BA Outline - Shepherd Spring 09

Business Associations-Professor Shepherd

Introduction:

A. Owning an Interest in a Business (1-14) According to Friedman’s view, the goal of every corporation is to make money/achieve the greatest profit. Social

responsibilities belong to an individual and not a business. A director is not acting as an agent, but as a principal where he pursues his social responsibilities. Shepherd believes this is too narrow.

Doctrine of Social Responsibility: In oppose to Friedman’s view, corporations can assume social responsibility. In AP Smith v. Barlow, it was held that corporate philanthropy is acceptable and a corporation derives benefit from acting as a productive member of society and creates good will. Board of directors actually profit-maximizing and charitable gifts are in the public’s interest. BUT,

o Cannot make indiscriminate donations.o Cannot give to a pet charity—cannot give in furtherance of personal rather than corporate ends. o MBCA § 3.02(13): every corporation may make donations for the public welfare or for charitable, scientific or

educational purposes. o Principal-Agent Problem: objectives of agent (Board of Directors, CEO) differ from those of principal

(shareholders).

Key Terms: o Intra Vires: within the powers of.o Ultra Vires: unauthorized (MBCA § 3.04).o Stockholder/Shareholder: person in whose name shares are registered in the records of a corporation or the

beneficial owner of shares to the extent of the rights granted by a nominee certificate on file with a corporation (MBCA § 1.40).

o Board of Directors: governing body of corporation elected by the shareholders (MBCA § 8.01; Delaware § 141(a)).

o Principal-Agent Problem: objectives of agent (Board of Directors, CEO) differ from those of principal (shareholders).

o Principal: the one for whom action is being takeno Agent: the one who is to act.

B. Making Money and Keeping Track of it (14-26) 2 General Ways an Owner of the Business can Make Money from the Business:

1. Distributions from earnings.2. Profit from selling one’s share.

*Generally Accepted Accounting Principles 1. Matching: costs and expenses should be booked for the same time period they are generated.2. Conservatism: date should be conservative—present the firm’s financial data in an accurate way,

but err on the side of understating its revenues and the value of its assets, and on overestimating its costs and liabilities.

What is an appropriate price for a business? How do you value a business? o Formula for market price :

o Market Value = {yearly return} divided by {appropriate interest rate paid on equally risky investments}. Let’s say the co. will get cash of $4,700 every year. Look at other alternatives for investing your money.

Risk-free bonds that will pay 4.7% per year Interest rate x total investment (200k x .047)

o Would you pay $200k for this co? No, b/c ($9,400/year bond vs. $4,700 co.)

o Would you pay $50k for this co? Yes, b/c ($2,350 bond vs. $4,700k co.)o Would you pay $100k? That makes the two investments equal.

SO, the co. is worth more than $50k and less than $100k. The value of a co. is based on the value of alternative investments.

1

Formula for determining value of shares o value of co. is 90K, then how much would you pay for each share if there are 1,000 shares?

o 90,000/1,000 = $90

How to Figure Out How Much a Business Entity is Worth? 1. Income Statement : Provides an idea of the flow of profits into the business (computes profit during given period –

month/year based on revenues & costs). Usually a conservative statement *(GAAP)o Depreciation : divided cost of a piece of equipment that will last X years.

Straight Line: divide price of good by the life of good. Accelerated: greater amount of value decreases after first year.

o Sales – (cost of goods sold + salaries + general & admin expenses + depreciation) = net income 2. Cash Flow Statement : Measure of how much more cash a business has available from operations during given

periodo Cash flow =

Net Income + Depreciation – Net Change in Assets Other Than Cash (e.g., new machine) + Net Change in Liabilities & Funds from New Equity Issues (borrow money or issue new stock)

o Putting cash into your businessprofits and borrowing Gifts = reflected in net income like as in sales loan from bank = not reflected in income statements, maybe interest for loan will be reflected in costs to

be subtracted in income statement stock issued = must add them in cash flow

3. Balance Sheet : A “snapshot” of the financial situation at a particular point in time. Shows assets & liabilities o Assets : The things company owns that has value (e.g. land, building, cash, accts receivable, inventory and

equipment - depreciation as shown in income statement is)o Liabilities : What the company owes (e.g. accts payable, wages, bank notes, loans)o Owner’s Equity : How valuable a company is to its owner (SH)

Asset – liability = SH equity Asset = liability + SH equity

C. Lawyers and Choices Available for Business Structures (26-34) 1) Lawyers Function:

o Assist in setting up businesses and making money, litigate, protect interests of client and community. Essentially, represent the interests of the corporation.

o A lawyer’s duty is to the corporation itself and not necessarily the CEO. Lawyer acts as an agent of the entity with duties to the corporation just as the CEO

o if manager is committing crime/unlawful act, you must go to the board of corp. who will take action (Sarbanes-Oxley Act)

2) Factors for consideration: 1. Tax treatment of profits

2 kinds of corp for tax purposes: C corporation – there is tax at the corporate level before money goes to shareholders S corporation – there is pass through taxation

o There is no taxation at the corporate level –it can keep all money & distribute money to shareholders, then SH pay tax

All shareholders have to be US citizens, and fewer than 75 shareholders (for small US companies)

2. Liability exposure for debts and other liabilities

The Sole Proprietorship The business and its owner are the same actual person and same legal personOwner and business are the same for tax and

legal liability purposes.o Sole proprietor is personally liable for contract liabilities and business debts.

2

o No legal requirements for formation – no filings with govt., just start businesso A business will remain sole proprietorship so long as one person:

1. owns the business;2. is responsible for the management decision; and3. receives the profits and bears the losses.

Agency Law - Problems in Operating a Sole Proprietorship (36-60) Employees of a business are considered Agents and can bind the business or create liability for the principal through

Contractual Liability. Rules of Agency: RSA (Restatement (second) of Agency) § 1

1. Agency is a “fiduciary relation”. Owes fiduciary responsibility. Includes:o Duty of Loyalty—Agent cannot enter into competition with principal.o Duty of Care—Agent must be competent and do the work.o Implicit Duty of Good Faith & Fair Dealings.

2. Must be a “manifestation of consent from principal to the agent that the agent will act on principal’s behalf and subject to certain controls.”

3. Must be consent by the agent to act. § 7 Authority: Authority is the power of the agent to affect the legal relations of the principal by acts done in

accordance with the principal’s manifestation of consent to him. Actual Authority: (created by manifestations from principal to agent)

o RSA § 26 –written, spoken words or other conduct of the principal which, reasonably interpreted, causes the agent to believe that the principal desires him so to act on the principal’s account

Express Authority: authority principal actually expresses that agent possesses. Implied Authority: recognizes that an agent has the authority to do what is reasonably

necessary to get the assigned job done even if it is not spelled out in detail (i.e., P tells A he is responsible for setting up kitchen and A buys pots and pans).

Apparent Authority: (created by manifestations from principal to 3rd party)o RSA § 27: Principal is liable if the principal indicates to third party that agent has authority and third

party reasonably concludes there is authority. Must be the principal indicating the authority, not the agent – principal has to do something

indicating authority in agent.o Liability: Principal is still liable to 3rd party, but Principal can seek indemnification from agent.o Hypo : X says to Y, “when the Coke guy comes by, buy me a Coke.” Coke guy hears this. There is

actual express authority and apparent authority. Apparent Authority by Position: Where Principal places one in a particular position must look at job title and

what other companies would authorize person of this title to do AND ordinary course of business for this corp.1. When P put agent to that position – then authority by position is created2. Reasonable for third party to assume that agent has authority ( normal practice of industry)

Hypo: P tells Cashier not to make promises as to when food will be ready. Cashier does it anyway. There was no actual express or implied authority; however, there is apparent authority because a third party can reasonably assume that the cashier has been employed by P and has the authority to take money and fill an order.

o Hypo: X is purchasing agent for Bubba’s Burritos and authorizes X to buy custodial supplies. If X goes and buys $1000 of tortillas, principal should still be liable b/c X was appointed purchasing agent; therefore, it is reasonable for a third party to assume that a purchasing agent would have such authority.

o Hypo: Cook is told not to buy food and he does from 3rd party anywayYes, apparent authority or authority by position.

o Hypo: BUT, where cook contracts with travel agent to send all employees on 7 day cruiseNo direct manifestation and not likely that person in the cook’s position would have this type of authorityno liability for P.

Policy Rationale: Place liability on the least-cost, cost-avoider.

Disclosed, Partially Disclosed and Undisclosed Principal: If Agent is working on behalf of a disclosed principal, agent is usually not a party to the transaction.

o Liability of an Agent Contracting for Principal Disclosed principal §320: if agent tells the third what principal they are contacting for. Principal is

solely liable for the K (if there was apparent authority)

3

unless not actual agent and was defrauding 3rd party – then agent liable for fraud Partially disclosed principal : if the agent notes she is working for someone, but does not say who, the

agent is party to the K. Agent will be held liable. Undisclosed principal 326 : doesn’t say anything. Agent is liable solely.

Inherent Authority §8(a): Not based on P’s conduct toward the agent nor the P’s manifestations to a 3d party—arises from status of the corporate officer (i.e., a CEO working on behalf of the corp.)

o Derived from agency relation.o Exists for protection of persons harmed by or dealing with a servant or other agent.o Can also be created when:

Agent does something similar to what he is authorized to do but in violation of the principal’s orders Agent acts purely for his own purposes in entering into transaction which would be authorized if he

were acting with a proper motive Agent is authorized to dispose of goods but departs from the authorized mode of disposal. Often created when CEO is also a majority stockholder.

Termination: Belief of agency with 3rd party must be terminated so that P is not bound. Ratification: Agency exists if P affirms existence even if agency relationship did not exist at time of initial purported

contract; ex post facto approval.o I did not want a Coke and my friend has no authority, but I say Ok, I will pay anyway.

Tort Liability: Respondeant Superior—Principal is liable in tort for negligence of agent.

2 Requirements for Respondeat Superior Liability: 1. Must be a Master and servant relation (RSA § 220)—subset of agency-principal relationship

o § 2 (1) Master controls or has right to control physical conduct of servant in the performance of the service, day-to-day job

o § 2 (3)—Compared to an independent contractor—contracts to perform a job but his physical conduct is not controlled. Principal not liable for the torts of an independent contractor.

2. Tort must be committed within the scope of employment. § 219 (1)o § 228 (1)—Conduct is within the scope of employment if:

(a)—it is of the kind he is employed to perform; (b)— substantially within the authorized time and space limits; (c)— by a purpose to serve the master, and

Look at difference between a detour—where the master is liable (i.e., to get lunch) vs. frolic—where the master is not liable.

(d)—if force is intentionally used by the servant against another, the use of force is not unexpectable by the master—i.e., a bouncer.

*Note: RS doesn’t apply to all cases – only to master/servant relationship

o Master is not liable outside scope of employment unless : § 219 (2)(a): The master intended the conduct/ consequences, or § 219 (2)(b): The master was negligent or reckless, or § 219 (2)(c): The conduct was non-delegable duty of the master, or § 219 (2)(d): The servant purported to act or speak on behalf of the principal and there

was reliance upon apparent authority, or he was aided in accomplishing the tort by the existence of the agency relation.

Rationale for Respondeat Superior: provides incentive for employers to be careful in hiring. Agents do have duties to Principal though. NOTE: In contract, only ER is liable but in tort, ER AND agent could both be liable (i.e. both can be sued )

o Independent contractor not usually agent If principal gives actual authority to IC to purchase supplies from Home Depot on his account, then IC is an

“agent Independent Contractor ” Though principal is liable in K to Home Depot for supplies, it is not liable for torts by “agent IC”

If principal gives no apparent authority to purchase supplies, then hired person is “non-agent Ind. contractor” - principal not liable for actions in K nor tort

4

Hayes v. National Service Industries: Hayes appealed from a decision enforcing the settlement agreement negotiated by her attorney. Court found there was actual implied authority and apparent authority (by position). Georgia law stipulated that when hiring an attorney, client gives attorney plenary authority unless otherwise specified, including settlement (Actual). There was apparent authority by position. Court says it’s because third party relied on agent.

o A better argument is by “placing” the attorney in the position of retained counsel, the client has “told” the other party that the attorney has authority.

o Client recourse to sue attorney for legal malpractice if attorney violated fiduciary duty. o Attorneys: agency relationship (but not servants)

Franchise Relationship:o Agency will arise if the franchisor-principal has the requisite degree of control similar to master/servant relationship over

the franchisee-agent, notwithstanding the customary boilerplate provision in the franchising agreement that the parties do not intend an agency relationship.

If relationship is distant, vicarious liability may arise through non-agent doctrines such as apparent agency or agency by estoppel

Miller v. McDonald’s: A corporation was liable when someone injures herself in a franchised entity. Court found that the relationship relying on: Billops (Del. 1978)—if franchise agreement goes beyond setting standards, and allocates to the franchisor the right to check

its premise & control the daily operations of the franchise, and agency relationship exists. Wood (Ala. 1986)—Shell dealer was required to set up premises in accordance with a plan, have Shell inspect books,

maintain competent staff, but this is not master/servant, because it did not specify how franchisee would meet requirements.

o Agency relationship existed. 2 theories put forth by Court to establish liability:1. Actual agency : examined degree of control McDonald’s had over 3k.

There was intimate day to day involvement. McD sent consultants to inspect 3k2. Apparent agency/authority : Lady went to place b/c it was McDonald’s and she was aware of its general

reputation. Customers don’t walk into the place b/c it is the 3k burger joint. o Apparent agency: § 267“one who represents that another is his servant or other agent and thereby

causes a third person justifiable to rely upon the care or skill of such apparent agent is subject to liability to the third person for harm caused by the lack of care or skill of the one appearing to be a servant or other agent as if he were such.”

Apparent agency is different from apparent authority. o Apparent authority extends actual authorityo Apparent agency creates agency where one didn’t exist before.

o What if franchise agreement stated that 3k was IC? It does not matter—these boilerplate assertions are in every agreement and rather than respecting this language, courts look to actual relationships between parties.

o How Franchisor avoids classification as Master/Servant or Apparent agency: Sacrifice some level of control(less favorable) Give notice to customers: BIG/VISIBLE SIGN Argue that entities are partners.

Making the Sole Proprietorship Grow (60-72) Financing Companies: Debt vs. Equity

o Debt v. Equity: Debt is a limited first claim on cash flow—money that must be repaid with interest. Whereas equity is the right to the remaining cash flow.

o Equity: Equity is ownershipinvestment corp. receives for selling away ownership, stockso Debt: A loan that a business is legally obligated to repay; “renting money.” So, if there is a lean year, the creditors

get profit first. In a risky situation (p. 64), lender

1. might not lend, 2. might charge higher interest rates, 3. make short term loans, 4. have creditor take some control over business,

5

5. give lender a share of profits. There is risk in both debt and equity situations.

o Equity investment is riskier because money is gone forever, but there is an ownership interest, which gives one a share of the profits and a say in how the business is operated.

o If money is called a loan but gives ability to make business decisions, ct. can construe that as an equity investment.

o Hypo: Business needs $100,000 and can get a loan at 10% ($10,000 per year). Another possibility would be taking on a partner in turn getting equity of 50%. Cash flow is $20,000 per year.

If loan/debt, business will make $10,000 per year. If equity, business will make $10,000 per year also (give half of cash flow to partner).

Degree of risk to providers of fund o When borrowing money, creditor is entitled to receive both repayment of the amount borrowed (principal) and

interest. When business fails, creditors must be paid first in full before owners get anything from the businesso If one provides equity funds, the business is not obligated to pay back that amount, but may distribute cash

dividends higher risks, higher potential returns. Degree of risk to the business

o Debt is riskier – if business fails to repay, lender can sue and even force business into bankruptcy o With equity, owner has no right to repayment – selling more equity in times of hardship will not make company

more risky, while borrowing more will. Cost of each to the business

o Debt has fixed cost – pay interest to those funds borrowed o Cost becomes worth a great deal when business does well – the cost to initial owners is large as it has to give part of

that money to investors limited liability corporation – what might lender do to protect itself?

o Require guarantees – if company can’t pay back, owner personally has to pay back, owner may have to guarantee, promise to give back

Loan or partnership? Profit sharing In re Estate of Fenimore: Sister gave money to her brother to help him run a used car business. Agreement states that brother will divide profits with her, and she will pay for costs of loans and he will pay costs of maintaining business. Was this a loan or partnership? Creditors first in line to be paid if bankrupt/insolvent.

o Factors to determine if money is an investment (which might indicate partnership) or a loan: Usually look at preponderance of the evidence.

Profit Sharing is prima facie of partnership (RUPA § 202(C)(3)), unless it’s for:1. payment for debt.2. Wages of EE 3. rent to landlord4. Annuity/retirement/ to widow or representative of a deceased partner.5. Interest on a loan, though the amount of payment vary with the profits of the business.6. Consideration for the sale of the business/ other property

Ability to make decisions. Duty to share liabilities on dissolution. Intent of the parties.

o Ct holds sister made equity investment, so she is partner Creditors, lenders get money before the owners – first in line Owners ,partners, stock holders residual beneficiaries

Martin v. Peyton Payton made loan $2.5 Million of property to firm, and agreed to receive 40%profits, and firm had to consult with Payton on

important matters, and Payton could veto any significant business of the firm Ct held that Payton was not a partner, and distinguished btw active control and reactive control, emphasizing that Peyton

could not initiate any transactions as partners do

The Partnership

Defined : (RUPA § 202) An association of two or more people to carry on as co-owners of a business or profit. Default situation if nothing is done to take on another form regardless of subjective intent.

