Bar Notes

California Corporations

I.iNTRODUCTION: THE CORPORATE FORM

A.The Corporation as a Separate Entity (OL I.A.)1.A corporation is:

separate person under the law

2.Shareholders:

limited liability

3.Board of Directors:

management

4.Officers:

run day to day affairs

5.Pay attention to:

functions of different people playing different roles in the corporations

6.The major characteristics of a corporation are:

a.free transferability of shares

b.continuous existence even if s/h dies

c.limited liability of shareholders

d.centralized management s/h dont manage corporation, but board of directors run it

B.Foreign Corporations (OL I.B.)1.Foreign corporation means a corporation with shares, or other business corporation formed under the laws of another jurisdiction.

C.Types of Business Corporations (OL I.C.)

1.S Corporation vs. C Corporationa.S corporations have special tax status, so owners and not business is taxed.

b.The identity of a corporation as an S Corp or C Corp is only relevant for federal income tax purposes. It has no bearing on the general status of the corporation under state law.

2.Publicly Traded Corporationsa.Publicly traded corporations are:

traded on the stock exchange, with hundreds of shareholders

3.Closely Held Corporationsa.A closely held (or privately held) corporation is a corporation:

is privately owned, and can have just 1 shareholder

II.FORMATION OF THE CORPORATION

A.Articles of Incorporation (OL II.A.)1.A corporation is ordinarily created by the incorporators:

Filing of articles of incorporation

2.Provisionsa.The articles of incorporation must set forth:

(1)Name of corporation

(2)Agent for service of process

(3)Number of shares authorized

b.The articles of incorporation may also include a:

limited liability for directors and officers

B.Bylaws (OL II.C.)1.Bylaws are:

constitution of corporation. details of how corporations are run and general rules

2.Unless specified in the articles, the bylaws must set forth:

when meetings are held, special requirements, how many directors, how many officers and their jobs

responsibilities

3.The bylaws may specify, among other things: a.the time, place manner of calling, conducting giving notice of shareholder, director meetings

the manner of execution, revocation and use of proxies

b.qualifications, duties, and compensation of directors, time of their annual election, quorum requirements

for board and committee meetings

4.The power to alter, amend or repeal the bylaws or adopt new bylaws, subject to repeal or change by the action of the shareholders, is:

vote of s/h is required, but often BOD can amend or repeal bylaws.

C.Organizational Meeting (OL II.B.)1.The board of directors named in the articles, or the incorporator(s) if no initial directors were named, must hold an organizational meeting:

at least once a year

2.The Board of Directors and shareholders must each:

D.Incorporator(s) (OL II.A.)1.An incorporator is:

person who forms the corporation

2.This person:

may or may not be a director

E.Defective Incorporation (OL II.D.)1.De Jure Corporation

a.A de jure corporation is:

substantial compliance with the rules to become a corporation

2.De Facto Corporation

a.A de facto corporation is:

corporation which has not been properly formed.

b.Three features of a de facto corporation are:

(1)good faith attempt to comply with incorporation statute

(2)business had a legal right to incorporate

(3)principals of the corporation acted in good faith as a corporation

EXAMPLE:Sarah and Sam have a trucking company. They try to form a corporation, but their lawyer dies just prior to filing the Articles of Incorporation. Sam and Sarah dont realize the corporation was never formed. It is likely it will be formed a de facto corporation. They hit all three requirements.

c.De facto status:

is going to insulate directors and s/h from liability just as if they were a corporation

d.However, the de facto doctrine would rarely apply today, because the state must approve the articles before they are filed, and a statement by the Secretary of State of the fact of incorporation is conclusive evidence of incorporation.

3.Corporation by Estoppel a.Absent de jure or de facto status:

Might still be protected under estoppel doctrine

b.This arises when:

if creditor treats a business as a corporation, the creditor is estopped from alleging that corporation

was defective and he could get to principals to hold them personally liable

c.The requirements for corporation by estoppel are:

(1)D must have held out as a corporation

(2)acted as a corporation

(3)honest belief that he or other principals were corporation

d.The estoppel doctrine is not a defense to:

tort claim because person with tort claim would not have notice.

e.It generally arises in:

contract claims where prior business relationship exists

EXAMPLE:Considering the facts of the previous example, if the company ordered computers from Dell and are unable to pay, even though they are not an actual corporation, they may be protected by both estoppel and de facto status. However, if a truck driver hits a pedestrian and breaks that persons legs, the company may be protected by de facto status but will not be protected by estoppel, because the victim will not have had notice of the trucking company acting like a corporation.

4.Ultra Viresa.This is when the corporation is:

acting beyond the scope of its authority in the AOI and the action can be enjoined

b.Limited in California by:

ultra vires cannot be raised as a defense by a corporation or shareholder against third parties involving any contract to which corporation is party. The primary remedy is to hold the responsible persons liable for damages

HYPOTHETICAL

The articles of incorporation of Bertos Corp. prohibit the corporation from incurring any debt greater than $100,000. The corporations board of directors approves the purchase of property worth $350,000. In connection with Bertos application for a $150,000 mortgage to finance the property, First National Bank requests a copy of the corporations articles of incorporation. It then approves the loan. May Bertos shareholders challenge the loan on the grounds that it was ultra vires?

Probably, in California. Restrictions in the AOI are binding and the s/h can assert the ultra vires doctrine provided the loan has not yet been made. If the loan has been made, then contract is protected and loan cannot be enjoined, so corporation or board of directors can be held liable. But if transaction has been made, bank should have known about the limitation. Either way s/h would have a claim against the directors on the board who approved the loan

F.Piercing the Corporate Veil (OL II.F.)1.A way the s/h can lose limited liability and creditor can pierce the veil to get at the private assets of s/h2.Even if a corporation is properly formed:

There are rules that need to be followed to establish the corporation as separate from its shareholders3.When it looks like the corporation is being treated as a shareholder, this:

is a unity of interest, which will raise a red flag

4.Typically, a court will only pierce the corporate veil where:

There is risk of grave injustice

5.The requirements to pierce the corporate veil are:

a.injustice

b.unity of interest not respecting separate existence of corporation

6.Therefore, to pierce the corporate veil, a plaintiff must prove that:

The s/h controlled the corporation to such an extent that there was no separate entity

a.This is also referred to as:

alter-ego

b.Actual fraud:

No requirement for actual fraud.

7.Failure to Comply with Corporate Formalitiesa.If a corporation follows formalities: cannot pierce veil

b.Common compliance failures include:

(1)not issuing stock

(2)not maintaining separate bank accounts

(3)failure to hold meetings

(4)failure to maintain separate corporate and financial recordsc.Note that since statutory close corporations arent required to have meetings, the failure of a statutory close corporation to observe corporate formalities relating to meetings of directors or shareholders in connection with the management of its affairs:

does not permit piercing the veil. But it must be a STATUTORILY CLOSED corporation

8.Inadequate Capitalizationa.When a corporation is formed:

it needs to have enough money to operate business

b.Adequate capital is not precisely defined, but generally must be sufficient:

for the corporation to meet its needs

c.Inadequate capitalization alone:

is not enough but not enough money put in corporation is evidence of ability to pierce the veil

d.There must also be:

sufficient funds to meet debts of corporations as they become due

(1)This will differ:

by nature of business.

9.Subsidiary Corporationsa.A subsidiary is:

stock is held in whole or part by another corporation

10.Liabilitya.If the corporate veil is pierced:

liability is generally imposed upon the shareholders involved in management. Possibility that it may

be extended beyond persons involved

b.Liability is for the full amount of the debt, not merely for the amount that would have constituted adequate capital.

11.Enterprise Liabilitya.Brother-sister corporation owned by common parent corporations

EXAMPLE:Three restaurants owned by a parent company. Each of those restaurants may be held liable for the debts of the others as brother/sister corporations.

b.This only arises when:

Those separate corporations have not respected the separation between them

c.This is less like piercing and more like:

Agency argument. Enterprise liability is horizontal while piercing the veil is a vertical argument

12.Further Shareholder Liabilitya.Shareholders may also be liable:

when they receive dividends they are not entitled to but this is not piercing the veil.HYPOTHETICAL

The three founders of Blue Devil decide to open a chain of upscale delis, called the Blue Devil Bakery Co. (Bakery). The founders formally organize it as a separate corporation, with all the shares held by Blue Devil Co., Inc. (Blue Devil) as the corporations parent. Bakerys officers are employees of Blue Devil. The rapid expansion of the new chain is funded through loans from Blue Devil to Bakery. When Blue Devil develops a credit issue, to keep the company properly liquid, Blue Devil recalls its loans from Bakery. Will this action be sufficient to pierce the corporate veil of Bakery?

