica, Michael; discussed in week 15!!!

Remember a key difference between corporation & partnership you can alter almost anything in the partnership agreement, whereas the corporate code is strict about some stuff, and you just plain can’t change it.

Limited Liability Partnership (LLP) -- Partnership with some limited liability; filing required; here the general partners are liable for the p-ships contractual obligations, but if an individual partner is not personally involved in negligence, wrongful acts, or misconduct, he is not liable for any of the damages resulting from that conduct – the p-ship is

Limited Liability Company (LLC) – Hybrid btwn. corporation and partnership.; flexible (but less so in some states); can achieve partnership taxation Can either be member managed, or manager managed; these control issues are left up

to choice (Member-Managed – Members have broad authority to bind LLC in much the same way as partners; Manager-Managed – Members have no authority to bind; more like corp.)

Members of LLC provide capital and manage the business according to their agreement; (Interests are generally not freely transferable; must have other members consent) like p-ship

Members not personally liable for the debts of the LLC entity like corp. Life Span – LLC arises with the filing of a certificate or articles of organization with

a state official. Many LLC statutes require at least two members. Duration – Not limited by statutes Veil-piercing – Some LLC statutes suggest that members can become individually

liable if equity or justice requires. Voting – Generally in proportion to members’ capital contribution.

Limited Partnership (LP) – 2 classes of partners, limited and general; Limited liability for limited partners, if they do not participate in control; taxed as partnership, so if there

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are losses, can give big tax benefit to a large investor; can use a corp. as a general partner so no individual is personally liable. Formation – Must be created with written agreement among the partners and

certificate filed with state official. Dissolution – Limited partnership lasts as long as the partners agree or, absent

agreement, until a general partner withdraws. Nature – 2 kinds of partners

o General – have the same rights and obligations that partners do in a regular p-ship; liable for all debts of the partnership (General partners may be corporations); General partners have authority to bind the partnership to ordinary matters.

o Limited – Not liable for debts of partnership beyond their proportional share of contributions (i.e. limited liability), but have no control over management of the p-ship; they generally have voting power generally over specific issues, but cannot bind the partnership.

Transferability of Ownership Interests o General Partner – Cannot transfer interest unless all remaining partners

agree or partnership agreement permits it.o Limited Partner – Interests freely assignable.o Both – can assign their rights to profits and distributions.

Historically, this form has been dangerous for the limited partners, where the limited partner got too involved and lost their limited partner status

If they wanted a limited partner’s consulting, for ex., they could always hire him and pay him

S CORPORATION -- Corporation that elects to be taxed similarly to partnership (single tax, pass through of losses); limits on a number and types of shareholders and capital structure.

o All corporate income, losses, deductions, and credits flow through to shareholders. (like p-ship)

o Eligibility must be made of domestic SH’s (no nonresident alien SH’s); can have no more than 75 SH’s; there can only be one class of stock.

o When heavy losses are anticipated, the S-Corp. may be less desirable than a partnership; b/c S-Corp. SH’s can only write off losses up to the amount of capital they invested. (unlike in p-ship, where they can all be written off)

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