6

RUPA § 201: A partnership is an entity distinct from its partners.o Partnership is the form of business in the absence of registration o UPA embraces “aggregate theory” – considers partnership not as separate legal person but rather merely the

aggregate of its partners RUPA § 202(b): if you have partnership and you form under another statute, like corp. or llc, then when you do that,

you’re no longer partnership (can’t take on two forms) Partners as Agents: (RUPA § 9)partner is an agent of the partnership and can bind partnership unless (i) partner has

no authority AND (ii)3d party has notice (not waivable)- 3rd parties are able to rely on the fact that a person is a partner. A partner must act in normal course of business

o Characteristics: 1. 2 or more people2. intent to make profit3. unincorporated4. each one brings something to partnership (capital, property, labor, etc.)5. each person co-owns the business6. each can co-manage; right to control business7. each shares in profits and liabilities

profits proportional, if fixed then it may be lender/agent o Why a Partnership?

1. Only taxed when money goes to individuals, single taxation (transparent) whereas in a corporation, there is double taxation.

2. Corporations used to be unavailable to professionals.3. Greater flexibility to create partnerships.4. Inadvertence, people do not know.5. It is “dumb” to do business as partnerships b/c if one person does something wrong, they are all liable.

o Note: A corporation can serve as a partner in a partnership (RUPA §§ 202(a) & 101(10)). Association of two or more persons carrying on business for profit Person means various things, including a corporation and other forms

Legal Problems in Starting a Partnership (76-79) Default Rules: In the absence of a partnership agreement, default rules will apply to fill in the gaps—avoids costs of

hiring lawyers. Oral agreements fine. Partnership Agreements:

o Partnership agreements usually will control. o Lawyer may not want to represent all partners – due to conflict of interest, disagreementso Partners do not have unlimited discretion in discarding default ruleso WHAT PARTNERS CANNOT ------- RUPA § 103(b)

(1) vary rights & duties to filing w/ Sec. of state but can limit duty to provide copies of statements to all partners

(2) unreasonably restrict right of access to books & records (under 403(b) rights to access books & records)

(3) eliminate duty of loyalty (under 404(b) or 603(b)(3) BUT partnership agreement may specify activities that do not violate duty of loyalty if not

unreasonable OR all partners or % as per agreement, may authorize or ratify, after full disclosure of material

facts, a specific act or transaction that would have violated duty of loyalty if otherwise (4) unreasonably reduce duty of care (under 403(c) or 603(b)(3)(5) eliminate obligation of good faith or fair dealing (404(d)) but may prescribe standards by which to

measure performance, but can’t be unreasonable (6) vary power to dissociate as partner (under 602(a)) except to require the notice (under 601(1)) to be in

writing (7) vary right of court to expel partner in the events specified by 601(5)(8) vary requirement to wind up partnership business specified in 801(4), (5), or (6)(9) vary law applicable to limited liability partnership (under 106(b))(10) ***Cannot restrict rights of third parties.

7

Legal Problems in Operating a Partnership (79-92)o Can own property as partnership – your econ interest, whatever the partnership agreement entitles you. o But you cannot have personal interest in asset of partnership. you only share part of partnership, but not assets of

partnership RUPA 501: partner is not co-owner of partnership property and has no interest in partnership property which can

be transferred, either voluntarily or involuntarily It protects partnership property from being taken by a partner’s personal creditors; though they may seek

partner’s transferable interest RUPA 502: only transferable interest of partner in partnership is the partner’s share of profits and losses of

partnership and partner’s right to receive distribution. Interest is personal property. Rights to participate in MANAGEMENT of business, VOTE may NOT be TRANSFERRED

o If you are changing your business property to partnership property– doesn’t happen automatically. It has to be efficiently transferred in agreement

Property: Who owns what? (RUPA §§ 203, 204).o RUPA § 204: If property is acquired in name of partnership, it belongs to partnership and not the partners

individually. (a) partnership property if acquired:

1. in the name of partnership OR 2. partner indicates in instrument transferring title that he is acting in the capacity as partner or

existing partnership (c) assumed partnership property if purchased with partnership assets (d) Property acquired in name of one or partner without indicating that it’s being transferred to

partnership and if acquired through personal asset and not through partnership, then it’s individual property

o * Need to look at title (deed) of property, whose name it’s under, whose asset it was, and whether purchaser was acting as partner

Making Decisions in a Partnership: Among partners and between third parties. § 103, § 401, §301. Look to partnership agreement (RUPA §301) for any specific delegation of authority, then statutes and then common-law agency theory. Can get rid of dispute of disagreement by listing one’s property as partnership property or personal when agreement is made

o RUPA § 401(j): dispute or decisions in ordinary course of business requires majority of partners ; dispute or decisions outside ordinary course of business requires unanimity (major things that change whole partnership).

If a tie occurs, go with status quo (no change) since that’s not majority Unanimity: Adding a new partner, selling business, changing agreement of partnership

o RUPA § 401(f): Each partner has an equal right to management. Exception: Subject to agreement—making someone managing partner OK, not prohibited by 103(b).

Fiduciary Duties in a Partnership (RUPA § 404): RUPA 404 (a): fiduciary duties partner owes to partnership and other partners are duty of loyalty and duty of care

o (b) Duty of Loyalty : Duty to account and hold, as a trustee, any benefit derived in the conduct of partnership. Cannot misappropriate partnership opportunity.

Meinhard v. Salmon: usurpation of a business opportunity Partner is a fiduciary for other partner. Requirement for Disclosure : S breached his duty by not informing M (his partner) of the

opportunity he obtained through his position. S should have disclosed and allowed M the opportunity to buy into opportunity.

Standard of loyalty for those in trust relations is of high degree. Must refrain from competing against partnership.

Hypo: X works in law firm and Y approaches as a friend and requests legal assistance at a reduced rate on X’s own time. X must refrain b/c he would be competing with his own firm under RUPA § 404(b)(3).

RUPA § 404(e): a partner does not violate the duty of loyalty merely by conducting to further his own interests.

8

Arguably, if one partner independently discovered an opportunity separate from the partnership, this would not be a partnership opportunity.

RUPA § 103(b)(3): you cannot completely eliminate duty of loyalty, but they can be modified . o i.e. may allow agreement to identify specific types of activities that do not violate

duty of loyalty if not unreasonable; may ratify specific acts that would otherwise violate duty of loyalty

o Duty of Care : (RUPA § 404c) refraining from engaging in grossly negligent or reckless conduct, intentional misconduct, or knowing violation of the law.

RUPA § 103: cannot unreasonably reduce the duty of care.o Duty of Good Faith and Fair Dealing: (may not be a technical duty) generally applies to those who enter into a

contract with one another, including a partnership agreement. Partner does not violate a duty just by furthering partner’s own interest. RUPA §103(b)(5): the partnership agreement may prescribe standards by which the good faith

and fair dealing of the partners will be measured. Can modify duty of good faith and fair dealing.

Partnership and Partner Liability: A partnership is considered a legal person and as such can be held liable and can sue or be sued. Entity Theory.

o A third party can sue the partnership for contracts that its agents have entered into and for the torts that its agents have committed.

o Ordinary Course of Business RUPA § 301(1): partner is assumed to be agent in ordinary course of business. Any partner can sign K on behalf of partnership for ordinary course of partnership business, and it binds partnership UNLESS that partner lacked the authority AND the person dealing with knew or had received notification that the partner lacked authority.

o Outside of ordinary RUPA 301(2): if act is outside ordinary course of partnership business, the act binds partnership ONLY if it was AUTHORIZED by other partners

Hypo: Cook goes out and buys stove without authority but represents to third party that he does. Does the partnership have to pay? See § 301Yes, Apparent authority principle and partnership is bound. Similar to rule of agency (apparent authority by position).

NOTE: If cook was a partner and breached an agreement the rest of the partnership could sue him for damages.

o Partnership suing partner RUPA § 405: (a) partnership may sue partner for breach of partnership agreement, violation of duty, causing harm (partnership can’t

sue for merely negligent acts of partner that occur in ordinary course of business) If the partner is just regularly negligent, then he has NOT breached a duty to the partnership so the partnership

cannot go after him for contribution. Major difference between. partnership and regular agency relationships:

Agency : principal can sue the agent for contribution if the principal was held vicariously liable for the agent’s ordinary negligence.

Partnership : Partnership cannot sue the partner for contribution if the partnership was held liable for the partners ordinary negligence.

o A partner can sue the partnership to enforce his rights under RUPA or under the partnership agreement. o Joint and Several Liability RUPA § 306: partners are jointly and severally liable for all obligations of partnership arising

during ordinary course of business. i.e. joint and several liability = P is free to sue one or more of the partners (where if only joint liability = P must sue

all partners together in single suit) partnership liable to third party RUPA 305: for loss/ injury caused to another/ penalty as a result of wrongful act/omission

by partner acting in ordinary course of business; partnership liable for misapplication of money received by partner in the ordinary course of partnership business

Judgment against Partnership 307(c):

9

if there’s a judgment against partnership, then judgment can only be satisfied by partnership asset. Can’t go after partner’s individual asset until there is a judgment entered against partner.o Exhaustion Requirement RUPA 307(d): Third party suing a partner may not levy execution against assets of the partner to

satisfy judgment based on claim against partnership unless partner is personally liable (for obligations of partnership) AND partnership is unable to satisfy judgment due to insufficient funds.

Third party must go after the partnership first—A judgment against a partnership may not be satisfied from a partner’s assets unless there is also a judgment against the partner (RUPA § 307(c)).

Third party must show exhaustion of partnership funds first, then go after any partner’s asset (regardless of who tortfeasor was).

o HYPO : partner is going to court (w/in course of business), and on the way, hits someone negligently with his car.

o Victim can sue tort-feasor partner. If judgment entered against partner, then he can get reimbursement from

partnership o OR victim can sue partnership.

Then under 305(a) Partnership is liable for torts of partner acting in the ordinary course of business

o OR victim can sue both tort-feasor partner and partnership Like normal rules for principal-agent rules, agency rules, vicarious

liability Rules of RUPA are same as those for agents in this case

o Can victim also sue non-negligent partner in the partnership? YES 306(a) – all partners are liable jointly & severally for all obligations of

partnership BUT to execute against non-negligent partner’s asset, you have to get judgment

both against partnership & non-negligent partner and show that you have exhausted the assets of the partnership to go after non-negligent partner.

o Third party can execute against asset of negligent partner once obtaining judgment against him (and Pship may indemnify). But for non-negligent partner, you can go after him only if you exhaust assets of partnership first.

HYPO : two partners, waiter & cook. Waiter drops food on client. Can client sue waiter? Yes. Can client sue partnership? yes , tort w/in normal course of business What if suit is only against waiter and waiter loses? Then can ask for reimbursement to

partnership Can P sue against cook too? Cook’s asset is at risk only if partnership does not have enough

money. If there is liability insurance or partnership has lots of assets to satisfy judgment, cook does not have to worry.

o Partners after liability RUPA § 306(b): one admitted as a partner into an existing partnership is not personally liable for any partnership obligation incurred before the person’s admission as a partner.

o Limited Liability Partnership RUPA 306(c): in limited liability partnership, whether act arises in contract or tort, obligation is solely on the partnership. A partner is not personally liable for such partnership obligation for solely being a partner.

o Indemnifying Partner RUPA § 401(c): partnership shall reimburse & indemnify partners for liabilities incurred in the ordinary course of partnership business or for preservation of its business or property (P-ship may indemnify for negligence, but may not for gross negligence)

Hypo: What if a partner drafts a crappy document and partnership gets sued in malpractice…can the partnership come after the partner for contribution? No.

Hypo: What if the partner who drafts a crappy document gets sued individually…is the partnership liable? Yes.

o Aggregate Theory UPA: partnership is viewed as an aggregation of the partners (not an entity)— UPA § 22: partner has right to an accounting(does not have independent right to sue) UPA § 13: partnership is liable for wrongful acts or omissions of a partner acting in the

ordinary course of business for the partnership or with the authority of his copartners. UPA § 14 partnership is bound to make good for a loss due to partner’s wrongful act.

UPA § 15: Partners are jointly (but not severally) liable in contract but jointly and severally liable in tort. Thus, with joint liability, a claimant must sue all partners together

10

Making the Partnership Grow (92-97)

Existing owners & Contributions : Can make further investment as contribution of capital (no statutory requirement that partners make additional contributions). RUPA § 401 (j): absent a provision in partnership agreement, there must be unanimous agreement to contribute additional capital.

for normal course of business = need majority agreement for outside normal = unanimous agreement

o There needs to be unanimity to change partnership agreement - consent from all common partnership agreement contain the following:

vote or events that trigger the obligation to contribute amount of each partner’s contribution obligations time in which to make additional contribution consequences of a failure to contribute

o RUPA 404(f): partner may lend money and transact other business with the partnership

Loan from an outsider : only requires majority agreement in the absence of any provision in partnership agreement—loans part of normal course of business.

o Creditors must go through partnership before getting to partnerso Likely that lenders will request guarantees from individual partners

Additional Owners (new partners) RUPA § 401 (i) : take on another partner in exchange for capital – need Unanimous agreement unless otherwise provided in the partnership agreement

o New partner not personally liable for partnership obligations “incurred before the person’s admission as a partner” RUPA § 306 (b)

o Can’t change the partnership agreement to require only 2/3 votes instead of unanimity, and then add new partners that way – b/c can’t change agreement first without everyone agreeing

Financial issues o Investor will balance risk, and decide to invest if return is high o Measuring investment return:

Comparing amount of cash flow – cash from business operations that could be paid to the business’s owners – with the amount of the owner’s investment in a business

Owner’s risk and “return on equity” are affected by not only business’s cash flow but also by business’s financial structure

The higher the amount of debt a business has, the higher the risk, and the higher the rate of “return on equity” the investor will look for

o “leverage” – use of debt to finance a business / renting money Debt “levers up” the return on equity Leverage helps when times are good, but hurts company when in bad times

o How does partnership decide to distribute money? majority agreement – normal course of business It should decide whether partnership has more lucrative investments, or partners have more lucrative investments

– economic calculus Possible to give distribution from partnership even if there is no profit in that year; it may be money saved

by partnership, collected, or from loans. Possible to have profits but no distribution as well.

Making Money for the Partners (97-113)

o Salary (RUPA § 401(h)): A partner is not entitled to salary for services performed for the partnership, except for reasonable compensation for services rendered in winding up the business of the partnership -- UNLESS PARTNERSHIP AGREEMENT PROVIDES OTHERWISE . To increase salaries, must be unanimous vote RUPA § 401 (j). One can be paid a salary even if he does not work and only invests (there is risk involved with investing—it is not cost-

free).

11

o Profits: Usually distributed equally unless partnership agreement specifies otherwise RUPA § 401(b): Default rule - each partner is entitled to an equal share of the partnership profits, and responsible for

partnership losses in proportion to the partner’s share of profits. RUPA § 401(j): Distributing profits is considered ordinary course of business and therefore only requires majority vote.

o Sale of Ownership Interest to a Third Party RUPA § 502 : Partner can only transfer the interest of partner’s share of profits and losses and its right to receive distributions.

o Partner cannot transfer right to make decisions/management/ right to vote.

o Sale of Ownership Interest Back to the Partnership: “buy-sell” agreements – existing partner selling her partnership interest back to the partnership or other partners;

designed to prevent sale to outsider Even if there is no buy-sell agreement, a partner has power to compel partnership to pay for her partnership

interest by withdrawing from the partnership

Withdrawal (Dissociation) of a Partner

Three different partnership (PShip) types:o Pship At will – indefinite

Unless partnership agreement says otherwise, a partner in a “partnership at will” (a partnership with neither specified end date nor a specific undertaking to complete) can quit at any time without it being wrongful

o PShip For a term – definite, for certain length of time Wrongful if quits before the term

o PShip For a specific undertaking – where there’s some specific task to be achieved by partnership Wrongful if quits before finishing undertaking

RUPA § 802: Partnership Continues After Dissociation only to carry on winding up. But partners do not have to wind up. o Partnership at will partnership dissolves automatically; but dissociating partner may consent, and everyone

agree, to continue on (waives right to dissolve). Dissociating partner gets liquidation value or going concern value

o In partnership term or undertaking it will continue on, unless majority wants to dissolve No need to get consent of wrongfully dissociating partners. Only those dissociating partners whose

dissociation was immediate cause of dissolution (at will dissociating partners) must waive right to have business would up (comment 2)

RUPA § 601—Dissociation: Events that cause dissociation: 1. Partnerships having notice of the partner’s express will to withdraw.2. Occurrence of an event agreed to in the partnership agreement as causing dissociation3. Partner’s expulsion pursuant to partnership agreement4. Partner’s expulsion by unanimous vote of the other partners (and paid econ interest of share) if:

i. It is unlawful to carry on with that partnerii. There has been a transfer of all or substantially all of that partner’s interest, (other than a

transfer for security or a court order charging the partner’s interest which has not been foreclosed).

iii. W/in 90 days after the partnership notifies a corporate partner that it will be expelled because the corporation has filed a certificate of dissolution.

iv. A partnership that is a partner has been dissolved and is being wound-up5. On application by the partnership or a partner; the partner’s expulsion by court order because partner:

i. engaged in wrongful conduct that materially affected the partnershipii. willfully or persistently committed a material breach.

iii. engaged in conduct that makes it unreasonably practical to carry on the business of the partnership with the partner

6. By becoming debtor in bankruptcy; executing assignment for creditors…7. Partners death; court order that partner has become incapable

12

8. Distribution by trust-partner of its entire p-ship interest9. Distribution by an estate-partner of its entire p-ship interest10. Termination of partner not an individual, partnership, corp., trust or estate

Power to Dissociate and Wrongful Dissociation (RUPA § 602): any partner may dissociate (withdraw) at any time—could be rightful or wrongful.

o Wrongful dissociation: if it violates the terms of agreement or under RUPA § 602(b):(1) if it’s in breach of express provision of P-ship agreement OR(2) in P-ship term/ undertaking:

o If partner withdraws before expiration of term/undertaking (unless: w/in 90days ago, there was another partner dissociation through death or under 601(6)-(10) or by wrongful dissociation)

o If partner is expelled by a judicial determination under 601(5) (wrong acts)o If partner is bankrupt ORo If partner is not individual (like corp), and it willfully dissolves or terminates.