There is an argument here that there was inadequate capitalization by recallable loans so therefore not separate so there is a risk of piercing. But there is no evidence of how undercapitalized the bakery was and whether it had access to other capital from other sources such that the veil would not be pierced.

III.PROMOTERS AND PREINCORPORATION TRANSACTIONS

A.Promoters (OL III.A.)1.A promoter is:

agent for an unformed corporation.

2.Generally, the promoter(s) will:

causes the corporation to be formed

B.Promoters Relationship to the Corporation (OL III.B.)1.Promoters stand in a fiduciary relationship to:

the corporation and to the people who would buy stock in that corporation. The promoter has a duty

to the subscribers. The promoter must disclose material facts about the corporation.

2.Duty of Disclosurea.If there is an independent board of directors and the promoters are the only shareholders:

then these issues are minimized

3.Promoter Liability for Breach of Fiduciary Dutya.In an action for breach of the promoters fiduciary duty, the corporation may either:

(1)sued for damages

(2)the transaction may be voided by the corporation

EXAMPLE:A corporation, XYZ, is formed to take people on marina tours. A promoter for XYZ sells a boat to the corporation for $100,000. If this price is incredibly high and the fact that it was so high is undisclosed, the promoter will have violated his fiduciary duty and that transaction can thus be avoided, or the promoter held liable.C.Promoters Relationship with Other Promoters (OL III.C.)a.If there is more than one promoter of a corporation, the promoters:

owe each other a fiduciary duty since they are join venturers. can create liability for one another if they are functioning as partners in setting up corporation

D.Preincorporation Contracts (OL III.D.)1.The question arises as to:

contracts they enter into before the corporation is formed

2.Liability of Promotera.General Rule(1)As a general rule, the promoter is:

personally liable on any contract that he enters into for any corporation that has notbeen formed

b.Promoter Personally Liable

A promoters personal liability will continue even after the corporation is formed unless there is:

(1) agreement that he is not liable

(2)only corporation is held as responsible for the contract

c.Promoter Not Personally Liable(1)Some contracts can be characterized as:

not a contract but offer made to a nonexistent corporation

(2)In the case of a revocable offer that is made to a nonexistent corporation, the offer becomes a binding contract when:

it is adopted by the corporation

(3)The promoter will not be personally liable on the contract, as:

the offer would only become binding when adopted by the corporation

(a)However, if there is performance on the contract prior to incorporation:

the promoter will be liable

d.Indemnification(1)The promoter may be entitled to indemnification by the corporation, if:

he entered into K in good faith to the extent that corporation benefited from the contract

Remember that the liability of a promoter for corporate contracts is not absolute. If the intention is clear that the promoters liability is to be limited, the promoter will most likely not be responsible for the obligation, regardless of whether the corporation is ever created or the contract is subsequently adopted.

3.Liability of the Corporation a.As stated above, a corporation:

doesnt automatically become liable on contract. That corporation must assume liability by ratifying/adopting the K

b.Novation or Adoption(1)Adoption can be express or implied.

(a)Express adoption:

Yes, we adopt

(b)Implied adoption:When corporation accepts and acknowledges the benefits of the K

EXAMPLE:Shipping Company ships candy to Candy Store. Candy Stores promoter made the agreement for this shipment prior to Candy Stores formation. Candy Store accepts the shipment and stocks the candy on its shelves. It has become bound to the agreement through implied adoption.

c.Acceptance of Benefits(1)A corporation may become bound to fulfill a contract made in its name and on its behalf in anticipation of its existence by:

Accepting the benefits of the contract

4.Enforcement of the Contracta.Prior to the companys formation:

promoter is party to the contract and can enforce the contract

b.Once adopted:

either promoter or corporation can enforce the contract

HYPOTHETICAL

Nick entered into an agreement to sell a large parcel of property he owned in Rockland County to Blue Devil Co., Inc., for its West Nyack deli and donut location. Nick also represented that he could build the site to meet Blue Devils needs. The agreement was completed, and Nick signed the contract to build on the land as Constellation Contracting Corp. (in formation). The Constellation Corp. was formed but refused to build, and never adopted the contract. Blue Devil Co., Inc. has sued Nick rather than Constellation Contracting Corp. Will Nick be liable on the contract?

Nick is liable. A promoters personal liability will continue even after the corporation is formed unless there is an express agreement that he is not liable or some evidence that only Constellation could be held liable for the contract. There is no express novation that establishes that he would not be liable and no indication that Blue Devil was only expecting performance from Constellation, The best answer is that he would be liable. Also, Constellation not liable as it never ratified the contract the contract. Nick will continue to be liable because there was no express novation.

E.Subscriptions for Shares (OL III.E.)1.A person may become a shareholder by:

agreeing to purchase shares

HYPOTHETICAL

Joe creates a company through which hell perform general handyman services. His first client is Miss Daisy, who agrees to pay $5,000 to have her house repainted. Joe signs the painting contract as the president of Handy Joe, Inc., even though he doesnt file the articles of incorporation until two weeks later. Can Miss Daisy argue that the contract is invalid and unenforceable, since it was signed by a corporation that was not yet in existence?

Not likely that Miss Daisy will succeed because this does not seem to be an offer to Handy Joe Inc. but an enforceable contract. It is enforceable contract which would have been enforceable against Joe. Mss. Daisy would also be bound by the contract and Joe can enforce against. If Joe Inc has adopted the contract, the contracted can be enforced against Miss Daisy and she would be estopped from arguing that the contract is not valid against Joe Inc.

BAR EXAM APPLICATION

Question 1Applicants were asked to analyze whether Rita and Fred are liable on a five-year lease entered into with Landlord for restaurant space for a corporation they wanted to form called Ritas Kitchen, Inc. The lease named Ritas Kitchen, Inc. a corporation in formation as a tenant and was signed by Rita and Fred as President and Secretary respectively.

After one year, the properly formed corporation failed to make a profit and ceased operations. It owes three months of back rent under the lease.

Can Landlord recover the unpaid rent from Rita and Fred individually?

Applicants must analyze the rules related to liability of promoters and corporations for pre-incorporation contracts, as well as possible indemnification from the corporation.Landlord rights to sue turns on a few issues whether Rita and Fred were promoters. Promoters are agents of unformed corporations who work to incorporate corporations. A promoter is liable even after formation of corporation unless there is an express novation of an agreement to the corporation or the contract was to be performed by the corporation. Since Rita and Fred entered into a lease agreement prior to forming corporation, they are liable as promoters and can be sued for rent unless the landlord only looked to the corporation for performance or lease makes it clear that Rita and Fred are not personally liable. There is an argument here that since landlord accepted rent from Ritas Kitchen, the landlord agreed to a novation to look only to Ritas Kitchen for payment. If neither of these elements can be shown, landlord can recover but he has to choose between suing the promoters or suing the corporation. Although it is not clear whether Ritas Kitchen accepted the lease, at a minimum, the company paid rent, received benefits of the lease, and thus, implied adoption of the lease. The likely result is that even though Ritas kitchen is liable for rent, Rita and Fred are also liable. The promoter may be entitled to indemnification by the corporation, if he entered into K in good faith to the extent that corporation benefited from the contract. If there is any money left in Ritas kitchen, Rita and fred may be able to seek indemnification. Assuming they followed the proper formalities in the formation of Ritas Kitchen, there is no cause for piercing the veil.BAR EXAM APPLICATION

Question 2Applicants were asked to consider issues arising from a pre-incorporation contract entered into by an incorporator on behalf of the corporation. Molly and Ruth were the incorporators and eventual shareholders of Dryco, Inc. Molly entered into a contract to purchase a dryer from Equipment Company (EC) on behalf of Dryco. EC was aware that Dryco had not been formed. EC delivered the dryer one week after Dryco was incorporated. After a year of making monthly installment payments, Dryco became insolvent.

On what theory or theories, if any, can Molly and/or Ruth be held liable for the balance owed to EC?

Applicants must consider whether Molly and/or Ruth are liable as promoters or as shareholders under the theory of piercing the corporate veil.

Ruth and Molly can be held liable as promoters. As a promoter, Molly would be liable on the contract unless EC made it clear that Molly would not be liable or looked to only Dryco for performance. There is an argument here that by delivering dryer to Dryco, and accepting monthly payments from Dryco, EC agreed to novation to look to Dryco for payment. This argument will probably fail as there was no express novation. If neither of these elements can be shown, EC can recover from Molly.A corporation can also be bound for preincorporation agreements by accepting benefits of a contract, quasi-contract, or accepting assignment. Dryco will be liable because it accepted benefits of the contract Molly had formed with EC. With both molly and Dryco liable, EC has to decide whether to sue Dryco or Molly. If Molly is sued, she can seek indemnification from Dryco if she had entered into a contract with good faith to the extent that corporation benefited from the contract.Co-promoter liability - In addition, since Molly and Ruth were co-promoters, Ruth may be liable for promoter if they acted as joint venturers or agents of one another. The issue of whether Ruth is liable as a copromoter turns on whether she acted jointly with Molly in forming the contract. Since Ruth did not sign the contract, she may not be held liable.Even if Molly prevails in showing novation, they may still be liable if EC can pierce the corporate veil. This can happen if Dryco did not follow proper formalities i.e. if Dryco was undercapitalized, failed to issue stock, comingled funds, did not have meetings and there was fraud or injustice. However, the hypo presents no evidence of this so Courts may not allow piercing the corporate veil.