Liabilities RUPA 602(c): Partner who wrongfully dissociates is liable to the partnership and to the other partners for damages caused by the dissociation, in addition to any other obligation to other partners (e.g. having to find someone else with partner’s expertise)

o RUPA § 701(c),(h): Damages offset by partner’s owed interest. Disassociating partner doesn’t get paid until term would have run its course (expiration of term/undertaking) unless dissociation partner can prove money or assets are not needed (i.e. P-ship has $$ to pay). If deferred payment, then must secured and bear interest.

Liability upon Dissociation Contracts:

Dissociated Partner’s power to bind partnership RUPA § 702 (a): partnership can be liable for acts of dissociated partner after dissociation for 2yrs, if third party entering K with dissociated partner reasonably believed that he was still partner/ did not have notice/ knowledge of partner’s dissociation (lingering apparent authority).

o 702(b): dissociated partner liable for such damages that partnership incurs under (a). RUPA 704(c) Partnership may file notice of dissociation under then liability shortened to 90

days after statement of dissociation is filed To be safe, partnership should notify all third parties of dissociation

Dissociated partner’s liability to other persons RUPA § 703(a): dissociating partner liable for things before dissociation; not liable after dissociation except for part (b)

703 (b): Lingering liability for certain contractual liabilities If third party reasonably believed that leaving partner was still partner Can only go on for two years HYPO : Liable on a lease or lawsuit of partnership while dissociating partner was still in

partnership? YES Note : rights of 3rd parties cannot be restricted so make sure if you leave partnership you put everyone

on notice.o Torts: incurred after one leaves dissociated partner is not liable.

Business NOT wound up RUPA § 701: a partnership does not automatically dissolve due to a change in its membership, but rather the existing partnership may be continued if the remaining partners elect to buy out the dissociation partner

o Creel v. Lilly (Nascar shop case). Wife of deceased partner wants partnership dissolved.o Under RUPA 601(7)(i) –if you die, causes dissociation o There are situations under RUPA 801 in which you have to dissolve partnership

If at will P-ship: 801(1) states other than 601(2)-(10), so 601(7)(i) doesn’t cause partnership be dissolved automatically anyway

If p-ship term/undertaking: 801(2) states that upon dissociation by death, majority must agree to:

o wind up and terminate, ORo purchase deceased partner’s shares.

13

Not wrongful, so no penalties/damages subtracted Not a partnership term or specific undertaking so estate doesn’t have to wait, can get it

right away o Analysis:

(1) look at partnership agreement…if at will/ term/ undertaking if that doesn’t solve the issue, then (2) look at RUPA § 602(b) to see if this type of dissociation is wrongful if wrongful, then no need to get their

consent to continue business, just majority (3) b/c death is NOT a wrongful dissociation, then look at § 801…if more than half of the remaining partner

wants it wound up, then it would be wound up.

o Methods for valuation RUPA § 701(b): Book Value v. Market ValueLook to greater value: Book Value (same as liquidation value?)—assets of the business, less its liabilities plus partner contributions or

“equity.” Market Value (going-concern value?)—also includes the value of intangibles such as goodwill, ongoing concern

value of the business, established vendor and supplier lines, etc. NOTE: subtract damages if dissociation wrongful.

701(a) – buyout price : after dissociation, partnership is compelled to buy partner’s interest:o Liquidation value – when you sell everything from the business when you shut down business (selling

equipment, stocked supplies)o Going-concern value – you sell business as going business, with the bookstore not shutting down (sell all as a

whole, a running business) o Partner gets the higher of the two – that’s basis of determining how much dissociating partner gets

o If it’s wrongful by dissociation before undertaking/term then need to subtract from the liquidation/going concern value the harmful damages caused by wrongful leaving (and payment may be delayed)

o UPA vocabulary: 1. Dissolution: starts process2. Winding up: process that ends with termination. Includes, liquidating assets, paying of creditors and distributing

remainder to partners.3. Termination: completion of winding up process.

a. Assumes that partnership dies with death of partner automatic dissolutionb. UPA § 38(b): the partners who have not caused dissolution wrongfully, may continue the business if

they all agree to continue and pay the dissolving partner for his interest.

Termination of the Partnership (113-133): o Dissolution is the commencement of winding up process. Winding up entails the selling of its assets, paying its debts,

and distributing the net balance, if any, to the partners in cash according to their interests. When the winding up is complete the partnership entity terminates.

RUPA § 801: Events Causing Dissolution and Winding Up (1)--In a partnership at will, when one partner wants dissolution [other than a partner under 601(2)-(10)]

o if partnership has notice from a partner that he wants to quit, then automatically causes dissolution of partnership

o BUT dissociating partner may consent for p-ship to continue 802(b) with consent of all partners, including withdrawing partner, partnership can continue

Dissociating partner gets liquidation value or going concern value (2)—In an partnership agreed upon term/undertaking.

o If there is dissociation by death/event under 601 (6)-(10) / wrongful dissociation, then majority (at least half) may vote to dissolve the partnership; or to continue partnership.

Wrongful leaving of partner – then gets value, but Subtract damages that dissociation caused, and payment can be delayed with interest

o Express will of all of the partners to wind up the partners to wind up partnership ORo Expiration of the term/undertaking

(3) Previously agreed upon event (in p-ship agreement) ,

14

(4) Event that makes it unlawful to continue, (5) Judicial determination that economic purpose is frustrated, or unreasonable to continue. (6) judicial determination that winding up is equitable, upon transferee’s claim of partner’s transferable rights

Also consider… Partner has made it unreasonable to continue, There are provisions that allow partnership to continue though. partner’s death or withdrawal remaining partners can purchase interest or wind up.

Default provisions at dissolution unless partners agree otherwise: o Shared responsibility equally for losses to 3rd parties and partners’ losses from investments in the partnership -

RUPA § 401(b).o Partner Account RUPA § 401(a): The amount of each partner’s loss from her investment in the partnership is

determined from her partnership account, a bookkeeping device which keeps track of how much a partner puts into the partnership and how much she has taken out of the partnership.

o Costs should be determined at beginning so there is no dispute about land, chattel or labor value at end.o Contribution – you’re letting Pship use money, then you get back at the end when Pship dissolves.

o Price for labor can be added but not under RUPA Kovacik v. Reed -- where one partner contributed capital and the other contributed labor and there

was loss. Ct holds that labor partner doesn’t have to pay the capital partner for the loss of the contribution . Ct holds that labor amounted to capital investment; labor partner lost wages, and capital partner lost his contribution.

RUPA § 401(a): Does not add value of labor to partnership account. Does not count as capital. § 401 rejects Kovacik.

o Partnership Accounts 401(a): how much does each partner get?o Amount invested by each partner. This include capital, property not labor.o (+) Share of the profits.o (+) Other gains, including appreciation (i.e. piece of loaned property appreciates during the term).o (-) share of liabilities. (-) share of losses. (-) distributions. o This can screw over someone who supplies labor and not capital.

Hypo: Partnership Accountso FACTS:

A gives $1 million B gives labor Profits: $200,000 (-) PS buys land for $100,000 (-) Each partner takes $50k distribution (-) $100,000 tort judgment against PS (-) Sold land for $10,000

A BContribution 1 million 0+ Share of Profits 100k 100k- Share of Liabilities -50k -50k- Distributions -50k -50k- Losses -45k -45kAmount Owed 955k (A must get) -45k (B must pay)

o If negative, partner has to pay backo If positive, then gets money

Partner may get more if they invest more, if they’ve had less distributions

Hypo: What if partnership is being wound up and a partner loaned money to the partnership? o RUPA § 404(f): a partner can lend to a partnership.

15

o RUPA § 807(a): Partnership must use partnership assets to pay back outside creditor and partner creditor before distributing (no priority as to which creditor to pay first).

Note: Creditors can sue partners individually (RUPA § 306) – “jointly & severally”HYPO :

o Partners invest the following: C =250K, P =150K, A = 2Ko Distribution: C=150K, P=142K, A= 0

o if no agreement, under default rules, share of profits will be equalo After doing accounting calculation at the end, these are the following on account:

C= 250 – 150 = 100 P = 150 – 142 = 8 A = 2-0 = 2

Assume $200K left in Pship. Appreciated.o There’s more in the partnership than there are in each account o Must get back contribution: C gets 100, P gets 8K, A gets 2K = 110K needed to pay back

200-110= 90K left, so divide equally each get additional 30 + outstanding balance SO C gets 130K, P gets 38K, A gets 32K

What if 20K left? Land seems to have been depreciated C = 100, P = 8K, A= 2K 110K total that they need to get. That means 20K – 110k = - 90K (loss)

o 90K loss must be shared equally: Share the loss each bear 30K losso C= 100k –30k= 70k ; P = 8k – 30 = -22K ; A= 2k – 30k = - 28ko C gets 70K , and P owes 22k, A owes 28k that means C will get what P, A owes

Expulsion: partners can get kicked out, without causing a dissolution. There is a buy-out price that must be met. Any one partner at will can cause Pship to dissolve.

Bohatch v. Butler & Binion (Tx) - P expelled because she informed Pship that there may be overbilling by one partner (whistle blowing ). Ct says that partners have no duty to remain partners. Pship can expel partner unless it’s for some greedy reason, for self-interest (breach of fiduciary duty). What if partner is no longer profitable? Yes, can expel If Expelled & dissociation is not wrongful then she should get her partnership share (going value)

o If all partners don’t want one partner, they can dissolve Pship, or expulsion of that partner If there’s expulsion provision in p-ship agreement, it doesn’t have to be for cause RUPA 601(3) – partner can be dissociated based on p-ship agreement

Expulsion provision (“guillotine” provision) in Pship agreements 601(4) expulsion by unanimous votes in limited circumstances 601(5) Person can be forcefully removed by ct order – list of factors:

Wrongful conduct, Breach of agreement…etc No Freeze out:

o Freeze out – holders of majority interest force minority owner to sell or otherwise give up interest.o A partner may not use adverse pressure to “freeze out” a co-partner and appropriate the business to his own use.

Page v. Page (CA)- D wants to dissolve, because the business finally started making profit after many losses, and there is a new business established that will make lucrative new venture. P argues P-ship at term until it makes profit.

Ct disagrees that p-ship is at term until it makes profit, or else all p-ship would be at term. But holds that P-ship at-will can dissolve at any time, but there’s a fiduciary duty owed to each partner, to protect each partner’s interest.

Pship can leave at anytime, but if there is bad faith, then can’t dissolve Like Meinhardt case, where one partner wanted to leave Pship and take up opportunity by himself

Can’t dump partner once you start making profits. Can’t do that if you’re trying to take advantage of partner. A partner may not dissolve a partnership to gain the benefits of the business for himself, unless he fully compensates his

co-partner for his share of the prospective business opportunity. Bohatch & Page – why different holding?

o Page – violation of duty of loyalty – partner breached fiduciary duty – for personal interest. o Bohatch – voluntary association, other partners don’t want to be partners. Exception – can’t expel partner while

breaching fiduciary duty. But here, found no breach of fiduciary duty.

16

The Corporation

1. Formal Creation : Filing of articles of incorporation.2. Legal Personality : corporation is separate legal entity from its owners . . . efficient and time saving, as there is no need to list

millions of shareholders.3. Separation of Ownership and Control : allows experts to be in control, but may not have the owner’s best interests in mind.

Principal-agent problem here? Possible solution: make the agent also an owner so his interests are affected too. This should provide incentive for agent to make profitable decisions.

o Market for corporate control – disciplines managers in control, need 10% stake of shares to control board o With 10% they can take over company, and replace managers

o Managers may create corp. rules, or procedures to make it hard to oust them4. Indefinite Duration 5. Transferability of Ownership : Can issue shares of stock in primary market—Secondary market is when people resell stocks

(like in NYSE- exchange market) . With a corporation, these rights are freely transferable –liquid (can turn quickly to cash). Note that one can buy economic interest in partner’s shares, but not necessarily the voting rights.

6. Concept of “Limited Liability”: o With partnerships, more risky – because they can lose all their personal assets o Shareholders don’t lose much, except whatever they invested to purchase the shares; they can also diversify their

portfolio Externalizing losses –

Company may lack funds (intentionally make corp. low on funds) – so if there’s a huge predictable cost, like judgment against – they don’t need to pay b/c they have no fund externalize losses

Engage in activities that are risky creditors can’t recover from owners of corporation.

o Creditors may charge higher interests bc of foreseeable risks o But tort victims are the ones with no protection

7. Tax aspects : double-taxationcorporate level and personal level. o Corporate then may want to retains profit rather than distributing – then company’s value goes up. Then

shareholders get to keep that capital gain.o capital gain rate – taxation from share value going up is lower than personal income tax so double taxation, no

big dealo HYPO :

personal tax rate: 60% (so gets 40%) corporate tax rate: 30% (so gets 70%) Pship: 60% (partners in partnership would only pay personal tax, so get 40%)

.7 x .4 = .28 (that’s what shareholders get) With capital gain, If Capital gain = 20% (or gests 80%) then:

.70 x .8 = .56 So SH then they get 56% from paying capital gain tax, compared to 28% (personal) Capital gain tax much lower, better than with partnership taxing. Corp. taxation doesn’t always

mean double tax in negative way.

How do states try to induce corporations to incorporate in their state? o Beware of “race to the bottom”weak constraints on corporations as well as boards of managers. o “race to the top” why would one want to incorporate in a state with tight regulations? Maybe people more likely

to invest if there is a lot of control over managers.o Note: Delaware is where it’s atRules are middle of the road. More developed legal system regarding

corporations & business disputes; good judgesall rooted in choice of law rule.

Sources of Corporate Law: 3. State Statutes: (Modeled on the MBCA) some provisions mandatory and some are default rules subject to change

via articles of incorporation.

17

4. Articles of Incorporation, bylaws and other agreements: Arguably, most important source since default rules can be contracted around.

Articles of incorporation trump bylaws when in conflict. 5. Case law: Cases interpret and apply provisions in corporate statutes and articles and fill in “gaps” to resolve

problems not covered by other sources.6. Federal Statutes: There is no general federal corporation statute, but there are federal statutes that govern

certain corporate activities.

Legal Problems in Starting a Corporation (141-155) Preparing the Necessary Papers: A corporation does not exist until there are articles of incorporation, and the articles of

incorporated have been filed. o MBCA § 2.02(a): What the articles of incorporation must contain

4. name of corp. w/ language indicating it is a corporation (MBCA § 4.01),5. number of authorized shares (max number of shares the corporation is permitted in the

future to sell),6. address of corporation and name of its registered agent,7. name and address of each incorporator.

o MBCA § 2.02(b): What articles of incorporation may set forth. For example, articles of incorporation may alter shareholder and director liability.

Delaware § 102 (parallel provision w/ MBCA § 2.02): Pretty similar, but more info in required regarding shares of stock, and statement of purpose. (Delaware § 106: stipulates existence begins upon filing).

o MBCA § 2.03: Corporation comes to existence once articles filed w/ Sec. of State. o MBCA § 2.06(a): A corporation must adopt by-laws. But state does not require filing of them.

Delaware § 109(a): by-laws not required. But may be adopted & amended by directors (before selling shares), and then shareholders once they buy shares and are entitled to vote.

o MBCA § 2.06(b): By-laws may contain any provision for managing the business and regulating the affairs of the corporation that is not inconsistent with laws or the articles of incorporation.

o MBCA § 7.07(a): (Record Date) Bylaws may fix record date.o MBCA § 7.21(a): (Voting Entitlement of Shares) unless the articles of incorporation provide otherwise, each

outstanding share . . . is entitled to one vote. Articles of Incorporation v. Bylaws: The articles are a contract between the corporation and its shareholders and a

corporation and the state, but bylaws are simply a contract between the corporation and its shareholders.