IV.FINANCING THE CORPORATION

A.These are of two types: equity securities (held by shareholders) and debt securities (OL IV.B.).

B.Debt Securities

1.Debt securities represent:

Money that is loaned to corporation and a person holding debt security is a creditor

2.Holders of debt securities have:

Priority over the equity security holders i.e. the shareholders, but do not have the right to vote

3.The three major kinds of debt securities are: debentures; bonds; and notes.

a.Debentures(1)Debentures:

unsecured loan to the company. Holders are generally called creditors.

b.Bonds(1)Bonds:

Secured by a mortgage or security interest in assets of the company. Holders are secured creditors.

c.Notes(1)Notes are long-term debt securities, which may be secured or unsecured. They are generally used when dealing with institutional lenders, and are generally not traded or transferred as bonds and debentures may be.C.Equity Securities (OL IV.D.)

1.Equity securities represent:

the capital of the corporation that is at risk in the corporation

2.Equity security holders have:

no rights to repayment of the amount they invested

3.However, upon liquidation, once:

creditors are satisfied, remaining assets go to the equity holders, also known as right to residual.

Typically debt holders have less at risk than equity holders.4.Shareholders usually have:

a.dividend rights right to a dividend, if any declared, at the boards discretion

b.liquidation rights right to share of the corporate assets at the end of the corporations existencec.s/h have voting rights right to elect management

5.Common Stocka.When there is only one class of stock, it is called:

common stock, which is stock that has no preference over any other shares

6.Preferred Stocka.Preferred stockholders are shares other than common shares.

b.Preferred shareholders have:

Rights that are somewhat senior or preferable to common stockholders

(1)These may include:

(a)better liquidation preference

(b)if there are dividends, right to dividend before any is paid to common stock holders

e.Cumulative Dividends(1)The right of preferred stockholders to receive dividends may be cumulative or noncumulative

(2)Cumulative(a)If the dividend preference is cumulative:

the preferred shareholders have the right to receive the stated amount each year, whether or not earnings are sufficient to pay it. and no dividends may be paid to common stock holders until all cumulated preferred dividends are paid.

(3)Noncumulative(a)If the preferred dividend right is noncumulative:

the shareholder is entitled to a dividend when and if the board declares it

D.Issuance of Shares (OL IV.E.)1.Authoritya.A corporation is empowered to issue:

the number of shares authorized by its articles of incorporation

b.Any unissued stock may be authorized:

(1)by vote of stockholders or

(2)vote of board of directors under authority of bylaws or vote of stockholders

EXAMPLE:Blue Devil Co., Inc., has 1,000 shares authorized in its certificate of incorporation. Each of the three shareholders is issued 100 shares, leaving 700 shares authorized but not issued. Only the 300 shares can vote or receive dividends. The other 700 shares are available for future solicitation.

HYPOTHETICAL

Gigobyte Corp.s articles of incorporation authorize 1,000 shares of common stock, all of which have been issued already. The company wants to raise additional capital by issuing a new class of preferred stock. The preferred shares would have no voting rights, but would receive priority distribution of dividends. May the corporation issue the preferred stock without the approval of its existing shareholders?

No. The articles of incorporation must be amended to create a new preferred class of stock that would receive priority distribution of dividends. This requires approval of existing shareholders.

HYPOTHETICAL

Blue Devil Co., Inc., has 1,000 shares at $10 par authorized in its certificate of incorporation. Pocco is given the shares for work done for the corporation both prior to and after it was incorporated, Pierre is given shares for a promissory note, and Peter is given shares for his promise to work for free for the corporation for a month. Are the shares issued properly? What is the board of directors required to do?

Par value shares may not be issued for consideration worth less than the par value. The par value here is $10 per share. Valid consideration for shares may be money, property received by corporation, services performed for the corporation. Pocco is fine as long as the work he performed for the corporation is equal to value of the number of shares he receives. Pierre has a more difficult situation a promissory note for future payment is not valid consideration in California unless it comes with security. Similarly, for Peter, future work is not valid consideration. This is different from rules in partnerships in LLCs

2.Consideration for Sharesa.Par value means the absolute least amount for which one share of stock could be sold. The money received from the issuance of par value stock is called:

stated capital. It needs to be sold for more than 0

b.No-par shares have no minimum, but must sell for over zero.

c.Valid Consideration(1)Valid consideration for shares may be:

(a)Money

(b)Property

(c)Services

(2)Note that a promise to perform future services and a debt or promissory note of the purchaser is unacceptable as consideration unless secured

3.Stock Certificatesa.Requirements(1)The face of each certificate must state the:

number of shares and the class and series, if any, that the certificate represents

b.Restrictions(1)Any restriction on the transferability of stock must be noted conspicuously on the share certificate

(2)A reference to see the written agreement is validly conspicuous.E.Dividends and Distributions (OL IV.F.)

1.A dividend is:

distribution by a corporation to it shareholders of cash, property or stock of corporation

2.Shareholders Rights to Dividendsa.A shareholder has:

no inherent right to be paid a dividend since BOD has discretion to decide whether and when to declare a dividend

b.The directors may NOT declare a cash dividend if:

the corporation is insolvent or if payment of the dividend would render it insolvent or a declaration or payment would contravene any restrictions in the articles

c.Bad Faith Refusal to Declare Dividends(1)Typically, a board of directors can decide whether or not to declare a dividend.

(2)If a shareholder can prove that the directors refusal to declare a dividend amounted to fraud, bad faith, or an abuse of discretion, then there may be a claim for the refusal to declare dividends.

HYPOTHETICAL

Titan Pharmaceuticals Corporation just ended a very successful year, earning $40 million in net income after taxes. Instead of declaring a dividend, however, the board of directors decides to throw all of the money back into the corporation, to be applied toward further research and development. May the preferred shareholders demand a dividend if the board of directors refuses to issue one?

No, as long as a BOD was fully informed, did not act in bad faith, had no conflict of interest, and did not act in bad faith, they would be protected under business judgment rule. Absent contractual rights, s/h have no right to dividends.

F.Redemption of Shares (OL IV.G.)1.Redemption occurs when:

company has right to force the shareholder to sell the shares back to the company

a.This right:

must be stated in the articles of incorporation

b.It usually applies only to preferred stock

G.Shareholders Preemptive Rights (OL IV.H.)1.Preemptive rights are the rights of existing shareholders to:

acquire uninsured or treasury shares in the corporation or options or rights in proportion to their current holdings when the corporation seeks to issue additional stock that would reduce their ownership percentages.

V.management and CONTROL

A.General (OL V.A.)1.A hierarchy of authority allocates power between:a.shareholders, who own the corporation

b.directors, who manage the corporation

c.officers, who run the daily operations of a corporation

B.Shareholders (OL V.B.)1.Shareholders do not have control over the day to day management of the corporation this is reserved for officers and directors

2.Shareholders have the right to:

a.can elect and remove directors

b.amend the bylaws; and

c.approve fundamental changes in the corporation, such as amendment of the articles of incorporationmerger, sale of substantially all assets, or dissolution

3.Management may seek:

ratification or approval of an action. If directors have a conflict of interest

4.Shareholder action on these matters:

is taken at a meeting

5.Boards act, shareholders react.

HYPOTHETICAL

Gary is the president of Pubco, a publicly held corporation that publishes childrens books. About a year ago, Gary was approached by another publishing company, which made a generous offer to purchase Pubcos educational division. Because the board of directors had been talking about moving away from publishing educational textbooks, Gary accepts the offer. He mentions the sale to his brother, Andy, who is on Pubcos board of directors and agrees that it is a good idea. Shareholders who find out about the sale disagree. May they demand that Pubco rescind the transaction?

Gary as an officer and Andy is a director. Gary is responsible for day to day management of the corporation, and if he has been given authority under his job duties to sell divisions, then he does not need board approval. Shareholders do not have power in management decisions. However, the question turns on how big the education division is and whether it is a fundamental change in Pubcos division such that the sale of the division is a sale of substantially all assets. If not, the shareholders do not have a say in the sale.