Contracting Before Incorporating:

o Promoter: someone who acts on behalf of a corporation not yet formed. o All persons acting on behalf of a corporation knowing there is no corporation jointly and severally liable for all liabilities

created while so acting. (MBCA § 2.04).o If promoter thought he had acted on behalf of corp. believing that corp. existed, MBCA 2.04 lets him off the hook

if promoter knows that corp. has not been formed promoter liable if he thought existed but does not actually exists not liable. Agency Rules :

o if undisclosed principal agent liable for K entered (RSA 320)o if principal known to be nonexisting agent liable (RSA 326)

Pro-promoter rule, third party is out of luck o E.g. Promoter accidentally deletes corp. filing online, but thinks it’s submitted and created – not liable

Derivative liability: Other promoters will also be liable for acts of a promoter entering into k knowing that there is no corp. (all jointly and severally liable).

But if there were several promoters, and one thought that there was a corp. formed he is not liable, and promoters are not liable

Hypo : If promoter had 2 other promoters working on behalf of corp. not incorporated yet The instant they work together partnership law applies Partnership law ends once they filed incorporation papers

Individual partners are liable for act of promoters through partnership

18

Corp must adopt K: All liability will rest with the promoter until the corporation is created and corp. adopts such k. A promoter can still be held liable even after the corporation becomes a party thereby serving as a surety for the performance of the corporation’s obligation.

After corp. adopts, are promoters liable? Yes application is still K law, since promoters agreed to K in the first place

“Secret Profit” Ruleo Promoter has duty to disclose to corporation any profit she is making while she was working for promoting

If promoter fails to disclose profit, corporation can recover for “secret profit” – under fiduciary duties that promoter owes to corp.

o There’s NO fiduciary duty and no secret profit liability for one’s pre -incorporation transactions if not promotero When corp. comes to existence, fiduciary duties attach and retroactively prohibit promoter from making secret

profit on her dealings with corp If property gained before S begins work as promoter, and then corp. is formed, and land sold to corp., then

it does not fall under secret profit rule Price paid by promoter, before he was promoter is irrelevant

If property gained while he was promoter, then there’s profit Test for profit: price paid by corp. minus price paid by promoter

How Corporations Raise Money: Get loan from bank Get loans from individuals Issue notes Retaining distribution rather than distributing it to shareholders Distribute earnings and get those distributions as loans of the dividends Issue stocks selling ownerships as stocks

Stock Issuance (MBCA § 6.03) & (Del. § 154): corporation sells its own stock, granting an ownership interest and some degree of control in governing business.

IPO: Initial Public Offering Authorized Shares : number of shares authorized for corp. to issue must be included in Articles of

Incorporation.o All authorized shares do not have to be issued – just a cap.o Corps. generally err on high side of authorized shares in case need develops in futureo Sometimes by keeping # of shares issued small, a corp. can keep the value of share high.

Outstanding Shares: shares corp. has issued and that have not been reacquired by the corp. o Treasury Stock: stock the corporation issued and then reacquired—i.e., held in treasury of corp. and can

be resold. Classes or series of stock: different kinds of stock, established in Articles of Incorporation. Could vary voting

rights, par stock, preferred, common, cumulative, cumulative preferred.o Common stock: normal shareso Preferred: must be paid first—must be stated in Articles. Preferences can be on dividends, liquidation,

redemption rights (right for SH to make corp. buy back share). Also, if company wound up, preferred stock holders get $$ first.

o Par: minimum issuance price, set in Articles (originally to protect SH from dilution) MBCA does not require par price; up to board to decide in states where par is required, many corps. set par so low it doesn’t matter (e.g. $.01). On the secondary market, people can sell shares for as low as they want b/c this is not

considered an “issuance, ” so par value doesn’t apply to them Stated Capital: money derived from issuance of stock, at par value for each stock issued (# of outstanding

shares X par value).o Cannot be used for dividends Designed to protect creditors.

Capital Surplus: extra money above stated capital gained at issuance.o Can be used for dividends.

Stocks split – all share holders get more stocks according to their proportion economic value of their stocks are the same (not affected value)

Payment for stock at issuance:

19

o Majority view (MBCA § 6.21) very broadtangible or intangible property or benefit to the corporation, including future services and promissory notes.

Goodwill OK as intangible property.o Traditional view (still alive in half the states, but declining) is payment for an issuance must be—money,

services already rendered, tangible property. Property: determined by board of directors’ valuation unless they are acting with fraud. Stock Options: count as issuance when they are exercised.

o HYPO: Can board give a CEO $10 million of stock. Yescan issue stock in exchange for services.

What do you get as shareholder?1. Small management rights – get right to vote for several things

o But don’t have a lot of day-to-day power2. Financial interest

o Residual owner of assets if corp. is liquidated, then you only proportion of your shareo Right to dividend o Capital gains when distribution is retained, and value of shares go up

Why would corp. not want to sell all the shares? o When corp. is doing really well, need to share those profits to all those shareholders, leaving less per shareholder

Dilution Less profits for the existing shareholders

Choosing the State of Incorporation and Qualifying as a “Foreign Corporation”

o A corp. can incorporate in any state, even if it has no business activity there. so long as the corp. files as a foreign corpo Articles of incorporation cannot change rights of third partieso Where corp. can be sued depends on personal jurisdiction rules – where state has PJo External dispute : state of incorporation’s laws have no bearing on torts committed by the corp no internal aff. ruleo Internal Affairs Rule – Regardless of where you’re doing business, the internal affairs of the corp. is handled by the laws of

the state of incorporation.o “internal affairs” – procedures for corporate actions and rights & duties of directors, shareholders, and officers.

Describes Right involved in those in the corporation, relations of board & shareholders & corporation. o If it’s NOT internal affairs (e.g., third parties involved, torts, etc.), then this rule does not apply (normal rules on

choice of law apply, as though it was a person who committed the tort).o “Foreign Corporations”: A corporation may be incorporated in Del. And do business in Alabama so long as it files as a

foreign corp. and makes requisite payments.

Liability to Creditors (157-165 & 177-179)

Rationale for Limited Liability : Concept of corporationsit is a separate legal entity and therefore should just have its own liability.

There can be Personal Liability if: o Personal guarantee: voluntary acceptanceo Piercing corporate veil: this is a judicially created doctrine.

Piercing the Corporate Veil: imposes liability upon shareholders otherwise exempt. o No clear doctrine that all cts. apply on PCVo No ct. has ever pierced the corp. veil in a publicly traded company.??

Only applies to closed corporations.

Dewitt Truck Brokers, Inc. v. Ray Flemming - P provided truck services and undertook more business, even though corp. doesn’t have enough assets to pay. D, main shareholder, held liable personally.

o Paid large salaries to himself, disregarded corp. formalities (no board meeting, no records), undercapitalized, no shareholder dividend

o Requirements : Resulting unfairness—injury. (undercaptialization: people who started corp. did not invest enough

money to being with). Stockholders/Corporation simply ignore the rules:

20

Not observing corporate formalities (no board meetings, no records, etc) Ignoring corporate form.

Factors to consider when determining whether to pierce corporate veil: 1. Not observing corp. formalities 2. Substantial ownership by one person

Though this factor by itself is not enough The mere fact that all or almost all of the corporate stock is owned by one individual or a

few individuals will not afford sufficient grounds for disregarding corporateness.Can have a corporation with only one stockholder, who is also a director, and he will not be liable if corp. is properly maintained.

3. Inadequacy of Capitalization (undercapitalization) Obligation to provide adequate capital begins at incorporation and continues thereafter.

o When corp. was Insolvent at time injurious action occurred.o Engaging in acts that it couldn’t finance in the first place

Depends on nature of business 4. Non-payment of dividends

corp. shouldn’t owe $ and still be paying owners.5. Siphoning of funds by dominant stockholder6. Insolvency of debtor corporation at the time action occurred.7. Non-functioning of other officers or directors8. Absence of corporate records9. Corporation is merely a façade for dominant stockholders.

Comingling funds; personal/business accounts Not telling others it’s a corp.

In Re Silicone Gel Breast Implants - Piercing also possible to sue a parent company through a subsidiary.o Bristol the parent corp. of MEC and only shareholder. Controlled most activities of subsidiary, kept it underfunded,

had incorporated financial reports, sold products under its name to market it. MEC didn’t have enough assets later to cover for tort.

o Looked like parent was trying to shield liability and make subsidiary take risk. Factors:

Product displays parent co.’s name Parent makes business decisions Operations not kept separate Common directors or officers; Common business departments Consolidation of financial statements and tax returns Parent finances subsidiary Parent pay expenses Subsidiary receives no business except that of parent Parent uses subsidiary’s property as its own.

o How to avoid PCV: Make corporation look like a distinct entity Hold formal shareholder meetings where things are actually decided. Keep records Leave some money in the corporation

NOTES: May require fraud for contract cases but not in torts

In contract, creditor has willingly transacted business with subsidiary, but could have insisted on assurances to pay by the parent

In tort, the injured party had no such choice – limitations on corporate liability were fortuitous and non-consensual

Courts reluctant to pierce the veil in tort cases and within corporate groups –more common in contract cases, with individual shareholders

21

o Agency liability Corporate subsidiary could act as agent of parent –when both intended that relation to arise –since agency is consensual

This is rarely true, and liability normally must depend upon parent’s direct intervention in the transaction – ignoring subsidiary’s incorporated directors, officers

Sometimes, veil piercing is used to create personal jurisdiction rather than to impose liability Enterprise liability – corps. although separate, are commonly-owned and in reality engaged in one enterprise –

together treated as a single legal entity for purposes of liability (theory not accepted)o Walkovszky v. Carlton (NY 1966)

P was injured when hit by taxicab. Cab was operated by Carlton Corp. Carlton corp.’s asset consisted of 2 cabs not fully paid– all operated of a single garage as

single business, same way, but were separate corp. P claimed that Carlton drained all profits from the companies, leaving them with little assets

Under piercing the corp. veil, court would have pierced through the one corp. and recovered from Carlton himself

Under enterprise liability theory, court would have treated all ten companies as one P would have been able to recover from combined assets of all ten companies

Enterprise liability would pierce the walls of all corps and go after assets of related corps., not the shareholder

Making Decisions (180-207 & 230-252) (Board of Directors and Officers)

Board of Directors: Most shareholders play virtually no role in making decisions regarding the operation of the business. That will be the role of the Board of Directors, which is elected by shareholders.

o Directors are the exclusive executive representatives of the corporation, charged with administration of its internal affairs and the management and use of its assets.

o Directors are NOT AGENTS: board of directors/ individual director of business are NOT treated as agents of the corporation or its members [shareholders].

In a large publicly traded corp., directors don’t engage in day to day management. HYPO: if one director signs K, can it bind corp? NO.

Individual director not agent, has no power to bind alone As a board together, they can vote to sign K and bind corp.

Outside director – directors not from w/in Inside director – directors also holding positions (like managers) inside corp. Interlocking board – same directors serve several corp.s, can create problems

o Role of Board of Directors (MBCA § 8.01) comments: Formulation of Policy Selection of the chief executive officer and other key officers, payment of officers Approval of major/important actions or transactions

o MBCA § 8.01 (every corporation must have a board of directors unless otherwise stipulated in shareholder agreement (MBCA § 7.32)).

SH agreements MBCA 7.32 SH in closed corp. with UNANIMOUS consent can make agreements to: Eliminate board of directors / restrict their power transfer power to SH to manage business & affairs of corp.

o board will be relieved from liabilities to the extent their powers are limited o this agreement doesn’t mean SH will be personally liable for acts

can make decisions about distributions regardless of proportion of shares Establish who board or officers will be and their terms, removal, selection how to exercise voting power by SH and directors about dissolution of corp. upon occurrence of event establishes terms/conditions of any agreement for transfer/use of property

Validity of Agreement under MBCA § 7.32(b): To be valid these agreements must: o (a) be set forth in articles or bylaws(written) and approved by all persons who are shareholders at the

time of the agreement OR o (b) in a written agreement that is signed by all persons who are shareholders at the time of the

agreement and is made known to the corporation.

22

subject to amendment only by all persons who are shareholders at the time of the amendment, unless the agreement provides otherwise

valid for 10 years unless provided otherwise. Notice of such agreement must be noted conspicuously on the front or back of each share.

Officers are agents and can bind corporations acting as board.o Presidents have inherent authority to bind the corp. in the ordinary course of business. I.e., can sign for

loans. o (MBCA § 8.40) Officers are usually hired by the Board of Directors.o (MBCA § 8.41) Look at by-laws to determine what role each officer can have. Officers can hire.

Look to Agency Rules also for roles of officers. o HYPO: Can a VP hire someone?If he has actual express authority (did corp. grant such power)? or apparent

authority by position (normal course, practice for VP)?o HYPO: Who can sign a loan? Not a shareholder . . . nor can a single director, but president (an officer) can,

under apparent authority (even if Board may have told him he can’t)o HYPO : can board hire intern? No, too small decision. Close business on Sunday? YES, major decision, lots of

profits involved. Close/add one store? No. For CEO – smaller decision.

Agreements between Directors that govern their conduct. o Old Rule: Directors may not enter into agreements to limit what actions they will take as directors. See

McQuade v. Stoneham where voting agreement among directors, who were also SH, found to be void Directors have a fiduciary duty to the corporation. Cannot abrogate their independent

judgment. (this is not the rule anymore) Shareholders can’t tie hands of directors their jobs as directors is to use best judgment to

act on behalf of corp. Thus, these agreements are void as per public policy.

o Modern View (MBCA § 7.32) SH can make agreements between themselves - applies only to closed corp. only, and with unanimous consent of all SH.

Liability: Such an agreement shifts liability for acts of omission imposed on directors to the shareholders that entered into such agreement.

Effect on Third Parties: Agreements entered into under §7.32 do not have any binding legal effect on the state, creditors or other third person.

o NY §620: permits closed corporations (few SH) to enter into agreements that control board decisions so long as:

Such provision is in the certificate of incorporation and all Incorporators/holders of shares must have authorized such provision

o DEL § 350: a written agreement among the stockholders of a close corporation holding a majority of the outstanding voting stock entitled to vote is not invalid on the ground that it so relates to the conduct of the business and affairs of the corporation as to restrict or interfere with the power/discretion of the Board.

o Note: The effect of such an agreement shifts liability for managerial acts or omission from the directors to the participating shareholders.

Shareholder’s Decisions Instead of Director’s Decisions:

Villar v. Kernan – oral agreement btw 3 SH not to have salaries but only distribution. Majority SH with approval of board & SH meeting, receives salary. Minority SH complains.

o Ct held that in certain circumstances, there can be agreements among shareholders to limit the boards’ power in closed corps. according to statute –BUT it has to be in writing

7.32(a)(5) could have agreement that sets term 7.32(b) must be in writing, in articles or bylaws, written agreement RATIONALE: If you want to bind the board, it has to be in writing (articles of incorporation, by laws, or

some other written agreement).o minority SH should have known in the beginning and possible that he had gotten discount for minority interest

shares Price capitalized (reflected) risk as minority shareholder

Shareholder’s Decisions about Directors and Cumulative Voting:

23

o Role of Shareholder: making decisions about directors Electing Directors (MBCA § 8.03(c), DE 211(b)) Removing Directors (MBCA § 8.08, DE 141(k)) Note: shareholder’s significance generally increases when moving from publicly held corp. to

closely held corp.o Straight Voting: there is a separate election for each seat on the board and each shareholder gets to cast

her number of shares in any way she desires for each of these separate elections.o Cumulative Voting: There is one at large election, in which shareholders cast votes and each shareholder

gets to “cumulate,” meaning one gets to multiply the number of shares one owns times the number of directors to be elected. Only applies to shareholder’s election or removal or directors (not when voting on other matters).

Formula to elect one director : [NxS/ (D+1)] + 1 = # shares needed to control voting of director (round up to next integer)

N = number of directors shareholder wants to elect S= total number of shares (outstanding) D = total number of director candidates at the election

Hypo: Assume 100 shares total & 1 out of 3 directors to be elected (1 x 100/3 + 1) + 1=26 shares needed to chose who they want

Default Rule: NO cumulative voting

o MBCA § 7.28(b): no cumulative voting unless specified in articles. o Del § 214: cumulative voting to be specified in certificate of incorporation.

Note: Shareholders can join together to gain voting influence. o Removing a Director:

o Del § 141(k), NY Bus. Corp. L. § 706 & MBCA § 8.08: majority SH can remove director with or without cause.

Shareholders’ Voting on Directors’ Decisions on “Fundamental Corporate Changes”:

o These things are not routine business decisions, but profound changes in life of corporation (cumulative voting not available for these decisions)

Shareholder approval is a shareholder reaction, as opposed to shareholder action. Possibility of supermajority approval

o Fundamental Corporate Changes that require SH approval: 1. Amendment of articles of incorporation 2. Dissolution3. Merger with another corporation 4. Sale of all or substantially all of assets of corp.

To succeed a passing of fundamental change, need a majority/ quorum of shareso MBCA 7.25(a) & (c) – SH may take action on matter at meeting only if quorum of SH exist. Unless specified in

articles, quorum is majority of shareholders entitled to vote (quorum = # of members required to transact business legally; usu. majority)

Not all shares have voting rights, depends on what corp. offers as shares HYPO : Who decides when to change line of product (e.g. burrito to chicken rotisserie)?

o Not fundamental change, so shareholders don’t get to voteo Can managers make that change? Probably not alone, issue is not to fundamental change, but important, so may

need board approval

Where Shareholders Vote, and Who Votes: Annual Meetings (MBCA § 7.01) v. Special Meetings (MBCA § 7.02)

o must have yearly meetings or SH may lose limited liability benefit (ct may later say formalities of corp. were not followed)

Record Date 7.07(b): Corporation may fix a record date, but cannot be more than 70 days before meeting.24

o Del. § 213(a) – record date has to be between 10 and 60 days. Managers may try to disenfranchise the power of new shareholders – to avoid that, you can only

set up date for 70days before (for admin. Purposes of conveniences in determining who’s the shareholder owner)

In practice, min10 to max 70days In DE min10 to max60 days

o HYPO : Suppose you buy stock 2 days before annual meeting. Can you vote? NO. min. holding of share is 10days Person who sold share (old owner) can vote then, he would still be record owner.

Record Owner: determined by who owns the share on the record date; has legal right to vote at annual or special meeting of shareholders. Need to look at bylaws for record date.

o If on record date, you’re the owner of share, and can vote. Notice Requirements: corporation required to notify record shareholders of annual and special meetings.

o MBCA § 7.05: notice required NO fewer than 10 NOR more than 60 days before meeting date. o MBCA § 7.20(a): Shareholder’s list guidelines.

Ownership Note: o If SH buy shares through broker-dealer firms, then brokers hold share certificates for buyers – “street

name” owner o Brokers relay changes of corp. to buyers

SH may not be able to vote because: o bought shares that preclude them from voting o Non-record owner (i.e., bought stock after the time set for determining who owns the stock, after record

date). People who own shares before the record date CAN vote, those who own it after the record date,

can’t vote. What if the new buyer who buys after the record date REALLY wants to vote?

o Can receive proxy from the previous owner. Have it in the contract that buyer wants the previous owner to vote a certain way.

o So “record owner” (old owner) appoints new owner as proxy. - i.e. record owner allows buyer to vote in their proxy.

o Proxy: document or agreement whereby the record date owner authorizes someone else to vote a certain way defined by the owner. Proxy holder is an agent (agency rule)

Default Rule: Proxy is revocable. Irrevocable when: coupled with an interest (consideration), and it is stated to be irrevocable.

o E.g. Proxy given as collateral for loan and executed as “irrevocable proxy” then it’s irrevocable, benefit – coupled with interest (plegee)

Examples of irrevocable proxy: (1) a pledgee; (2)a person who purchased or agreed to purchase the shares (i.e., purchased after the record

date; (3) a creditor of the corporation who extended it credit under terms requiring the appointment

(i.e., even if shares are not pledged to a bank, the bank may want some say in how shares are voted b/c of interest in getting principal back from debtor).

(4) an employee of the corporation whose employment contract requires the appointment, or (5) a party to a voting agreement created under § 7.31 (voting trust)

Shareholders’ Inspection Rights under MBCA:o MBCA 7.20(b): shareholder has absolute right to know who other shareholders are (list is made available by corp. after

fixing record date for meeting). If no meeting schedule, then they must show purpose for obtaining SH list. Shareholders often want list of shareholders in circumstances of a proxy fight. SH need info to contact other

shareholders, and ask them for their proxy, to throw out other boards Under MBCA this is automatic right, but under DE Code, you need to request in writing stating proper

purpose (DE 220b)o MBCA § 16.02 – Inspection of Records by Shareholders

SH is entitled to inspect & copy records listed under 16.01(e) which are:

25

articles of incorporation, by-laws, resolution of board relating to shares & interests, shareholder meetings (and records of pas action taken by SH), communication sent to SH (and stuff sent to them like past financial recs), list of directors & officers, annual report filed with sec. of state

SH must meet the following requirements (per 16.02c) to obtain other records (those records listed under 16.02b):1. If SH made demand in good faith & for proper purpose2. With reasonable particularity of purpose & which recs. wanted 3. Records directly connected to SH’s purpose

16.02(b) – not readily accessed, but must meet reqs above such recs include: meetings of board, committee, SH, accounting recs., records of SH.

This Right of Inspection cannot be abolished by the bylaws/articles Hypo : CEO of Pepsi buys a share of Coke stock. CEO demands Coke’s secret formula

from Coke. Can get it? NO, no proper purpose. Kortum v. Webasto (DE) – WAG co. and Magna co. are SH of WSI co.; WAG’s CEO who is director of WSI and also SH

(acting agent of WAG) demands records due to variance of profits. WSI (managed by Magna) refuses bc claims there is conflict of interest and possibility that WAG will compete with WSI.

o Directors’ rights –entitled to look at records reasonably related to his position as director, since he is part of making important decisions as board

DE § 220(d): any director shall have the right to examine the corporation’s stock ledger, list of its stockholders, and other books and records for a purpose reasonably related to the director’s position

Burden: once the director makes a demand, a prima facie showing of entitlement has been made and the burden shifts to the corporation to show why inspection should be denied (for example hostile intent against corporation).

Presumption in favor of directors so long as they establish that its reasonably related Director has duty to inspect – may be required by corp. law WSI has burden to show that inspection by director is for improper reasons

Shareholder’s right – SH has burden to show that inspection is for proper purpose DE § 220(b): Demand + Proper Purpose requirements w/ “preponderance of evidence” standard.

o Must submit written demand under oath. o “Proper purpose” Bona fide requirement (i.e. valuing one’s shares). If your purpose is

reasonably related to interest as a stockholder, you can inspect books. Books and Records sought are “essential and sufficient” to state purpose.

o Burden: The burden is on the shareholder to show a reasonably related purpose. Unlike in cases involving Directors, SH bears the burden of proving that his purpose is proper.

Note: In a closely held corporation, the presumption of validity seems to favor stockholders even if stockholder may be a competitor (See Kortum).

Shareholder’s Voting Agreements: Voting Agreements (MBCA § 7.31): Courts will uphold voting agreements among shareholders through specific

enforcement o Ringling v. Ringling (DE) - Shareholders Ringling (315 shares), Haley (315 shares), and North (370 shares).

R & H had agreed to appoint each other as directors and name another whom both agreed or arbitrator suggested. H decided not to.

Del § 218: allows voting agreements but does not specify what relief is available (nothing about specific performance) – so could go both ways to either to hold for specific performance (revote) or not (to dismiss vote).

(Unlike MBCA 7.31 (b) which states that agreement btw SH is specifically enforceable) Voting Trusts (MBCA § 7.30): Sign over shares to a trustee and the trustee is given

written instructions as to who/how to vote. SH can make agreements among each other and act selfish Ct holds that agreement btw SHs on how to vote is enforceable, but H’s votes are dismissed – in

the end, North gets control of voting as majority SH H & R could have worked together under cumulative voting [4x1000/(7+1)] +1 = 501 need these shares to control voting of directors They had 630 shares together

26

BUSINESS JUDGMENT RULE Business Responsibilities: management to create value for shareholders. Legal Responsibilities: Directors of corp. owe owners fiduciary duty.

Business Judgment Rule: judicial policy that courts will not interfere with business decisions by corporate directors as long as directors are acting with disinterest, good faith, and due diligence

(MBCA § 8.31, 8.42): Codified Business judgment rule – will not hold directors/ officers liable for decisions taken/omitted in good faith, lawful, furtherance of co.

Courts apply a higher level of negligence when reviewing business decisions, much tougher to show than regular negligence.

o Presumption that board is acting in the best interest of corp.o Burden on plaintiff.

o 2 way courts use the business judgment rule: (1) Court won’t even examine whether it’s negligent at all; not the courts role(2) Court will examine the nature of the director’s/manager’s decision, but only find liability if there’s gross negligence.

Rationale: Courts abstain from examining corporate affairs Courts give great deference to corporations. Stockholder’s assign this duty to BOD—assume the risk. Can’t chose what they like and don’t like in every single decision. Ex Poste Facto determination through litigation is a bad alternative to evaluate corporate decisions. Because high risk yields high profit, too harsh judicial review would create risk aversion in business.

You want officers to take risks and be aggressive so they make profit. Stockholders get a bargain when purchasing stocks that public knows has bad officers. Can’t sue that

officers are not making profits, when already knew before purchase. Delegating Duties & Reliance (MBCA § 8.30(c-e)) : directors can rely on officers, employees or committees that it

reasonably believed to be competent and merited confidence, and also rely on financial info presented by such people and any legal accountants with expertise & skills

O unless the director has knowledge that the reliance is unwarranted, Officers MBCA 8.42(a) – An officer, when performing in such capacity, shall act:

(1) in good faith AND(2) w/ the care that a person in like position & circumstance would reasonably exercise AND(3) in a manner the officer reasonably believes to be in the best interests of the corporation.

27

EXCEPTIONS TO BJR

o Violations of duty of care (MBCA 8.30b) No-win situation, grotesque negligence (only in some courts – not in DE)

Wrigley – DE: ct will not second guess business decisions, even if stupido Some cts do not believe there’s ever a no-win situation that will incur

liability Joy v. North -Liability not imposed ‘simply’ on bad judgment, must be gross

Uninformed decisions (recognized in DE) Assumption is that decision was informed Van Gorkum (DE) uninformed decision that amount to gross negligence

Failure of oversight – bad things happening because of their inattention - grotesque duty of ongoing oversight and further investigation 8.31(a)(2)(iv) Barns case - damage and causation must be shown 8.31(b)(1)

Easier to show causation w/ violation of loyalty Caremark - Duty includes to establish reporting system, BUT no need to be perfect

system. McCall – liability only if systematic failure that amounts to grotesque negligence

o Violation duty of loyalty (8.30a)(cts deal much harsher with violation of loyalty)** Conflict of interest

1) Competing o Jones – officers & directors can’t compete with principal

2) Usurping corp. opportunity o Golf case - ALI test

Learned opt. while in capacity as officer/director Learned opt. through company information If opt. closely related to business (only for officers)

If corpt. Opt. must disclose & be authorizedo Broz – DE test

Line of business Financial ability of corp to exploit Interest & expectancy of corp. Whether it would put officer/director in conflict w/ corp.

3) Interested director transactions o HMG – transaction ok if:

Disclosed & approved by disinterested SH/board OR Ds must show fair procedure & fair price

Fraud Stealing/embezzlement

**Rationale: Shareholders expect their directors to take risks, but not to work against the corp. Duty of loyalty violations are harder to catch than failures of duty of care, so you make the penalties large to deter such activity (It’s immoral – it’s just wrong to steal from your company)

o § 8.31 applies only to directors, but § 8.42 is the same rule for managers and officers. DE Code 141(a).o NOTE: Apply above rules to each case involving potential director/officer/manager liability.

1. NO WIN SITUATION

Shlensky v. Wrigley (Incorp. in DE 1968) ct will not question judgment (even if stupid) Minority shareholder brings derivative suit for decisions of directors/management to not have night games scheduled on the

corp. stadium. Wrigley opposes to night games b/c it worries for neighborhood, and wants baseball to be day game.

28

o Ct says that there was no fraud, illegality, or conflict of interest and that it will not second guess business decision . Will not determine whether it was good judgment and defer to business judgment.

DE code applied -internal affairs rule (though if tort claim, then choice of law would apply) In general, minority shareholders get discount for shares knowing that there is majority shareholder that

controls business.

Joy v. North (2nd cir. 1982) stupid grossly negligent decision, so lawsuit proceeds (no BJR) Directors & officers gave loans to very risky business with low interest, no-win situation, huge risk. Corp established special

committee to review allegations after this derivative suit was filed. If decision makers are deciding whether to proceed with suit, then there is conflict of interest.

o So corp. established committee of outside directors who decided not to proceed w/suit Two levels of business judgment rule:

o Whether officers screwed up and exception of BJR applieso The business decision by special committee decides whether lawsuit should proceed

For P to proceed, P must show that exception of BJR applies, and that special committee decision should not be protected under BJR either

Ct holds that possible grotesque negligence, that suit can proceed. Allegations were substantial. o possible that special committee was not independent but were tied to management, so there was conflict of

interest

MBCA 8.31 – guidance when dealing with director liability claims (BJR exceptions are codified)(a) A director shall not be liable unless P establishes that:

(1) no defense applies to director under the articles of incorporation (per 2.02(b)(4) where they can limit liability) or other protections AND(2) the challenged conduct was:

(i) action not in good faith; OR(ii) a decision

(A) which the director did NOT reasonably believe it was in best interests of the corporation (i.e. totally stupid decision)(B) as to which the director was not informed to an extent reasonably appropriate in the circumstances; or

(iii) a lack of objectivity due to the director’s personal relationship with, or a lack of independence due to another person’s control of director (iv) failure to devote attention to ongoing oversight, failure of timely attention, when particular facts and circumstances would have alerted a reasonably attentive director (v) receipt of a financial benefit to which the director was not entitled or other breach of director’s duty to deal fairly that’s actionable

(b) The party seeking to hold the director liable:(1) for money damages, shall also have the burden of establishing that:

(i) harm to the corporation or its shareholders has been suffered, and(ii) the harm suffered was proximately caused by the director’s conduct;

3. UNINFORMED DECISIONS

Smith v. Vangorkom (DE 1985) not informed director, but should have been reasonably informed CEO gave short presentation on board meeting about corp. merging, and then board & CEO decide quickly to sell company

stocks for much lower than its value. Inform SH of low value stocks, and SH approves.o In DE, if there is decision that’s dumb, that’s not enough to hold director liable, but can be sued if they make

uninformed decision o Ct finds that board did not reach informed decision, that its conduct was not logical. Directors unreasonably relied

on this type of information provided by others, did not consult specialists.O determining if informed judgment : whether directors have informed themselves on all material information

reasonably available to them (standard: uninformed that amounts to gross negligence) DE Code141(e) : directors are protected in relying in good faith reports made by officers; directors entitled

to rely on chairman’s opinion of value & adequacy, provided such opinion is reached on sound basis (reasonably believed it could rely on reports & statements)

29

MBCA 8.31(a)2b and 8.30 c,d,e – can rely on report only if it’s reasonable to rely on such information (this language seems to reject Vangorkom holding)

o HYPO : would directors still be sued if share market price was much lower than offered price for merger? There would be a lawsuit if they had not accepted that offer, such a good deal not to accept (traditionally,

court would not have imposed liability on this case, but after this case, DE code imposes that directors look at all info before acting). MBCA language rejects Van Gorkom; enough that obtained reasonable info as deemed appropriate.

3. FAILURE OF OVERSIGHT

Barnes v. Andrews (NY 1924) – failure of oversight, for not paying attention - but no causation (negligence – duty of care) D took office as director, factory erected, but corp. experienced delay due to incompetence of factory manager &

disagreements. P claims that D failed to pay attention to affairs of company, was inattentive to his duties as director.o Ct holds Violation of duty, but no causation proved director not liable

Duty of director must be informed to the reasonable extent D was not well suited by experience for this job, but he can’t be held liable on that account

NOTE : accountant board of directors held to higher standard they are compared with reasonable accountant’s standard

o P failed to show that D’s neglect caused losses to company, that such loss couldn’t be ascertained. P must go further than to show that D should have been more active in his duties P has burden of showing causation that performance by D would have avoided loss, and what loss it

would have avoided “Causation” Complaining shareholder must establish LINK btw director’s bad behavior & corporate loss

o Inattentive directors cannot be held liable for corporate loss if it is shown that proper attentiveness would still not have prevented loss complained of

o If director did something bad, but director shows that there was no damage then lose caseo MBCA 8.31(2)(4) failure of oversight (b)1 need to show causation btw harm & director conduct

Francis v. United Jersey Bank(NJ 1981) – failure of oversight, find causation (misdeed involved duty of loyalty) P widow takes husband’s over corp. with sons as directors, and use up all money from corp. Ct held her estate liable for her

breach of duty of care, which required her to exercise degree of diligence, care, and skill that ordinary prudent person would use in similar circumstances.

o P had to show D’s dereliction caused harm to corp. causation was clear Causation harder to show in violation of duty of care cases (easier to show violation of duty of loyalty

where intentional conducts are involved, like fraud)

4. PERMUTATION OF OVERSIGHT (info system to check EE’s conduct): when EEs involved in fraud, are directors liable if they don’t catch wrongdoing of EEs? Does duty of oversight, does that

require directors to create systems to detect bad things done by underlings of companies?

Graham v. Allis-Chalmers Mfg. Co (Del. 1963) derivative suit, where shareholders claimed that directors breached duty of care by failing to monitor mid-level EEs’ acts of violating fed. antitrust laws. Ct held that directors had not breached their duty

o Board could be responsible only for very broad policy issues, and not for immediate supervision of EEs o Directors not required to set up monitoring system until they had some reason to suspect that EEs were not being

honest (overly sweeping holding) not the rule anymore.

In Re Caremark Inc. Derivative Litigation(DE Ct 1996) failure of oversight, need reasonable sys. EEs involved in giving kickback to doctors. Failure of directors to oversee EEs’ activities that engaged in criminal act

(causation less of problem to prove) – case settled.o In dicta, judge explains about director liability:

BJR in DE –normally in DE, just a dumb decisions by directors do not give rise to liability. Only if there’s been a lack of information or lack of good faith would the directors be liable.

Earlier case: If there’s criminal liability (i.e.) on some underlings, the directors are not liable the first time, but if the underling does it again, then the directors are liable.