6.Shareholder Meetingsa.The Annual Meeting(1)A meeting of shareholders is to be held annually for:

election of directors and the transaction of any other business

b.Special Meetings(1)of the shareholders may be called by the president or the directors or ipon the written application of the holders of 10% of shares entitled to vote.

c.Quorum(1)The basic rule is:

unless the articles or bylaws provide otherwise, majority of shares entitled to vote at a meeting

is a quorum

(2)For shareholders:

present at a meeting at which quorum is present, may continue to transact business until adjournment even after withdrawal of enough shareholders to leave less than quorum

(3)In no case may a quorum consist of:

less than a third of the shares entitled to vote at a meeting

(4)A majority consists of:

50 percent plus one.

HYPOTHETICAL

Peaches and Apples Corp. has 1,000 common stock shareholders. Six hundred appear at the annual meeting. After a lunch break, only 300 shareholders return for the remainder of the meeting. May the remaining shareholders of Peaches and Apples elect new directors after the lunch break?

Yes, since quorum was met by 600 members (60% of majority share holders), shareholders can continue to transact business until the meeting is adjourned as long as at least a majority of shares required constitute a quorum, which would be 251 in this case. If 251 vote for the new directors, then they can approve. If 250 and less, then no new board of directors.

7.Election and Classification of Directorsa.Straight Voting(1)In straight voting:

each share has one vote for each director. Thus a majority stockholder can elect the

entire board of directors.

(2)Note that:

to ensure representation stock can be classified for purpose of electing directors. But

usually, the majority shareholder wins

b.Staggered Terms(1)In this scenario, a majority stockholder:

always wins

c.Cumulative Voting (1)This is:

general rule in California, except for public companies

(2)In cumulative voting:

number of shares to be voted multiplied by number of positions to be elected. EXAMPLE:If there are 1,000 shares and five positions up for election, there will be 5,000 votes. If a shareholder has 100 shares, that shareholder would have 500 votes to cast.

(3)A shareholders votes:

A shareholder may use all of his cumulative votes to elect one or more directors.

(4)This allows minority shareholders to:

pool their votes together for certain candidates and have some representation on the boardHYPOTHETICAL

Marsden Co., Inc.s bylaws call for three members on the board of directors. Sarah and Sally each vote for themselves, and Simon votes his share for Jessica, a person with extensive restaurant experience. Will Simon have the right to have control over the company once Jessica becomes a director?

No. Each of the directors have to act on behalf of all shareholders. If Simon does not like how Jessica performs, he can replace her at the next meeting.

8.Proxy Votinga.Every shareholder entitled to vote:

can do so by proxy

b.The term proxy means:

giving someone else right to vote on your behalf

c.It may also mean:

an instrument granting the authority

d.The agent to whom authority is granted is called:

proxy holder

e.A proxy is revocable unless:

it is coupled with an interest

(1)a proxy is deemed to be coupled with an interest if the proxy holder is a :

pledgee

person who has purchased or agreed to purchase the shares

beneficiary of a trust

person designated by or under the shareholder voting trust or agreement

creditor or employee of the corporation whose contract provides for the granting of a proxyf.Mechanics of Proxies(1)California permits an electronic transmission authorized by the shareholder in lieu of a signed written authorization

9.Shareholder Voting Agreements and Voting Trustsa.Pooling or Shareholder Voting Agreements(1)to consolidate voting power in order to gain or strengthen control of corporate affairs, stockholders may

arrange to vote their stock collectively. Shareholder voting agreements are contracts designed to ensure that the shareholders will vote in concert with regard to issues designated by the agreement.

(a)It is ordinarily used by minority shareholders to exert some control over the company.

EXAMPLE:Linkletter Co. has 100 shares of outstanding common stock. John owns 46 shares, while Alice, Mike, and George own only 18 shares each. Alice, Mike, and George sign a voting agreement that requires each of them to vote all of their shares as any two of them decide, giving them veto powerthe potential to outvote Mike.

(2)These are generally valid absent fraud or other illegal objective,

b.Voting Trusts(1)A voting trust involves a transfer of legal title to the shares to a trustee who votes them for a specified period according to the trust terms.

(2)Voting trusts are generally subject to stricter statutory regulation than are voting agreements.

(3)In California, there is a:

a 10-year limit to the duration of a voting trust

10.Shareholders Right to Informationa.Statutory Right(1)Shareholders have the right to get information about the corporation such as books and records and minutes of shareholder and director meetings, access to bylaws, obtain annual report of corporation and so on.

C.Directors (OL V.C.)1.Directors:

are the centralized management of a corporation

2.Directors may:

a.Adopt actions or implicitly ratify actions of the officers or agents

b.Hire officers

3.Directors are charged with:

Fiduciary duties

4.Numbera.California law requires:

Minimum of three directors

5.Quorum of Directors (OL V.D.)a.A quorum is:

Number of directors that have to be present for a board to legally adopt an action; and it is majority of directorsb.Unless otherwise provided in the bylaws:

A majority of the authorized number of directors constitutes quorum

EXAMPLE:If there are five directors on the board, and only three attend a validly called meeting, the votes of two directorsa majority of those presentwill constitute a valid act of the board [Corp. Code 307].

6.Director Participationa.A director cannot:

vote by proxy. Even if the proxy holder is another director. If he is to vote, he must be present at the meeting.D.Officers1.Officers are elected or appointed by the board of directors in accordance with the bylaws

2.One person may hold the offices of president, secretary, and treasurer simultaneously

3.Authority of Corporate Officersa.Officers act:

with either actual (express or implied) or apparent authority

b.Apparent Authority(1)Apparent authority of an officer to do an act is based upon a representation by the corporation to

the third party that the officer has the authority to do the act, together with reliance by the third party on the representation. After such a representation, the corporation is estopped to deny the authority of the officer.

c.Ratification(1)Acts of a corporate officer or agent:

that have not been properly authorized may be ratified by the board

(a)Ratification occurs:

means it happened after the fact. Ratification requires full disclosure (2)To be effective, ratification must occur: after such reasonable and full disclosure of facts of the transaction as the circumstances reasonably require

(3)Ratification requires:

actual knowledge by those individuals whose ratification is claimed

(4)Ratification may be:

explicit by passing a resolution or implied by acceptance of the benefits of the agreement

HYPOTHETICAL

Blue Devil Co., Inc.s board of directors appointed Pierre to serve as treasurer of the company while Sara, a very intelligent graduate of UCLAs hospitality program, was hired to be president. Pierre decided that it was proper to sell and lease back all of the deli cases so that the company would have cash for a major expansion in California. Sara agreed with the plan. Was her action proper?

This depends on size of transaction. If the purchasing is in ordinary course of business, then Saras actions are proper. However, if it requires major financing, then it may rise to the level of requiring board or shareholder approval. We dont need to worry about apparent authority because call of question asks whether she had actual authority.

BAR EXAM APPLICATION

Question 3Applicants were asked to consider potential problems arising from a shareholder agreement that was entered into by 75 investors, five of whom agreed to serve on the board of directors of Ritas Kitchen, Inc. Unbeknownst to the 75 investors and their representative, Rita and Fred asked an attorney to draft a shareholder agreement that would designate Rita and Fred as permanent directors and officers of the corporation and would set Rita and Freds annual salaries at 12.5% of the corporate earnings.

Is the shareholder agreement valid?

Applicants must consider matters related to shareholder agreements of a closely-held corporation, and a directors fiduciary duties.

From the February 2007 California Bar Exam

Shareholder agreements are usually valid and since 75 investors signed it, there is a presumption that it is valid. However, even if agreement is valid, provisions may be unenforceable. While s/h can elect directors through agreement, they cant permanently appoint board of directors for life. It deprives them of right to elect directors. S/h can agree on who to elect but not on how they may vote since directors have fiduciary duty to all shareholders. Any provision that requires board of directors to vote a certain way will be invalid. Any director who gives up right to vote and follows instructions would be violating duty of care. It also appears that the provision to appoint Rita and Fred as permanent BOD with 12.5% earnings is a conflict of interest and potential violation of duty of loyalty. Since it is not clear that the action was approved by disinterested board of directors, it can still be cleansed by informed s/h approval. If the shareholders agreement is deemed as a vote, then it can be seen as approved. However, it is not likely to be a vote and even if, the s/h do not seem to be informed. Since it does not appear reasonable, the provision or entire agreement is void or voidable as a violation of duty of loyalty. BAR EXAM APPLICATION

Question 4Applicants were asked to evaluate the validity of certain corporate actions taken by the directors of Sportco, Inc. (SI). Alice, Bob, Larry and Carole are all directors on the seven-person board of directors of SI. Bob is also President of SI. Prior to becoming a director, Carole had entered into a valid written contract with SI to sell a parcel of land to SI for $500,000 for SI to build a retail store. After learning that the land would appreciate in value over the next few years because of a planned mall development, Carole asked Larry, who also performs legal work for SI, for advice on how to get out of the contract with SI. Based on his suggestion, she asked Bob for a release from the contract, which Bob granted orally. At the next board meeting, attended by Bob, Alice, and Larry, the board passed a resolution ratifying Bobs oral release of Carole from her contract with SI.