30

THIS Court : Directors should set in place information system to catch problems before they occur (NO need to wait until crim. liabilities on EE have been imposed)

The fact that liability of EE resulted from violation of criminal law alone does not create breach of fiduciary duty by directors

Here, directors did have a good system in place, so no liability in that standard. (EEs may be acting to evade system, hard to catch)

Rule : Directors have to set up in good faith a reasonable information system to catch wrongdoings.o Have duty to establish system to attempt in detect wrongful actions of EEs, but don’t need to be perfect

MBCA 8.30, 31 – liability if failure of oversight – model act reflects rule in Caremark Generally, if they have a system, only systematic failure of board to exercise oversight – e.g.

utter failure to attempt to assure reasonably adequate reporting system – will establish lack of good faith that is necessary condition to liability

Here, Corp info system appears to be have been good faith attempt

Sarbanes-Oxley Act duty of care that corp.’s management owes to corp. All corp’s annual financial reports must include that corp. has implemented adequate internal control structure and procedures for financial reporting

McCall v. Scott (incorp. in DE) failure of oversight - if systematic failure, then liability P claims that EEs committed all sorts of fraud because senior managers created unrealistic high expectations that implicitly

permitted fraudulent acts. Claim that conduct was not just negligent, but reckless that came to be intentional acts.o Failure of oversight case – directors should have had mechanism in place

Here, corp had incorporated in articles a waiver of director liability for negligent acts In DE code & MBCA – can’t waive liability of directors for intentional acts

ct finds that facts of this case, that particularized facts are sufficient to allege there was substantial likelihood of director liability for intentional/reckless breach of duty of care

o Level of care of directors there must be utter failure to set up system o if there is systematic failure – then liability imposed

not just negligence need grotesque negligence or intentional act P’s evidence prior experience of directors & officers Given their prior experience, their failure to act was the result of intentional or reckless disregard of the

red flags that warned of the systematic fraudulent practices employed and encouraged by management Board liable if:

o recklessly puts confidence in obviously untrustworthy employeeo has refused to perform his duty as director/ or o has ignored willfully or through inattention obvious danger signs of EE wrongdoing

Duty of Loyalty: Duty of loyalty generally arise when the director:

1. Competes with company 2. Takes for herself a corporate opportunity OR3. Has some personal pecuniary interest in a corp.’s decision

1. Competing

Jones Co., Inc. v. Frank Burke, Jr. (NY 1954) officers competing against ER P’s advertising agency’s company officers, while still employed, began new competing agency and lured away some clients

and EEs. P sued former officers for breach of fiduciary duty for competing with ER.o Ct held Ds as officers, directors, EEs of P corp. fell below standard required by law of one acting as an agent or EE of

another Ds were prohibited from acting in manner inconsistent with his agency and bound to exercise utmost good

faith and loyalty in performance of his duties Ct holds: when you’re still an officer of company, you can’t be officer of another company against the interest of the

principal o Officers should have resigned first, disassociate with corp. before they took new employment o Need to get permission first by corp.

Majority rule – not permitted to compete, unless :

31

Harm to corp. outweighed by benefit that corp. may derive Competition is authorized or ratified following disclosure (by board/shareholders)

What if he’s board of two competing companies? Then need to get permission/waiver from both

2. Usurping a corporate opportunity Like stealing, indirectly taking profit from corp. by taking away from corporation and using for self

o Officer CAN usurp what would otherwise be a corporate opportunity if: (1) disinterested directors approve/ratify it – you would tell directors and ask them if you can take the

opportunity; you’re not allowed to vote since you’re not disinterested. (2) if director takes opportunity w/o asking the directors, you would have to look at ALI test (Harris) to see

if it was corp. opportunity and see if there was disclosure

Northeast Harbor Golf Club, Inc. v. Harris (MN 1995) takes oppt. to buy land for herself President of golf club purchased lots of property around the golf club for herself, and decided to develop subdivision. Claims

that board didn’t show interest and corp. did not have $$ to purchase them. Guth v. Loft case (DE law)

requirements – Corp. opportunity only if o it’s in the same line of business o if corp. has financial ability to exploit that opportunity o the corporation has an interest or expectancy in the opportunity; ando by taking the opportunity for board/officer’s own, the corporate

fiduciary will thereby be placed in a position conflicting with his duties to the corporation

Ct rejects DE law because:o Other corps. may be interested in extending line of business – add diverse business portfolio o Incentive for CEO to take advantageo CEO may run corp. really poorly so that corp. may not be able financially to take oppt. and CEO may take the oppt.

herself Ct adopts ALI test, corp. oppt. if:

1. Learned of through position as officer or director2. Learned of through information from the corporation 3. If it is closely related to corp. business (this third part applies to officers only)

More lenient to outside directors (those only directors not officers) than officers of corp. o Financial component is irrelevant to this rule – don’t need for corp. to be in financial position to take oppt., since

they can raise capital through issuing stocks/ get credit o ALI test focuses on source of info.

First parcel, she was approached as CEO, so learned it through her capacity as officer Second parcel, she found out through golfing with owner -- can also argue she learned through position

o For both opportunities, she would have had to disclose it to board/officers and they would have decided whether to take opportunity

Central feature of ALI test : strict requirement of full disclosure prior to taking oppt. (1) Director/officer must present/disclose corporate opportunity to the directors (corporate

opportunity = broadly defined). (and) (2) Corporate opportunity must be rejected by the corporation, and (3) Either:

o Rejection is fairo Rejection authorized in advance or after disclosure by disinterested directors oro Rejection authorized in advance by disinterested SH

Applying the ALI approach to this case:o (1) Was this a corporate opportunity?

Both properties were revealed to D in her role as President.o (2) Did D disclose it to the directors? No.

32

HYPO : Suppose a director finds out about an opportunity on his own (i.e., not in his capacity as the director). Would he have to run it past the directors?

No, if you follow the ALI rules. If this were an officer, part 3 of the corporate opportunities definition would apply.

Yes, if we apply the Guth test.

Broz v. Cellular Info Systems, Inc (DE 1996) not usurping corp. opportunity (Guth test) Broz (D) is director of CIS but also president & sole SH of RFBC (a competitor). Broz was offered new cable license, and Broz

bought it for RFBC. New owners acquired CIS and claim Broz usurped corp. opportunity & unfair competition Ct applies law in Guth v. Loft

o Line of business Both companies were in same line of business But both located in other parts of country – so amorphous

o Financial ability to exploit CIS were bankrupt and coming out of it (no financial means) When determining of financial corp. you look at the financial condition at that time when oppt. came

along. At that time, new owners had not taken over CIS yet o Interest or expectation

CIS board before acquisition was not interested in this line Irrelevant that new owners wanted this opt., bc they were not owners of CIS at that time

o Taking oppt. Creates awkward conflict for the directors HYPO : How could Broz have avoided this problem? He could have disclosed it to board of CIS

o If boards were disinterested and shareholders were disinterested then Broz could then have taken that opportunity HYPO : If applying ALI – how would the case have come out?

o He learned of oppt. through his position o Info from the corp.o For officers (not directors) Closely related to corp’s business – closely related area

Broz is director would not have been liable under ALI either conflicts if director serves two corps. (shareholders from each corp. may sue the other, or director for not using that oppt.

for their corp.)

3. Interested Director Transaction

HMG/ Courtland Properties v .Gray (DE 1999) interested director transaction Gray & Fieber are directors and have ownership interest in NAF. Fiber discloses his interest and does not participate in

voting, but Gray doesn’t disclose his interest and participates in negotiating transaction. o Claim: Gray has interest in deal, he did not try hard to negotiate with NAF

CT analysis – not liable when:o Sect. 144 DE

1. Disclosure & approved by disinterested directors OR2. Disclosure & approved by disinterested shareholders OR3. Still permitted if fair: fair procedure and fair price (no harm no foul excuse)

o Burden of proof on defendant directors to show the above o presumption interested director’s conduct is NOT fair

NO BJR? NO b/c it involves “interested” directors’ transaction. (so not P who has burden) CT holds – Both liable, have not shown fairness.

o They didn’t disclose to SH/ directors o Fair procedure? NO. Gray was negotiating for his interest – not negotiating to his full potentialo Fair price? NO. Could have gotten better price, possibly.

IF directors had not disclosed, and Gray was not negotiating still may be problem, since they are sitting on the board to vote about whether to enter transaction or not, it affects board decisions

HYPO : What if board member wants to negotiate for his higher salary? o They do not allow the director to vote for their own salary – only disinterested directors voteo Generally compensation committee is established

33

Derivative suit plaintiff is the corporation – shareholders are brining suit on behalf of corp, against officers & directors for harming the

corporation o It permits shareholders to force corporations to sue officer & director o If shareholders win money from derivative suit, the corporation gets the money It increases values of shares

Several reasons for corp. not to proceed with lawsuit o BJR – directors decide not to sue if there are other reasons, such as wanting to keep good business relation with

another corp., not spending money on litigation ct will hold BJR to protect the board’s decisiono What if 2 of 3 board members do something wrong and decide not to allow derivative suit?

If there is conflict of interest, and interested director makes transaction, then ct will not hold BJR for directors. May impose liability.

SO, when there’s a lawsuit against an insider, BJR might not apply b/c of a conflict of interest. When it’s a suit against an outsider, BJR will probably apply.

Direct suit vs. derivative suit? derivative suit if P is trying to vindicate rights of corp.

o harm to corporation o ALL SH must be harmed – i.e. may be direct suit if not all SH harmed (FIRST STEP OF TEST)o BUT even if all SH are harmed, it can be direct suit if corp. is not harmed

e.g. if articles of incorporation are amended so that there is no dividend, all SH are harmed, but it helps corp. – so direct suit

direct suit if they are trying to vindicate their own Shareholder rights.o Harms different SH differently

Analysis If different harm to different shareholders direct suit. If same harm to all shareholders, then:

Look to see if it’s a corporation is harmed, or shareholder’s rights HYPO: A suit to force directors to distribute dividends direct suit ( can use class action device)

o Affects ALL SH but harm is to SH and not to corp. Officers & directors have issued shares to others disregarding SH preemptive rights direct

o Good for some SH, bad for existing SH SH has been denied right to inspect books direct

o Corp. not harmed, so direct suit SH sues directors for giving themselves huge bonus (officers looting treasury) derivative

o All SH have been harmed for directors’ conduct Looting treasury hurts corporation – corp. becomes less valuable since money is depleted, so indirectly

SH’s shares’ value declines If director usurps corp. oppt. derivative

o All SH harmed same. o There’s been first harm to corp. because stolen opportunities, so indirectly harms SH

If bad decision by director derivativeo All SH harmed sameo Hurt corp. because of bad decision– indirectly lowers value of SH

May not be able to win on merits – depending on jurisdictions on how they treat JBR Officer, who is bouncer, hits SH both derivative & direct

o Direct – one SH hurt SH can sue either corp., agent, or both

o Derivative suit CEO’s act harms corp. under respondeat superior corp. will have to pay damages

Values of shares drop as a result, and indirectly hurt SH Hurts all SH equally

If corp. dissolves direct suit, b/c at that point corp. does not exist What if CEO pays huge amount to himself and SH bring derivative suit but they lose? Can corp. sue then?

o NO b/c Preclusion effect Res judicata

34

o Real plaintiff in derivative suit is the corporation. Corp can’t sue again once they lose in derivative suit.

Requirement of Derivative suit: Contemporary ownership requirement – must own share at the time cause of action arose

SH Standing MBCA 7.41 – must be SH at time of act, or through transfer of operation of law [e.g., inheritance /automatic way] from one who was a SH at that time; and adequately represents the interests of the corporation (like class action) HYPO : Lawyer sees in news that corp. is involved in wrong, and buys SH. Can he then bring suit? NO. At the time of

alleged bad deeds lawyer was not SH.o Rationale: stock price at the time SH bought it already reflects the market adjustment in response to the

wrongdoing. Security/bond requirement – need security to cover frivolous claims and pay for D’s attorney fees.

o In NY, only for actions brought by P with less than 5% (or $50k) of shares. If P has more than 5% shares, then this requirement is waived.

if P has only 2% of shares – NY law allows P to get together with other shareholders so that they collectively meet the 5% shares requirement (or pay the bond if they don’t meet requirement)

o MBCA § 7.46 has no requirement of a bond/security in advance. But there is restriction of brining frivolous cases. Fee shifting:

§ 7.46(2) – ct can order P to cover any of D’s reasonable expenses (including attorney’s fees) incurred b/c of the suit.

§ 7.46(1) – if P wins, the money goes to the corporation. In that situation, the corporation can be required to pay the attorney’s fees for the plaintiff.

But this provision might give the board of directors an incentive to pay off the P’s attorney (i.e., drop suit, no judgment, pay to P’s attorney). There’s no one else representing the interests of the SHs besides the P’s attorney.

All statutes require that judge approves the settlement (MBCA 7.45)o Law permits attorney fees if P created substantial value through this lawsuit – on behalf of corp. o Since derivative suit is on behalf of corp., if P wins amount of damages for corp. then court will likely grant attny

fees as well Other shareholders may intervene to represent their own interest

Bringing derivative Suit whether demand is required determines whether case will be dismissed P makes demand , then possibilities are:

1. Corporation takes the suit , and then P is done. Board takes over.2. Corporation may reject demand

NY & DE law : if P makes demand P automatically loses because that means that corp. is allowed to dismiss suit with impunity

rationale : if P submits demand – it is deemed as a concession that board is competent to proceed. The business judgment rule applies. P essentially saying that board has right to decide whether to proceed with lawsuit

SO in DE & NY P never makes demand o They don’t make demand and expect to be excused of making demand

P does NOT make demand o If No demand, then D will make motion to dismiss that P should have made a demand o At this point, Ct may decide:

1. there should have been demand then case dismissed, and P will lose. 2. no demand needed b/c futile then P can proceed

usually cases are settled at this point OR go into litigation OR corp. establishes SLC

3. Corp may establish Special Litigation Committee (SLC) to decide whether lawsuit should proceed SLC may be formed by disinterested existing directors or new directors.

SLC decision is usually respected in NY (BJR) – Auerbach case SLC decision is questioned in DE – Zapata case

35

How does ct decide whether to allow excuse of demand?

Delaware law : P must allege particularized facts that create reasonable doubt that:o Directors are disinterested & independent ANDo Challenged transaction is product of valid exercise of BJR

NY Law : would be futile if:o (1) Majority of directors were “interested,” oro (2) Failure to inform to a reasonably necessary degree about transaction ORo (3) Transaction was so egregious so that BJR should not apply.

NOTE: (2) and (3) just comprise what’s (2) in the DE system above. ALI : universal demand – all should be required to make demand, bright line rule. MBCA 7.42 – no SH may commence suit until written demand made, and 90days expired from demand; or earlier when

demand was rejected; or earlier if there would be irreparable harm by waiting 90days. NOTE : Not enough for P to name all directors as D so that there is always claim of conflict of interest – needs to show more.

o P has to name something more, something substantive about directors to name them as D

Eisenberg v. Flying Tiger Line, Inc. (2nd Cir. 1971) direct suit, no need to put security bond minority SH owners sue because they want to undo merger of airline corp. Minority SH were given shares of another

subsidiary that did not have control of airline corp., so voting power became diluted. Majority SH were not harmed because they were given airline shares.

CT holds that it’s direct suit, and no need to place security bond. o Minority SH were hurt, not majority SH. Can’t tell if corp. was hurt, bc it may run better this way.

Whether demand would have been futile?

Marx v. Akers (NY 1996) interested directors, then futile P filed suit against directors of IBM, claiming that board gave an excessive pay increase to outside directors and executives. P

didn’t make demand, D moved to dismiss for failure to make demand. DE & NY – must show that making demand would have been futile – that directors would not be able to make valid decision

anyway because they have conflict of interesto Rule : demand futile if majority who are making decision to proceed or not are interested, have some conflict of

interest 2 claims by P:

o That insider directors got excessive pay (3 inside directors out of 18 directors) Are the majority of directors able to make disinterested decision? Here, only 3 involved, so other directors could make disinterested decision

P should have demanded that corp. brought suit against them not futile No excuse in making demand b/c hasn’t shown to be futile

o All other directors got excessive pay as well Is demand futile against 15 directors out of 18?

Yes futile, because majority are interested directors. Most that make decision will be interested Claims against 15 directors are futile

o Then claim may possibly proceed BUT ct dismisses claim because there is NY statute that directors can set up their own pay increases, so despite that demand

was futile, P would have lost

Whether to BJR applies to SLC decision?

Auerbach v. Bennett (NY 1979) decide to respect SLC decision, applies BJR if not disinterested 15 directors, where 4 accused that they are doing something bad. They set up SLC of 3 new directors. (old case where P able

to survive motion to dismiss b/c named all directors as Ds, and so no demand required). Corp then set up SLC, and then SLC decided not to proceed with claim.