Was Bobs oral release of Carole from her contract with SI effective?

Was the resolution passed by Bob, Alice, and Larry to ratify Bobs oral release valid?

Applicants must examine the authority of officers and directors to bind corporations and the corporate formalities required to take corporate action.

From the July 2005 California Bar Exam

As a director, Bob cannot release Carole from the contract, but as president, he may have the authority. Even though President usually has power to terminate agreements, given the size of the agreement and that it may not have happened in ordinary course of business, it is likely that Bob did not have actual, implied or apparent authority to release Carole from the contract.

The transaction is a conflict of interest, which should have been disclosed and cleansed by the directors or shareholders. Termination of contract may also require a written release under SOF because it involves sale of land. Corporate opportunity issue here by taking this opportunity for himself, Bob is violating his duty of loyalty to SI.

There was no quorum for the ratification since there are seven board of directors and only three of them attended the meeting where they approved the resolution. Furthermore, Larry was an interested director and he did not disclose his interest. So release and approval of release is not valid.

VI.Fiduciary and other duties of management and controlling shareholders

A.Fiduciary and Other Duties of Directors (OL VI.A.)1.Duty of Care

a.In general, directors, officers, and incorporators must perform their duties:

(1)Duty of care good faith, in best interests of corporations, and with such care of ordinarily prudent person. (2)Duty of loyalty conflict of interest

(3)Declare dividends

b.Simple negligence:

is not sufficient to breach the duty of care

c.Defenses to breach duty of care - Business Judgment Rule (1)Business judgment rule shields directors from liability and insulates board decisions from review. It creates a rebuttable presumption that directors are honest and well-meaning and acting through decisions that are informed and rationally undertaken in good faith.

(2)The business judgment rule does not apply in situations involving:

(a)When duty of loyalty is at issue (if there is conflict of interest, look to duty of loyalty)

(b)A board director will not be insulated by the rule if the decision was illegal, egregious, based on fraud, involved a conflict of interest, made in bad faith or uninformed.

(c)Does not protect directors or officers when no action is taken because no judgment was made

(3)Reliance on Reports and Experts(a)A director or officer is entitled to rely upon the judgment or expertise of experts provided that:

1)It is properly presented and

2)Information is thorough and reasonable to rely upon

(b)Experts include:

1)Counsel, public accountants or other persons as to matters that the director or officer reasonable believes to be within that persons professional or expert competence

(c)The director or officer is not considered to be acting in good faith if he has knowledge concerning the matter in question that would cause his reliance to be unwarranted.

(4)Shareholder Ratification(a)if a majority of the shareholders ratify the action with full disclosure, the directors cannot be liable

d.Bad Faith Requirement(1)Proof of a directors bad faith is required by a shareholder claiming:(a)Bad faith refusal to declare dividends or other distributions(b)Distribution of Assets in Dissolution

(c)Making an Improper Loan or Guaranty

HYPOTHETICAL

Van, the CEO and shareholder of Transonion, a large, publicly held corporation, was nearing retirement. He met privately with Rich, and suggested that Rich cause one of the corporations he controlled to enter into a merger with Transonion at a price of $55 per share (market price was $38). Rich agreed, and ordered his underlings at Perch Corporation to prepare a cash-for-stock merger agreement between Perch and Transonion at $55 per Transonion share. Van then called a special meeting of the Transonion board, of which he was chairman, and in a 20-minute presentation, urged the board to approve the proposed Transonion-Perch merger without any discussion of the price being fair. The directors also thought that they could sell it to someone else if a higher bid were made. Without looking to see if the merger agreement had those terms, the board voted unanimously to approve the proposed merger after a meeting lasting two hours. Would the directors be liable?

Yes, they are liable for duty of care because they made an uninformed decision. They are not protected by the business judgment rule because they rubberstamped instead of investigating the merger. Note that they have an affirmative defense if they can show that the transaction was fair but here since the directors did not inform themselves and did not use duty of care in evaluating the transaction, they have violated duty of care to transaction.

2.Duty of Loyaltya.The fiduciary duty of loyalty requires that officers, directors and employees be loyal to the corporation and not promote their own interests in a manner injurious to the corporation.

b.Examples of this type of conflict of interest include:

(1)where officer or director has business dealings with the corporation or other interest in corporate transaction

(2)where officer or director takes advantage of a corporate opportunity;

(3)enters into competition with the corporation

EXAMPLE:The director of Medco Inc., a medical services company, must refrain from voting on a contract between Medco and a medical equipment company owned by the directors wife.

c.Business Dealings with the Corporation(1)An interested transaction is one in which:

where director has financial or familial interest

(a)A direct financial interest could mean a personal profit or profit for a close family member.

(b)Interlocking directors: occurs when director is on the board of or has a financial interest intwo transacting businesses. This does not necessarily constitute conflict of interest. (2)Transactions that involve a conflict of interest are void or voidable by or on behalf of the corporation unless the interested person can prove that:

(a)material facts about the conflict has been fully disclosed to the board; and

(b)transaction has to be approved by majority of disinterested shareholders; and

(c)the contract should be just and reasonable to the corporation when it is approved

or

(d)material facts about the conflict are disclosed and fully described to the shareholders

(e)the transaction is approved by a disinterested majority of the shareholders or

or

(f)a court determines the transaction to be fair

(3)The board of directors may set director compensation provided:

reasonable or ratified by shareholders

Remedy: a corporation may rescind a transaction that is not fair, and damages can be awarded.

d.Corporate Opportunity(1)The fiduciary duty of loyalty prohibits directors and officers (and sometimes employees) from:

taking something for themselves that belongs to corporation unless

(a)it is fully disclosed to corporation

(b)the corporation is first given the opportunity

(c)corporation then says it does not want take the opportunity and lets the individual pursue it (2)Factors to determine what constitutes a corporate opportunity include:

(a)whether the individual became aware of the opportunity while acting in his capacity as director or officer (b)whether the business constituting the opportunity closed related to business the corporation

(c)whether the board have an interest or expectancy in the opportunity

(d)whether the opportunity in the business line of the corporation

(e)whether corporate funds or facilities were use in discovering or developing the opportunity.

If the opportunity is outside line of business, did not come due to directors position, and not something for which business funds were used, then individual can perhaps take advantage of the opportunity without breaching duty of loyalty.EXAMPLE:Toymaker, Inc. makes all kinds of toys. The president, Harry, meets someone selling the rights to a new lifelike doll. Harry buys the rights and starts a new company to sell these dolls. Harry has usurped a corporate opportunity from Toymaker, Inc.

EXAMPLE:Same facts as above, only now someone approaches Toymaker Incs president with a recipe for a cookbook. The president buys the recipe and publishes a cookbook, something Toymaker has never done before. This will be permitted and there would be no conflict.

(3)If the person presents the opportunity to the corporation and:

if it is rejected by vote or even silence/inaction, then it ceases to be an corporate opportunity and

the director can take advantage it

(4)Remedy(a)If a director has usurped a corporate opportunity or entered into competition with the corporation, the court may:

1)hold the individual liable and make them constructive trustee of the corporation

2)this person would have to deliver any property, income or profits derived through the corporate opportunity. Person would also be liable for damages.

(5)Other Defenses(a)Another defense to a claim of usurpation is:

inability and incapacity.

HYPOTHETICAL

Susan has leased several locations to Cottle Hill Co., Inc. She comes to Jack, who is the president of Cottle Hill, and asks if Cottle Hill would like to buy her properties instead of leasing them. Jack thinks that Cottle Hill cannot afford the purchase, so he says he will buy them himself. Does the corporation have a cause of action against Jack?

Fid. Duty of loyalty prohibits officers from taking something for themselves that belongs to the corporation unless full disclosure is made about the opportunity to the board, the board has an opportunity to first reject it and allow the individual to pursue it. Here, the properties are ones in which Cottle hill would have had an interest. Jack did not present the opportunity to the board so the corporate opportunity has not been cleansed by a vote of the board. Jack could argue fairness but he did not pay anything for the property. Jack can also argue defense of inability and incapacity, as the corporation could not have performed due to financial incapacity. Since we do not have any evidence about Cottle Hills financial capacity, Jack would hold the property in constructive trust for Cottle Hill and he would be found liable for usurping the corporate opportunity.

B.Duties of Controlling Shareholders (OL VI.C.)1.Fiduciary Dutiesa.Shareholders:

Majority or controlling shareholders have a fiduciary duty to refrain from exercising their control to obtain a benefit

from the corporation not shared proportionally with the minority shareholders.

b.Controlling shareholders are ones who:

have the ability to make impact on the decisions of the company

c.Majority or controlling shareholders have a fiduciary duty:

an obligation to refrain from exercising their control to obtain benefit from corporation that isnt shared proportionallywith the minority shareholders

(1)This is most commonly seen when:

dominant s/h gets something that minority s/h does not get

EXAMPLE:A dominant shareholder uses his influence to have a dividend issued. The shareholder receives millions while the minority shareholders receive only a dollar each. This is permissible if it was proportional.d.Examples of improper conduct include:

(1)causing the directors to guarantee loans made to, or to enter into loans with, a majority shareholder

(2)causing the directors to issue additional stock for the purpose of diluting minoritys interest

(3)causing the directors to enter into contracts with the majority shareholders or an entity affiliated with him on unusually favorable terms or causing the board of directors to dissolve the corporation, sell its assets, for purpose of excluding the minority shareholders from participation in profitable business

e.Because of the absence of disinterested parties, cleansing can only occur where:

by showing that the transaction was fair and reasonable. If not, it is a violation of duty of loyalty

2.Sale of Controla.A shareholder is permitted to obtain a control premium for selling a majority or controlling portion of the stock.

b.However, where the seller:

knows the person who the shares are being sold to can hurt the corporation. This is when the transfer will result in

prejudice for minority shareholders

c.Note the terms dominant, majority, controlling are interchangeable terms.3.Freeze-Out Mergers

a.A freeze-out merger means that:

minority shareholders are forced to sell their shares and get frozen out of the corporation. This may be permissible

for a legitimate business purpose, and usually subject to judicial review for fairness to the minority shareholders.

(1)In California, this can be done when someone controls 90% or more of the company. HYPOTHETICAL

Steve, the president and sole shareholder of a closely-held movie distribution company, decides to retire and transfer his shares to Judy (his second wife, who is also the companys chief financial officer), Jeff (his son, who works the companys cash register and is not related to Judy), and Paul (the companys vice president of sales). After discovering that Jeff has been taking $100 per week from the cash register, Judy fires Jeff, offering to buy back his stock, but not the stock owned by Paul. A few months later, Paul learns that a competing business is selling all of its assets at a significant discount. After mentioning the sale briefly to Judy, Paul establishes a new company and purchases the competitors assets. In what way did each of the shareholders most likely breach their fiduciary duty to the other shareholders?

Steve seems to be in the clear provided he followed federal security laws about transferring shares and there are no s/h agreements requiring him to transfer his shares to someone else. Judy fires Jeff and it is unclear whether she had the authority to fire him. We also need to know whether she did it to buy back his stock and get him out of the way, in which case, she violated fiduciary duty as a s/h. if she did have authority to fire, then she was well within her rights as Jeff was stealing. Judy should have disclosed to Paul any material info she had about the stock before she bought it else she may have violated federal and state security laws. Jeff committed a crime so he violated his fiduciary duty of loyalty to the company. Paul took a corporate opportunity and it is not clear if his disclosure was sufficient. He didnt disclose to the board but to Judy, which may not be enough for cleansing his action. He may need the board to approve his taking of corporate opportunity for he violated his fiduciary duty of loyalty by taking the corporate opportunity.

C. Federal Securities Law (OL VI.D.)1.Rule 10b-5a.Rule 10b-5 is:

an anti-fraud provision that prohibits false or misleading statements in connection with the purchase or sale of

securities

b.Rule 10b-5 prohibits:

(1)the use of any device, scheme or artifice to defraud;

(2)omissions or misstatements of material fact; and

(3)any act, practice or course of business that operates as fraud or deceit

c.Actual fraud is not required for a 10b-5 violation.

d.A security means:

any note, stock, treasury stock, security future, bond, debenture, as well as a variety of other interests involving an investment, the return on which is dependent on the efforts of a person other than an investor.

e.Rule 10b-5 regulates companies whether or not they are publicly traded.f.Jurisdiction

(1)After finding a security, the next thing to examine is jurisdiction.

It must involve interstate commerce (2)Examples include:

(a)Mail

(b)Things transported across state lines

(c)Internet

(3)If a transaction is entirely intra-state:

then state security laws apply

g.The elements of a 10b-5 action are:

MNEMONIC: Man, Securities Can Make Real Damages

(1)Misrepresentation or omission of material fact

(2)Scienter (intent to deceive, manipulate or defraud)or knowledge of the misrepresentation or material fact(3)Causation

(4)Materiality

(5)Reliance on the plaintiff, generally assumed if the statement/omission was material

(6)Damages: must have damages

h.Privity is not required, and the defendant need not be a buyer or seller in direct contact with person who made the misstatement as long as:

his fraud was in connection with the purchase or sale transaction in which plaintiff was a buyer or seller i.e.

someone who chooses not to buy or sell based upon misrepresentation or omission does not have a claim.

EXAMPLE:If President makes a false statement regarding patent approval, and Shareholder buys stock from someone else relying on that, and President was lying, Shareholder has a claim against President even though Shareholder didnt purchase the stock directly from President.

i.Enforcement(1)Enforcement may be:

enforced by SEC, courts and individuals can also sue for a private cause of action

j.Note that in order for there to be a 10b-5 claim:

a plaintiff must have purchased or sold security

EXAMPLE:Joan is about to sell her stock in Hot Air Balloon Rides Corp., but decides against it when the president tells her that the company is about to sign a big contract with Birthday Balloons Unlimited. Even if the presidents statement was in violation of Rule 10b-5, Joan would have no right to sue him because she didnt purchase or sell the stock. If she bought more stock, then she would have claim for additional stock she bought based on false information.

2.Insider Tradinga.10b-5 has been applied to insider trading transactions. Insider trading involves someone who has material inside information, about the corporation of which he is an insider, that would influence the value of its stock. Such a person is obligated to not make a secret profit by dealing in that stock before public disclosure of the material information is made.

State laws also regulate fraud in the purchase and sale of securities. Where this arises and the issue is honesty, mention that there might be common law claims.b.Insiders(1)An insider is anyone who:

(a)learns of material non public information as a consequence of corporate position as director or officer OR

(b)has a fiduciary duty to the corporation

(2)Anyone who breaches a duty not to use inside information can be held liable under Rule 10b-5.

(3)Insiders typically include:

directors, officers, controlling shareholders, attorneys, accountants

c.Tippers and Tippees(1)Tippers are:

insides who make selective disclosures of material inside information in a breach of their fiduciary

duties to someone else, and the tippee trades on it. A tipper can be liable for the profits of their tippees who trade on that information

(2)The fiduciary duty of the insider is breached when:

the tipper receives a benefit, i.e. even an enhanced reputation, financial benefit.

(3)Note that information can be passed on without a breach of duty.

EXAMPLE:An insider may be a person talking on a phone in an elevator without knowing that someone else is in the elevator also, and the insider inadvertently discloses information. There is no breach of duty here, and the other person on the elevator could trade on this information.

EXAMPLE:A corporate executive who talks in his sleep and reveals information has not breached a duty. The person who overhears the executive may be able to trade on this information.

(4)Tippees may be liable only if:

tipper breached his duty and the tippee traded on or told others about the material inside

information knowing that the tipper acted improperly.

(a)The tippee has:

no independent duty to the corporation as derivative; a beach by the insider must be shown

(b)Outsiders:

An outsider who develops information on their own have no duty

EXAMPLE:In the movie Wall Street, Budd Foxx follows a well-known investor around town one day, noting who the investor spoke with, what buildings he entered, etc. He came to a conclusion about the investors intentions, and traded on that assumption. This is not inside trading.

3.Misappropriation of Inside Informationa.Under the misappropriation theory, a person may be prosecuted by the government under Rule 10b-5 even when he has no duty to the corporation or shareholder of the corporation when:

he has traded market information in breach of the duty of trust and confidence owed to the source of information. Tipper and tippee rule also applies to misappropriation.

(1)RETACRelationship of Trust And Confidence.

EXAMPLE:Printer who worked at a company that printed information, through his job, eventually figured out the importance of some of that information and traded on it. Printer violated his duty to his employer, the printing company, and was liable even though no duty was directly owed to the company.

EXAMPLE:Financial reporter R. Foster Winans was held liable for revealing financial information he intended to publish in his Wall Street Journal column Heard on the Street to others who traded on the basis of this advance information. Although the confidential information did not come directly from the corporations whose stock was traded and no duty to those corporations was breached, the court found a sufficient breach in the use of material nonpublic information belonging to Winans employer, The Wall Street Journal [United States v. Carpenter, 791 F.2d 1024 (2d Cir. 1986) affd 484 U.S. 19 (1987)].