TEST: 2 part test o Whether members of this committee are interested o Whether SLC had bad procedures

36

So even if they are honest & disinterested, if they didn’t do any investigation or didn’t have good procedures for investigation, then they are not off the hook

Ct found that procedures for investigation seemed appropriate – they created reports, records o As long as SLC committee sets disinterested directors, and they are informed and investigate with appropriate

procedures, then their decision holds (BJR applied) NOTE: does not take into consideration of structural bias – that those in SLC may share same views as

majority and thus, the reason they were appointed

Zapata Corp. v. Maldonado (DE 1981) concerned SLC is tainted, so look into merits of decision Demand not required, so then D establishes SLC – at this time, new board hired to be SLC, and 4 directors left corp . Must

disinterested directors appoint SLC? OR Can the tainted board appoint SLC? o Ct says that existing board are allowed to appoint SLC directors, though they can’t themselves serve the board

test: o Requires good faith and must be independent (whether interested or not)

If interested directors then futile to demand o If they are, then see if there are reasonable procedures for investigation

Then Ct also requires a step further (than in NY) o Ct uses its own independent business judgment to determine the merits of SLC’s decision; will look into other

factors in determining how SLC derived with the decision In response to structural bias and concern that SLC may be tainted

Court gives much less deference to the SLC than NY courts would. (better for P)7.42, 7.44 MBCA - like NY, deference to committee if disinterested (not look into their decisions) Requires universal demand – every P has to make demand If there is no majority disinterested directors, board can appoint disinterested committee that can make disinterested

decisions § 7.44 – Dismissal – Court will dismiss the case if:

o (1) independent directors constituting a quorum votes to dismiss. If no quorum, then:o (2) majority vote of a committee consisting of 2 or more independent directors appointed by majority vote of

independent directors If Ct finds that committee meets the two requirements (that they are disinterested, and have good procedures to

investigate), then ct will not look further into how they came up with the decisiono Everything is the same as in NY but different labels - sounds like New York

Jury Trial In the past, if case arose in ct of equity – then judge; if in law – then jury Now, ct says that you must look at underlying claim – if underlying claim would have been tried by jury, then despite that it’s

a derivative suit, you will get jury (torts, etc.)

What can directors/officers do to avoid liability?1. limit/eliminate their liability to the extent allowed in the articles of incorporation

o Delaware 102(b)(7): may eliminate/ limit personal liability from breach of fiduciary duty as a director, BUT shall NOT eliminate/ limit liability for: breach of duty of loyalty; for acts/omissions not in good faith or which involve intentional misconduct or a knowing violation of law; unlawful payment of dividends/purchase of stock (§ 174); for any transaction from which the director derived an improper personal benefit.

DE adopted this after Van Gorkom case – viewed holding as too harsho MBCA 2.02(b)(4 ) – articles may contain provision that eliminates or limits liability of director to corporation or

SH EXCEPT for: financial benefits that director was not entitled intentional harm violation of excessive/unlawful distribution (8.33) intentional violation of criminal law (ONLY deals with duty of loyalty, but doesn’t allow director to

eliminate duty of care)o Director’s Contract (§ 8.58(a)): agreements to indemnify are appropriate in contracts, but same result can be

achieved without any contract. 2. Board can ask for director/officer insurance MBCA 8.57:

37

o O&D policy; policy such that if you’re director found liable, then insurance will pay for such liability (whether or not corp. is able to indemnify)

o “ Claims Made Coverage”: one must be insured when claim is made rather than when incident occurred. Therefore, a director who ends tenure still wants to be covered even after his time is up. Write this into contract.

Does NOT cover not cover intentional acts (like violation of duty of loyalty) Indemnity may not be helpful when corp. goes bankrupt –b/c P may go after directors/officers. So officers

& directors may want to rely on D&O policies If corp. is bankrupt, P will not want to draft complaint so that if Ds are found liable, that insurance will

cover 3. indemnification in the articles, for liability under duty of care, but can’t indemnify for violation of duty of loyalty.

(rationale: want directors to be able to take some risks, not bad acts) (also MBCA 2.02(b)(5)) Permissible indemnification of directors MBCA 8.51 – corp may indemnify director if he acted in good faith in his

official capacity and reasonably believed it was in the best interest of corp. o No Indemnity in derivative suits against director 8.51(d)1: If there is a derivative suit against director,

then director cannot be reimbursed for actual judgment, only for reasonable expenses (e.g. attny fee) if he acted in good faith…

Rationale: If P wins in a derivative suit, it’s like the corp. wins, since it’s the corp.’s right that was vindicated. If the corp. can just give the money back to the director, that would eviscerate this whole process.

But director may be covered under insurance policy Mandatory Indemnification of directors MBCA 8.52 – corp. shall indemnify director (or officer) who was successful

on the merits OR otherwise Reasonable expenses – including attorney fees

HYPO: What if officer is accused of fraud, of stealing from corp. with substantial evidence, but still wins case on technicality?

He won “otherwise,” so he gets automatic indemnity. If he doesn’t win, then corp. does NOT have to indemnify

HYPO : What if director engaged in fraud for the corp., to save corp. from bankruptcy? Corp. can’t indemnify for criminal act 8.56a2iii

But if civil fraud – then maybe (see if there is good faith, for the benefit of corporation)

IF in criminal proceeding, director reasonably didn’t know it was criminal act, then corp. may indemnify 8.51a1(iii)

MBCA 8.56 – indemnification for officers: A corporation may indemnify an officer of the corporation except for liability arising out of conduct that constitutes (violation of duty of loyalty):

(i) receipt by him of a financial benefit to which he is not entitled,(ii) an intentional infliction of harm on the corporation or the shareholders, or(iii) an intentional violation of criminal law.

o Can’t indemnify for violation of duty of loyalty, but may for violation of care

The Corporation-GrowthA. Borrowing Money (393-394) B. Issuing Stock (Intro to 10b-5) (394-421)

Preemptive Rights: to avoid having shares diluted and lose control of corp. (voting power), include preemptive rights to articles of incorporation so if company is going to issue more stock, give preexisting shareholders rights to buy proportional shares.

MBCA 6.30: No preemptive rights unless stated in the articles (default)o Preemptive right is a choice – if SH can’t afford, then doesn’t get them

If share values are too expensive, may still benefit SH b/c that means their existing shares went up value as well

o Preemptive rights apply only to new offerings by company, not in secondary market – sales of existing shares are not affected by preemptive rights

E.g. if on SH wants to sell her shares, others can’t claim that they have the right to be offered those shares bc of preemptive rights, since not applicable for secondary market

o More common in closed corps. to have preemptive right. W/ public traded corps., too expensive to contact all SH and offer new shares

38

o Closed Corporation: 1) Very few shareholders.2) No public market for the shares (no liquidity).3) SH help run corp./ involved in management

Fiduciary Duty: Some cts may prevent corps. from eliminating preemptive rights (See Vivadelli).o Byelick v. Vivadelli (VA 1999) breach of fiduciary if majority SH sell many shares to themselves

Majority SH changed bylaws to eliminate preemptive rights and issued more shares to themselves at almost no value, diluting shares of minority SH.

Not a problem to change bylaws, since majority of SH/ directors can do that (SH can enter into agreements like in Ringling case)

o BUT by issuing shares to themselves, they breached fiduciary duty – there’s a conflict transaction (sold shares to themselves at low price), so BJR does not apply. (exception to BJR breach of duty of loyalty)

o Even when no preemptive rights are not provided for in a closed corporation, a director’s fiduciary duty in a closed corporation nonetheless constrains the issuance of shares if purpose is to affect control and not raise capital.

o Some cts hold that in a closed corp, then you have fiduciary duty as in Partnership (Meinhardt) MA law recognizes this duty – Donahue case v. Rodd Electrotype Co.

Trust & confidence essential to this scale and manner of enterprise, and due to inherent danger to minority interests in closed corp. – stockholders owe one another substantially same fiduciary duty as partners owe

Price of Shares capitalize for their valueo DE law you’re not protected because as SH, you probably got discount when buying shares. Shares will be

lower because you’re relying on good faith of Majority SH that they may not rip you off o In MA – shares will be higher because you’re protected by fiduciary duty to SH

C. Venture Capitalists: group or often company that gets money from other investors and uses it for investments – chooses companies that they think will thrive and invest in those companies

o Companies unable to seek financing by other means seek VC (most Cos. are unstable & risky) VC is source of money VC gets stocks VC may become directors of the corp.

o Start-ups generally are required to give up a piece of the business to get financing(equity financing= fancy term for VC)o VC usually demand high returns bc of the riskiness o Downside protection :

o liquidation preferences – VC must be paid if co. assets are sold offo upside protection :

o right to acquire additional shares at predetermined priceo Voting/veto rightso exit opportunities – redemption right to sell shares back to co.

D. Private Placement: try to get private investors. Main way of selling shares & bonds (rather than public)

No need to register with SEC - registration is costly and time consuming SEC Fraud Requirements Apply (though don’t have to comply with all disclosure requirements). Market value: price per share X # of shares

E. Public Offering (IPO): sell new shares when going public, existing owners sell their shares IPO shares may go up in price b/c of high expectations or bc of UW underpricing (worry about risk of not selling, if

restrictions that they can’t flip if sticky stock; or to get future clients ) Must register offering with SEC and follow disclosure requirements

o Registration for public offering: 1) prospectus: “selling” document2) additional info so that disclosure is complete and not misleading.

SEC does not determine merit of corp. but looks to see if in compliance Need to balance number of shares offered – if too little, then unable to cushion hard times; if too much, then owner

may dilute all his shares

39

10b-5 Anti-Fraud Provisions in ’33, ’34 Act: o It shall be unlawful for any person by use of any instrumentality of interstate commerce to defraud in

connection with purchase or sale of security is illegal, including misleading statements and omissions; Omitting statements/not revealing are not enough to impose liability There has to be a statement initially for which any other omission of statements will mislead someone

if not disclosed.o If this rule doesn’t apply, then they can use background law – common law fraud

Common law – need to show person relied on that person (not for 10b-5)

HYPO : Telling them that they’ve gotten VG rating when it’s false – fraud under both 10b-5 & common law Telling them that they never got Bad rating ever, but know that they’re about to receive Bad rating

o Not common law fraud to omito Violation 10b-5 – there’s affirmative duty to disclose, to not mislead

What if buyer wants to know about health reports, and CEO tries to change subject and does not tell? o Not common law fraud o NOT Violation 10b-5 – there has to be statement initially, for which omission will mislead. Here there is no

initial statement. If property owner lies and company buys property by paying with stock? Still covered under 10b-5.

o “in connection with purchase or sale of any security” o Not only applies to seller ripping off buyer, but also buyer ripping off seller

Debt v. Equity (421-422) Debt (loans) : will often be the most attractive way to raise money b/c it is often cheaper—determined by interest

rates. But if a business does not take in enough money to pay interest in a given year, they will be forced to bankruptcy

Increased risk if default loan But tax incentives – interest paid on loans are tax deductible, while dividend payments to SH are not

tax deductible Issuing Stock (Equity): Costs of issuing stock more expensive than loans.

Arguably cheaper, but at the same time, issuing stock is dilution of ownership. COSTS: More dilution (more stock issued) the less money you get to retain as an owner.

G. Using Earnings (422) Retained earnings: (do not borrow any money or issue stock. Keep money in corporation).

Consider opportunity cost of the money if it were distributed and invested by the shareholder.

Closed/private corporations How do SH make money?

Receiving Salaries: salaries are principal return on investment in close corporations and shareholders do not have to be paid equally/ in proportion to ownership. (often don’t get dividends but only salary)

Tax incentive: Salaries are deductible expenses, but dividends are not. Close corporations are more likely to distribute through really high salaries.

Who Decides on Salaries (MBCA § 8.01): board of directors authorized to manage the business and affairs of the corporation.

This includes the decision of what salaries to pay its shareholders Minority SH : risky, less protection

Freeze out – when oppressing minority SH, by some choices that hurt minority SH, making them sell their shares

Force out – Removing minority SH, engage in transactions that eliminate minority SH from corporation (mergers & other maneuvers)

Squeeze out – does mean stuff to minority SH (includes both) What can be done? MBCA 7.32(a)1 make agreements (decide who officers, boards will be, etc.) in

advance and put them in articles to protect minority – as long as other SH agree to it

40

§ 7.32(a)(5): establish terms and conditions of any agreement for the transfer or use of property or the provision of services between the corporation and any shareholder, director, officer or employee of the corp. or among any of them.

Default rules in closed corporation if there is oppression: Oppression = when corp. departs from standards of good faith and fair dealing (i.e., violation of fiduciary duty) Ct may hold:

1. Dissolution – MBCA 14.3 (not in DE)2. Forced buyout 3. Breach of fiduciary duty

Wilkes v. Springdale nursing home – MA law recognizes fiduciary dutyo There was agreement unwritten that each would get salaries but 3 of 4 directors removed the 4th

director o CT said there was fiduciary duty as controlling SH, just like in partnership

if harming minority SH, they have to show that there is legitimate business purpose If D shows BJR – minority SH can argue that they could have chosen another alternative

that did less damaging to obtain remedy, P must prove damage

Business Judgment Rule: Typically, “oppressive acts” would be shielded from judicial scrutiny via business judgment rule, but courts recognize unique opportunities for abuse in close corporations and courts will examine business decisions

Dividends not the same as salary o Board determines salaries – majority decides – BJRo Must be careful about not giving excessive salaries – may look like tax evasion

o IRS would go after them if salaries are unreasonable and consume all net income of corp., b/c looks like a dividend

Hollis v. Hill (5th Cir. 2000) SH salary cut off, then fired. – applies fiduciary duty for closed corp. Hill & Hollis did business together – each had 50%. Hill president, Hollis VP.

o Hill oppresses Hollis – fires his wife, reduces his salary, then later gives him no salary, then fired Ct followed MA for Nevada– breach of fiduciary duty – treat like partnership (based on Meinherdt case)

o Did not want to follow DE law – where they would treat like public corp. and say no fiduciary duty (would have needed agreement if SH wanted to be protected)

In a public corp., BJR would apply unless it falls in one of the exceptions Ct held that there was no legitimate business purpose to fire P, so P can recover.

o Remedy: buy- out at fair price (value of share calculated at the time when claim is filed)

EXACTO Spring v. Commission of Internal Revenue (7th Cir. 1999) – IRS arguing too high salaries IRS brings case against closed corp. with CEO given huge salaries – claim that they are dividends Indirect market test : the higher the rate of return that a manager can generate, the greater the salary he can command.

Whether SH got what they expected (return on investment)?o CT said that this corp. was more profitable in the industry than others; the corp. was doing well, even for

SH, so the salary seemed fair Whether SH/board approving were disinterested

o BJR applies – unless conflict of interest If CEO raises his own salary (interested director/officer) ,then burden on CEO to show

that this salary is reasonable Ct finds salary not excessive and NO conflict b/c CEO salary was decided by other disinterested SH

Giannotti v. Hamway (VA 1990) interested directors w/ excessive salaries to themselves (no BJR) Claim that D gave themselves too high salaries. Salaries were established by themselves as directors, there was no

committee to set up. P seeks dissolution of corp.o Analysis: there is conflict of interest, so no BJR – they are interested directors

burden is shifted to D to show that transaction is fair (i.e. D does not automatically lose) Ct has the full power to liquidate assets of corp in any action by a SH when it is established: (i) that the acts of the directors

(those in control) are illegal, oppressive or fraudulent or (ii) that the corp. assets are being misapplied or wasted.

41

o Can look at the work, experience, and complexity to determine whether the salaries are exorbitant Ct finds that there was waste, corp. could have been more profitable, and Ds didn’t do much work

Coase Theorem (Re: Oppression Suits): If P is entitled to shutting down corporation (mandatory dissolution) that does not necessarily mean corporation will be shut down. P gets power to bargain.

Dividends: Definition distribution of 1.40(6) – transfer to money in respect to each share; only exists not because of services, but

because of owning shares) - does not govern salarieso Mature industries more likely to pay dividends where developing companies might find it more beneficial to

reinvest.o In closed corp. lower dividends, higher salaries – tax advantage o Retained earnings - Corp. can withhold dividends for investments purposes which will indirectly profit SH by capital

appreciation Why would a CEO tend to have a bias toward retaining earnings? Stock Options of CEORetaining lots of

earnings will increase value of corporation and CEO’s own stock will become more valuable.

Question of whether to distribute dividends – question of BJR o BJR applies to decisions to give dividends unless there is a conflict of interest or self dealing.o In closed corps. there will be some protection for oppressive transactions by majority SHo In all states, there are some restrictions

2 approaches: 1. MBCA 6.40(c) (modern approach) Situation in which corp. prohibited to issue dividends

1. If corporation can’t pay it’s debt (6.40c1)2. If corp. makes assets less than liabilities plus amount needed to pay back if there was a

dissolution (to pay back preferential SH rights)(6.40c2) NEED MORE ASSETS THAN LIABILITIES Even if you have a lot of assets, if they can’t pay debts because assets are

illiquid, then they can’t issue dividends It protects creditors to be paid back MBCA § 8.33: if in violation of distribution rules, directors that made decision to

distribute can be personally liable, and SH may be asked to return money if they knew about the above when they accepted. NOTE: Directors will often have insurance.

2. DE law 170 (traditional approach) – dividends only out of surplus (nimble dividend)OR net profits

o Can distribute dividends from capital surplus or earned surplus Earned surplus: value generated by business (all profits minus all loses minus

distributions previously paid). An earned surplus would indicate business is making money and may be used to pay distribution.

Stated capital: generated by sale of par value stock cannot be used for distribution. (amount of par value allocated to stated capital) Capital surplus: generated by sale of stock can be used for distribution (excess of par price per share goes into capital surplus)o notice : when making a dividend out of these funds, the corporation must inform

the shareholders. default rule: in DE if there is no par value set, then all goes to stated capital unless

corp. says otherwise. (i.e. if they decide to have par value)

HYPOs: Assets 20K, Liabilities 15K Shareholder Equity 5K. Can corporation distribute 4k in dividends?

o Under MBCA, yes. More assets than liabilities after distribution. o what if there are preferences so that preferred stock owners would get 10K? No distribution to common

stockholders possible here. Preferences are treated like liabilities. Preferred Stock : might provide preferences on dissolution. But lender will still get the money first.