Look at the question under both theories. Look first to see if there was traditional insider trading, then examine the question under the misappropriation of information theory. Be certain to mention both theories.

4.Section 16(b)Regulation of Short-Swing Profits STRICT LIABILITY STATUTEa.A per se rule of invalidity is applied to short-swing profits made by insiders on in-and-out sales (sales/purchase) transactions within a short period of time.

b.Under Section 16(b), any profit is recoverable if:

(1)made by an officer, director, or beneficial owner of more than 10% of a class of equity security

(2)from any sale or a security

(3)occurring no more than six months from a purchase or sale of the same security

c.This cause of action requires:

two transactions (purchase and sale), while recovery under common law or 10b-5 requires only one transaction

d.To be liable, an officer or director need only:

have been in office at the time of purchase or sale. Also, office or director may be liable for sales made within six

months of purchase, even though he is no longer director or officer

e.A 10% beneficial owner must have been a 10% beneficial owner:

at both times (i.e. must have owned more than 10% prior to the purchase and prior to the sale).

EXAMPLE:If Shareholder owns 9% of the corporations stock, and then purchases stock which makes him 11%, then sells stock, this would not count. The purchase that puts Shareholder over 10% does not count towards this rule. Shareholder must own 10% at the time of both transactions.

D.Other Federal Securities Law (OL VI.E.)1.Sarbanes-Oxley Act of 2002a.The Sarbanes-Oxley Act (SOX):

increases the duties of directors of publicly traded companies

b.SOX requires principal executives and financial officers to certify:

(1)they have reviewed the financial reports

(2)that the reports do not contain any untrue statements or material omissions

(3)financial statements accurately portray the corporations financial conditions

(4)they are responsible for implementing and evaluating the companys internal control and have evaluated the companys internal controls within the last 90 days and they have listed

(a)any deficiencies in the controls;

(b)any fraud involving corporate employees; and any significant changes in corporate controls and anything that could have a negative effect on corporate controls.

c.Attorneys must report:

evidence of any material violations of securities laws or breaches of fiduciary duties to either the chief legal counsel

of the corporation or the CEO.

VII.SHAREHOLDER SUITS

A.Direct and Derivative Suits (OL VII.A.)1.A direct suit is:

shareholder sues on his behalf to redress an injury to his interest as a shareholder

a.Typical examples include:

(1)compel payments for dividends

(2)enforce the right to inspect corporate records

(3)protect preemptive rights, to enforce the right to vote

(4)recover for breach of a shareholders agreement

2.A derivative suit:

shareholder sues on behalf of the corporation to redress a wrong to the corporation when the corporation fails to enforce its righta.The shareholders right arises from the corporations right to sue, and can only exist where there has been a wrong to the corporation.

b.The most typical type of derivative suit is:

breach of fiduciary duty

In examining a shareholder suit, ask who is being hurt? If the shareholder is hurt, it is direct. If the corporation is harmed, and the shareholder is suing, it is a derivative suit.

B.Derivative Suits (OL VII.B.)

1.Conditions Precedenta.Contemporaneous Ownership(1)In a derivative suit, the plaintiff must normally allege in his complaint that he:

was a shareholder at the time of the transaction complained of or that his shares passed to

him by operation of law (i.e. inheritance) from a person who was a shareholder at that time.

(2)In California, a shareholder can still bring a lawsuit if:

(a)there is a strong prima facie case in favor of the claim asserted

(b)no similar action has been or is likely to be instituted

(c)plaintiff acquired the shares before there was disclosure to the public or the plaintiff of

the wrongdoing of which plaintiff complains

b.Demand on Directors(1)A shareholder must first:

attempt to persuade the board to enforce the corporations right by making a written demand upon

the directors

(2)The exception to this rule is where:

demand is futile

(a)Demand is considered futile when:

1)majority of the board is interested in the transaction;

2)directors fail to inform themselves of the transaction; or

3)the directors fail to exercise their business judgment in approving the transaction

c.Dismissal(1)If a majority of disinterested directors or a majority of a special litigation committee determine that the suit is not in the corporations best interests, a court will dismiss the derivative proceeding.

(a)The decision must be made:

in good faith and after a reasonable inquiry.

(2)A special litigation committee is a committee appointed by the directors consisting of disinterested or new directors who then investigate the claim.

(3)A special litigation committee must:

(a)disinterested

(b)operate in good faith

(c)reasonable inquiry

(4)If the special litigation committee acts properly, its decision:

protected by business judgment rule

2.Security Bonda.In California, the court may require the plaintiff to post a security bond.

3.Defensesa.Since stockholders in a derivative suit stand in the shoes of the corporation, they are subject to the same defenses that could have been raised against the corporation.

4.Recovery of Expensesa.If a shareholder wins, the defendant has to pay their legal expenses.b.However:

any recovery in funds in damages gets paid directly to the corporation for because the suit is brought on behalf of the corporation.

HYPOTHETICAL

In the proxy fight at Pasadena Windows, a shareholder wants to bring a derivative action on the excessive proxy expenses authorized by the directors. The board has 12 directors, all of whom approved the expenses. Is demand of the board of directors required? Can the board do anything to avoid demand?

In order to bring a derivative suit, shareholder has to meet several contingencies, including making a written demand to the board. However, s/h can sidestep this by asserting that demand is futile because the majority of the board approved the transaction. This appears to be the case here so demand is not required as it is futile since all of the board approved the excessive proxy expenses.

The board can avoid demand by appointing a special litigation committee to investigate the complaint. To do this, it would have to appoint two disinterested directors since existing 12 are already interested. Any appointment would have to be in accordance with the bylaws. If the special committee decides, in good faith and after reasonable inquiry, that the suit is not in the corporations best interest, then the corporation can dismiss the suit and this dismal is subject to the business judgment rule.

VIII.CHANGES IN CORPORATE STRUCTURE

A.Shareholder approval is required to: (OL VIII.A.)Make fundamental changes in the corporate structure, although the directors may pass a resolution recommending, accepting or rejecting the proposed changes.

B.The following are fundamental changes: (OL VIII.B.)1.amendment to articles of incorporation

2.mergers and consolidations

3.sale of all assets

4.dissolution

C.Reorganizations (OL VIII.D.)1.Mergers, sales of assets and share exchanges are generally called reorganization.

2.Mergers a.one corporation is absorbed into another. Sometimes it is one that survives; sometimes brand new company is formed.

b.Short-Form Merger(1)parent owning 90% of the outstanding shares can merge the subsidiary corporation into the parent corpc.Effect of Merger new corporation gets the liabilities, duties and assets of former corporation

3.Sale of All Assetsa.When a corporation sells or transfers all of its assets to another corporation, the purchaser is not liable for the debts of the seller, unless:

(1)express agreement that the debts are going to be assumed OR

(2)there is fraud to avoid liability

HYPOTHETICAL

Madeline Windows Corp. is primarily engaged in the business of manufacturing high-end windows. Section IV of the companys articles of incorporation provides that one purpose of the company is to sell, lease, exchange, or otherwise engage in the transfer of assets of the corporation. Does this section permit the directors to sell substantially all of the corporations assets without shareholder approval? Is such a provision valid?

No, while sale of asserts is regular course of business, the sale of ALL assets is a fundamental change to the corporation requiring s/h approval.

D. Dissenting Shareholders Appraisal Rights (OL VIII.E.)S/Hs that do not vote for a merger retain the right to appraise their shares and buy them at fair market value. Notice and objection required, demand for payment, appraisal proceedingsE.Dissolution (OL VIII.F.)1.Dissolution is the extinguishing of corporate existence.

2.Voluntary Dissolutiona.Vote of Shareholders(1)A corporation may be voluntarily dissolved by:

50% of more of the voting power of its shareholders and the filing of a certificate of voluntary

dissolution with the secretary of state

b.Vote of Directors(1)directors can vote for it without shareholder approval upon filing a certificate of voluntary dissolution if the corporation is bankrupt, disposed of all assets and has not done business in 5 years, has not issued shares and is not obligated to do so.

3.Involuntary Dissolution a.Attorney General (1)The Attorney General may bring an action against a corporation seeking dissolution of the corporation on the grounds that the corporation has gotten into some kind of trouble

b.Directors or Shareholders(1)The directors or shareholders can institute an involuntary dissolution where it has become impossible or impracticable for the corporation to carry on its business.

HYPOTHETICAL

John, Mark, Dylan, and Ryan decide to form a landscaping business called Fourlanders, Inc. They incorporate the business in Florida, and each owns 25% of the outstanding shares. The business takes off, with Mark, Dylan, and Ryan doing most of the labor and John managing the books. Five years later, Mark dies, leaving his interest to his daughters, Anne and Betty, neither of whom has any interest in doing the work. Dylan goes into a deep depression over Marks death and does not come to work for six months. Unable to handle things by himself, Ryan decides to sell his share of the business, but no one is interested in purchasing his shares. What are Ryans options?

Ryan can proceed with a voluntary or involuntary dissolution. He can try to get s/h to vote to vote for dissolution. A corporation can be dissolved with 50% or more votes from shareholders. Ryan has 25% of the vote so he needs either more shareholders to join him, such as John, or Anne and Betty. The other option he has is an involuntary dissolution, where he needs either one-half of directors above or shareholders owning at least one third of the outstanding shares to approve the dissolution. However, Ryan would also need to show that the corporation has gone bankrupt, abandoned the business, disposed of its assets and not done business in 5 years, and not obligated to do so.

BAR EXAM APPLICATION

Applicants were asked to review a sequence of events involving Corp, a publicly held corporation whose stock is registered under Section 12 of the Securities Exchange Act of 1934. On January 2, Corp publicly announced that it expected a 25% revenue increase this year. On March 1, a Corp director (Director) sold 1,000 Corp shares for $25 each. On June 15, Corp learned that, because of unforeseen expenses, its revenues would decrease by 50% this year, contrary to its January 2 announcement. On June 16, a Corp officer (Officer) consulted his lawyer (Lawyer) for personal tax advice. Officer mentioned, among other things, the probable devaluation of his Corp stock. On June 17, Lawyer telephoned his stockbroker and bought a put option for $1,000 from OptionCo. The put option entitled Lawyer to require OptionCo to buy 1,000 Corp shares from Lawyer for $20 per share. On June 18, Corp publicly announced that its revenues would decrease by 50% this year. Its stock price fell from $30 to $5 per share. On June 19, Lawyer bought 1,000 Corp shares at $5 per share and required OptionCo to buy the shares for $20,000 pursuant to the put option. On July 1, Director bought 1,000 Corp shares for $5 per share.

In each of the foregoing events, which of the actions by Director, Officer, and Lawyer constituted a violation of federal securities laws and which did not?

Applicants must analyze for each party whether he has violated Rule 10b-5 or Section 16(b) and on what grounds.

Insider trading liability occurs when officers or directors breach their fiduciary duty by disclosing material facts for a benefit. Officer did not trade so he does not have insider-trading liability. He also does not have tippee liability. Even though he cannot pass inside information for a benefit, Officer is allowed to discuss material facts with a professional advisor. This is neither an intentional or reckless violation of his duty unless the officer was compensated for the info but there is no violation of duty, and since there is no breach of duty, there is no securities violation.

Under traditional insider-trading, tippee liability is derivative and if the tipper did not breach the duty, the tippee is not liable for the breach either. Lawyer has not violated traditional insider-trading laws since the officer did not breach his duty by discussing the material facts with the lawyer, the lawyer could not violate a duty by trading on the information. However, the lawyer is bound by attorney-client relationship and owes fiduciary duty to his client. He is still liable for misappropriation of inside information for breach of the duty of trust and confidence owed to the source, the Officer. Therefore he breached his duty by trading on the information. Whether he bought puts or stocks is not relevant. Since he violated his duty of trust and confidence with his client by trading on material facts, he is liable under rule 10b-5 for misappropriation of insider information.

A 16b violation occurs when an officer, director, owner of 10% of stock makes a purchase and sale of the same security within six months. The statute does not require intent. Here, the Director violated section 16(b) by selling and purchasing his shares within 6 months of either transaction. He sold 1000 shares for $25 each on March 1 and bought 1000 shares at $5 share on July 1, which is a sale and purchase within 6 months. He is liable to the company for $20,000 which is the difference between the sale price and the purchase price times the number of shares.

IX.TAKEOVERS AND CORPORATE CONTROL TRANSACTIONS

A.Tender Offers (OL IX.A.)1.Individuals, groups of corporations seeking to acquire another corporation normally attempt to do so by negotiating with the board of directors. If this fails, the would be buyers go directly to shareholders and make a tender offer

2.A tender offer is a:

public and usually published solicitation by a bidder of the publicly held shares of the corporation to be acquired (target)

3.The offer is usually made at a premium over the current market price.

4.The bidder also need not accept the tender of more shares than any maximum number of shares specified in the tender offer.

5.Defensive tactics by target companies against takeover attempts include:

a.white knight finding a more acceptable bidder

b.poison pills creating classes of stock that increases tin rights if any person acquires more than a specified percentage of shares, making acquisition more expensive for bidder.

B.Federal Regulation of Tender Offers (OL IX.C.)1.The Williams Acta.No Secret Purchases

(1)A party that directly or indirectly acquires more than 5% ownership of a corporation must disclose certain information, such as:

(a)partys identity and number of shares held, source and amount of funds making share purchases

(b)arrangements the party had made with others concerning shares of the target; partys purposes in acquiring the shares and intentions regarding the target

b.Tender Offer Disclosure (1)A bidder must disclose, on the day it commences its tender offer:

(a)purpose of th tender officer, bidders plans for the target, past negotiations between bidder and target, bidders financial statements, regulatory approvals that may be necessary and any other material info.

c.False or Misleading Statements(1)Section 14(e) of the Exchange Act prohibits:

false and misleading statements or omissions in conjunction with tender offers.

(2)Section 14(e) also prohibits:

insider information trading in a tender offer

(a)Note:

No requirement for duty to anyone. In securities, use rule 10b-5, and 14(e) in tender offers

X.PROFESSIONAL CORPORATIONS

A.Professional Corporations (OL X.A.)1.Formationa.The only individuals who may be shareholders are those who are licensed or otherwise legally authorized within the state to render that professional service.

b.Persons entitled to form professional corporations include attorneys, accountants, and various medical personnele.g., physicians, surgeons, and dentists. (1)The persons must all be of the same profession, however.

2.Liabilitya.Shareholders enjoy limited liability, but must post a bond for those who interact with the corporation.

BAR EXAM APPLICATION

Question 6Applicants were asked to analyze issues arising from Adco, Inc.s inability to pay for services provided by Web, Inc. Beth, Charles, and David, directors of Web, Inc., agreed to provide services and extend credit to Adco, Inc. conditioned on review of Adco Inc.s financial statements. After Adco Inc. informed him that the sooner Web, Inc. could begin its work, the sooner it could pay them, David falsely told Beth and Charles that he had reviewed Adco Inc.s financial statements and that they should proceed with the work. Beth and Charles agreed without further inquiry. After Adco, Inc. was unable to pay, Beth, Charles, and David learned that Adco Inc.s shareholders had regularly taken its funds for their personal use.

What duties to Web, Inc., if any, have been breached by Beth, Charles, and David regarding the money lost on the Adco Inc. job?

Applicants must analyze director liability for breach of duty of care and the business judgment rule as a possible defense.

What rights, if any, does Web, Inc. have against Adco Inc.s shareholders for Adco Inc.s failure to pay for the web site?

Applicants must analyze the doctrine of piercing the corporate veil to determine the potential liability of Adco Inc.s shareholders.

From the July 2006 California Bar Exam

What duties were breached?

A director has duty of care to corporation, which requires a director to act in good faith and exercise the care of an ordinarily prudent person on behalf of the corporation. David breached this duty of care when he lied to the other directors about the finances of Adco. His actions may even amount to bad faith in this instance, as it goes beyond reckless disregard. He is not protected by business judgment rule because he made uninformed decision and his actions constituted bad faith.

Beth and Charles are entitled to rely on an expert when acting on behalf of a corporation. An expert can be another director if there is a reasonable basis for the reliance. Since it does not appear here that Beth and Charles had any reason to not rely on David, they can assert reliance on expert opinion as a defense and their approval would not subject them to liability. However, they did not make any further inquiry into Adco and they may have acted in good faith, but not following up with even a question is not sufficient information. They just rubberstamped what David said and there is a good chance that they would be found to violate duty of care and the fact that they were not informed would prevent them from using business judgment rule. Piercing the Corporate veilWebco may have a claim for piercing the corporate veil of Adco. Veil may be pierced when there is a unity of interest between shareholders and corporations and to not pierce would lead to injustice or fraud. The fact that Adco was alluding that it could enter into contract with Webco when they did not have financial capacity amounts to fraud. They also appear to have comingled funds as shareholders had frequently taken funds for their personal use. If these funds were withdrawn without formalities and that left Adco unable to pay creditors, then it is possible that veil would be pierced and Adco shareholders held personally liable. But even if the funds were properly taken, if they left Adco in inadequate financial capacity and unable to pay creditors, shareholders may be personally liable for the dividends and need to return those funds.

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