Issued shares = 1,000, par value = $1, each share = $3, retained earnings (earned surplus) = $2k

42

o Then, stated capital = $1,000 and capital surplus = $2,000. Under DE rule, only able to distribute 4K ($2k from earned surplus and $2k from capital surplus). NOTE: Under the MBCA standard, they would be able to distribute $5k if no liabilities

Assets 1K, SH equity 1k, liabilities 0 (SH equity = assets – liability) Stated capital 1 Under MBCA: can give 1K to SH No dividend

Why Limitations on Dividends? To protect creditors. Additional ways to protect lenders, in initial agreement, restrict dividend, make directors personally liable (guarantee loans), high interest.

Why stock splits? o “sweet spot” for share prices: People may not be able to afford $150/share, but $25/share may be affordable to more

investors. Stock dividend – get more stocks as dividends. Doesn’t do any good, you still get same proportion of shares – nothing that’s

of economic increase.o MBCA 1.40 – distribution does not include salaries, or dividend of stocks

Not declaring dividends in BAD faith (See Zidell)o Zidell v. Zidell (date???)

P was minority shareholder and employee. P wanted increase salary, but was denied by majority SHs. P quit and was receiving no salary, so he demands an increase in dividends. P argued that company was doing well, and could afford more dividends. P was able to argue conflict of interest (so no BJR), but Ds were able to show that their decision to retain

earnings was reasonable.o P may have succeeded by showing that all other employees/directors enjoyed exorbitant salaries, which

may indicate that they were funneling money away from minority SHs to majority SHs. ( But such was not the case here)

o P has the burden of proving bad faith by the directors in determining the amount of corporate dividends. Elements of bad faith: must be the motivating factor.

Hostility between minority and majority shareholders Exclusion of minority from employment High salaries, bonuses, or corporate loans to officers in control. Desire by majority shareholder to acquire the minority stock interests as cheaply as possible

o HYPO: What if 2 classes of stock; One class owned by majority and the other by minority. What if majority decides that their class is going to receive dividends, but minority gets nothing. There is a conflict of interest here—exception to business judgment rule.

o Corps. generally will not be faulted for declaring too little dividends (exception is Ford vs. Dodge). Ford paid high salaries and low dividends because he wanted his EEs to be loyal. But Ford’s claim was based on how

they wanted to make cheap cars. Ct held not good reason, no BJR.o Efficiency Wage Theory:

Suppose market wage for babysitter is $10/hour. Why would I voluntarily pay $13/hour? If I pay them above the market wage, they will want to work for me again so it would reduce their incentive to steal stuff from me and increase their incentive to work harder/better.

Tests to review corporate decision on dividends--complaints that corporation paid too much in dividends (See Sinclair) Sinclair v. Levien (date ???) all SH got huge dividends, if all benefits, then no BJR.

Sinclair was majority shareholder of Sinven. Sinven’s directors were officers/EE of Sinclair. These directors approved a huge dividend issuance (allegedly to send money to Sinclair). Minority SHs sue, stating that Sinclair violated duty of loyalty to Sinven by preventing Sinven from taking opportunities to grow. (Note: derivative suit, bc hurting the corp. Not direct suit)

BJR applied in situations where there is no self-dealing Ct holds that if everyone gets same dividend, everyone benefits – so no self-dealing

There would be conflict of interest if Sinclair had only given itself dividends (maybe bc they held preferred stocks) and left out minority SH self dealing. Then D would have burden to prove that their decision was fair.

o Intrinsic Fairness Test: If there is a conflict of interest, BJR not applied(Directors must defend their actions under the Intrinsic

fairness test

43

Court looks at the overall fairness of the decision Procedural review Substantive review

Classes of Stock : dividend implications Articles can set up different classes of stock and determine who gets paid.

Common stock : residual category of stock Preferred stock : must be defined in articles. Holders get paid first with regard to some category (does not

necessarily mean pay more). Preferences include: Dissolution preferences Dividend preferences

Preferred participating : holder gets paid first, then again with the common shares Preferred cumulative : holder accumulates rights from year to year regardless of whether dividend is declared until

all it’s paid. (usu. preferred stocks are coupled with cumulative or participating) If noncumulative, the common SH may want to withhold dividends, and then issue total all together – then

preferred only get the amount of their preferred share, and common get the rest, don’t want that HYPO1: Class 1 = 5,000 shares of common stock Class 2 = 3000 shares of preferred stock @ $3/share preference ($9k) If 9,000 distributed, then only preferred stock get something HYPO 2: If 49k total to be distributed, 5k common share, 3k preferred @ $3 each Pref = 9K Common = 40KHYPO 3: What if pref. participating? $40k/8k (class1 + class2) = $5K Preferred participating = 9K(preferred) + 5k Common = $5k/ share

Mutual fundso Index funds – portfolio constructed to match/track market index (e.g. Standard & Poor 500)o Survivorship bias – tendency by mutual funds co. to drop funds with poor performance and only include those

successful to show current success. How to determine value of share? See where/how much people would want to invest, pay

(1) Rise in interest rates – would decrease value of shares. (2) filing with SEC, past earnings (3) Investment advisors, brokers used by issuer

o Efficient Capital Market Hypothesis: Price accurately reflects all of publicly available information. Price fluctuates according to info available to public.

44

Reliability of Information Elements of a 10b-5 claim Standing:

1) Private cause of action and 2) in connection actual sale or purchase of a security

Misstatement or Omission of Material Fact: must be material1) Materiality: factual analysis

o Is there substantial likelihood that a reasonable investor think this info was important (usu. affects price of stock); OR

o Did it significantly alter the mix of info available on the market.o Does NOT have to actually affect decisiono Mere puffery not enough

Contingent Events: merger negotiations likely speculative. o depends on the probability that the transaction will occur; o anticipated magnitude of the event in totality with corp.

o need balance – one less the more the other Note: mergers will likely become material earlier for small companies. (See Basic).

2) Forward looking statements: An issuer is not liable for a forward looking statement if it is identified as forward looking and is accompanied by cautionary statements.

Rationale: Encouraging predictions increases amount of info available to public.3) Bespeaks caution doctrine: For forward looking statements, cautionary language if sufficient (must be

directly related and specific) – Common law doctrine Rationale: Someone should not be able to sue just because a prediction does not come true. Can’t be boiler plate language, but must be specific, detailed and tailored to the forward

looking statements Scienter: must be intent to deceive (most courts allow gross negligence to satisfy), must plead with

particularity in the notice pleading. (if CEO said something by mistake, then not liable under 10b-5) Reliance / Transaction Causation:

1) Fraud on the Market Theory: Price of a company’s stock is determined by available material info regarding company and its business. Misleading statements will defraud purchasers of stock even if the purchasers do not directly rely on the misstatements.

No need for actual reliance : It is appropriate to apply a presumption of reliance supported by the fraud on the market theory, the presumption however is rebuttable.

Damages / Loss Causation: injury—but, for (misstatements causing loss, not natural forces, or bad economy) Must be interstate commerce: Jurisdictional nexus w/ 10b-5

1) (See Dupuy) a deal need not traverse state lines. It need only touch interstate commerce(mail, phone, internet, national stock exchange or check). Liberal reading to achieve comprehensive statutory scheme.

Cash transaction with guy next door not likely to invoke 10b-5

Basic Inc. v. Levinson (U.S. 1988)o P sold stocks before merger because CEO negated any merger talks. If people think that there’s an upcoming merger,

they are willing to pay more for the stock, b/c mergers tend to drive stock prices up of the target corp. Issue: material to lie to negate merger talks?

o Does it significantly alter the total mix of information for a reasonable investor o If event is contingent or speculative in nature, materiality will depend upon a balancing of the following

factors: (1) The indicated probability that the event will occur AND (2) The anticipated magnitude of the event in light of the totality of the company activity.

o Merger didn’t seem too certain but magnitude was huge, so materialLittle deal High deal

Low prob NO material Maybe High prob Maybe Yes material

Reliance/Transaction Causation Many people may not have relied on the statements. But ct finds that even if a SH may not have changed

decision, that this info was important, and SH would have wanted to know.

45

significant price change when info was revealed strong indication that this information was important

if there’s no significant price change when info revealed may or may not be significant, doesn’t necessarily matter that there was no change to determine materiality (price may have been fully capitalized before official announcement)

Fraud on the market theory applied. This is a rebuttable presumption. D could rebut this presumption by showing that everyone in the market KNEW that the statements were lies .

EP Medsystem v. Echocath D issued IPO, and told P (investor corp.) that there were talks with other corps and contracts to sell equipment were

“imminent.” In registration docs, they had disclaimers on how negotiation talks may not materialize. There were no talks about contracts. P Sued in state court – not 10b-5 (fed court)

o Statements in registration are w/in safe harbor if accompanied with cautionary language o Ct doesn’t find that they are forward looking statement – they are historical statements , current state of

discussions – cannot be subject of bespeak doctrine Even if they were forward looking, later made statements also had to be followed with cautionary

statements. Not enough to just put them in IPO registration docs.o Pleading fraud must plead fraud with particularity (FRCP 9)o Reliance claim P must show but-for the false statement, he wouldn’t have invested in these securities – P must

show that statements were material (here, the transaction was face to face – cannot rely on presumption of fraud on the market theory)

o Must show damage & loss causation. PSLRA (Private Securities Litigation Act 1995) – the private securities law, identical bespeak caution doctrine in statute (it’s

not applied so broadly as the common law doctrine. Designed to make it harder to bring fraud suits)

State Claim: Shareholder Does Not Sell B/C Corporation Overstated Earnings: State Securities Laws You can’t bring a Rule 10b-5 claim in state court. You CAN bring both a state fraud claim and a 10b-

5 claim in FED court. D may try to have the court dismiss the federal claims to get the state claim also dismissed (pendant state claim).

10b-5 does not protect shareholders who do not buy or sell in the face of a false or misleading statement—no private case for damages.

o Malone v. Brincat (DE): publicly traded co. misrepresented statement of earnings in annual report P held onto stock because the annual report said they were doing so well (D’s acts led them not to engage

in sales). D claims only duty to disclose when SH requests in action. 10b-5 does not apply – can’t assert claim without purchasing/selling securities BUT they can bring suit under state law for fraud In DE, there’s a state law claim for securities violation (not the same as in the MBCA) – protects SH who

receive false info from directors even in the absence of request of info Duty of Care Duty of Loyalty Duty of Good Faith (MBCA does not call this a duty, but requires it. In fed court, there are two

fiduciary duties: care & loyalty. Non-fiduciary: good faith & fair dealing) Fiduciary duty includes duty to deal with stockholders honestly.

When corporation makes statements they must be truthful (even when disclosure was not required).

Generally, don’t need to disclose all material info., but once disclosed, can’t be misleading. P should bring a direct suit (not derivative, since didn’t harm corp.)

Insider Trading 10b-5 claim: there has to be interstate commerce, mails, or national exchange

o Dupy v. Dupy – suit allowed to be brought under 10b-5 in fed court, even if only jurisdiction based on transaction made over the phone (same building) – considered using interstate instrumentality

If they had made transaction face-to-face, then not interstate Checks, internet - instrumentalities of interstate commerce Fraud induced for purchasing or selling – both applies under 10b-5

Under Common Law (states law)

46

o Goodwin v. Agassiz (MA 1933) – geologist speculated ore in land, and director bought shares from current SH when such info was not publicly available. SH claims there is fiduciary duty to disclose.

Ct holds that fiduciary duty exists when transaction is face-to-face and when there is special kind of fact, but not in indirect trading on exchange (as in this case). Also, information was theoretical and not substantive, so not material.

Material (Special facts/important) + face-to-face + Shareholder = fiduciary duty to disclose Potential liability if purchasing from shareholders. NO duty to disclose info to someone that is not

a shareholder yet (no liability for sale of shares) Old law, only few states follow (narrow holding)

o Trading on an Exchange (impersonal means): a director or officer who has obtained nonpublic information by virtue of his office is not under a common law duty to disclose that info in buying or selling stock.

o Special Facts Exception: elastic concept that covers material facts, very important info fiduciary of copr. Has duty to disclose special facts when engaging in stock transaction with a stockholder of corp.

Rationale: can’t notify every single person in impersonal exchange market. No requirement that all SH be on equal footing when making investments.

Hypo: X is a director of company. After obtaining insider info, X purchases lots of stock on impersonal, open market. This is fine—economists argue that there is no harm to shareholders. Face to Face transaction would probably give rise to duty.

Differences among states:o Kansas Rule (minority view): directors hold insider info in TRUST for SH and have duty to disclose when purchasing

from SH, even in impersonal stock exchange. (duty to SH only, so not when selling) director has duty to SH to communicate all material facts in connection with transaction which director

knows or should know. o New York Rule: goes further to impose a duty in purchase and sale of shares. Liability would be owed to the corp.,

not the shareholders.o Many states: NO duty rule.o Middle ground: Some states have a rule that resembles the rule from the Goodwin case.

Insider Trading Under 10b-5: DISCLOSE or ABSTAIN (although exact literal reading of 10b-5 doesn’t state this)

Basis for Insider trading liability – 10b-5 liability.o (1) No equal access rule – not everyone who obtains non-public info will be liable o (2) Classic insider trading – buying or selling by insider’s own company’s stockso (3) Constructive insider – one who has received info by another who owes fiduciary duties o (4) Tipping (Dirks) – derivative duty (on tipper’s shoes)o (5) Misappropriation theory – stealing info from source other than the company whose stock you buy/sell (O’Hagan)o (6) Eavesdropping – if you overhear insider info, does not create insider liability.

SEC v. Texas Gulf Sulphur (Ct of App): co. found ore and wanted to keep secret so they could buy that land for cheap. Directors, insiders, and tippees purchased stock in open market before disclosing info.

o Disclose or Abstain Rule: If information is material then insider must disclose or abstain from trading. (Even if impersonal market, you can’t trade with inside info. Equal Access Rule)

o Classic insider trading theory : Violation if insider trades shares of its own company based on nonpublic material info due to relationship of trust and confidence btw shareholders and those insiders who obtained info by virtue of their positions.

Materiality is determined by whether an ordinary investor would find the information important by balancing the probability and magnitude.

Eavesdropper – no fiduciary duty to SH, so not liable for trading on nonpublic info. If insider looks at disclosures already made and sees trend/pattern and buys stocks from that info,

then not violation b/c info is available to public. Why insider trading might be good?

o Incentive: added incentive for those on the inside to work harder. Court does not buy into this and holds that these people get adequate compensation through stock options and other alternatives.

47

o No harm to shareholders: they were selling at market price. Also, insider trading allows price to more accurately reflect the price of the company (public would have more notice). With insider trading, price slowly escalates and signals public that corp. is doing well. Ct says unfair.

Chiarella v. United States (US 1980): Financial printer decodes info and trades on that info. A purchaser of stock who has no duty to a prospective seller because he is neither an insider nor a fiduciary has no obligation to reveal material facts. A duty to disclose does not arise from mere possession of nonpublic market information.

D has no fiduciary duty to either acquiring/target co Compared to Texas Gulf Sulphur: where insiders bought stock from their own shareholders to whom they owed a

duty, here, Chiarella owed no duty to target company nor acquiring company Compared to Goodwin: basis of liability is breach of insider’s fiduciary duty (not here)

Cady Roberts v. SEC – when director also a partner in firm helping with acquisition tipped lawyers in same firm, SEC found it liable for constructive insider trading

Constructive insiders : those who are temporarily working for a corp. (UW, accountants, lawyers helping with offering, or helping in acquisition)

After Chiarella: 1. There is inside trading liability in “classic” situation – transaction of its own firm’s shares2. No rule for Equal Access (for all)3. Court has not accepted misappropriation theory yet(stealing of information) - dissent

Liability of Tippers (Dirks v. SEC): Dirks discovers fraud through former EE and tries to alert others. SEC charges him with securities law violation.

o For liability, the tipper must have been violating his fiduciary duty in order to extend that duty to the tippee. o The tippee’s duty is derivative of the tipper, so if the information was improperly passed along in breach of the

tipper’s duty, the tippee is liable if he knew. o Tippee’s liability:

A tippee’s duty to disclose or abstain is derivative from that of the insider’s duty and liability depends on:

(1) whether tipper breached fiduciary duty by providing info and (2) whether the tippee knew of the breach(3) tippee trades on that info from tipper

TEST to see if Tipper breached duty: What is purpose of disclosure?1) Is tipper getting personal benefit by tipping info? (tippee pays tipper for info)2) Is tipper getting reputational benefit (looking out for himself & not corp.)3) Tip made as a gift (works as if tipper is doing the trade, and tippee then gets gift)

o If it meets the above, both tipper & tippee are liable o Note: Claim of insider information: can go from tipperto Xto Yetcto clients. So long as you know that the

information is the product of a breach. (if there is no trading of stocks, then no 10b-5) If tipper had received payment from Dirks and all his relatives traded on that info? If all knew that info was

obtained through breached duty, Everyone liable. If you overhear info, not liable. If insider leaks info to one broker and one broker tells all brokers? May not be leak.

Stealing Information (US v. O’Hagan): D partner of firm helping GMet, acquiring corp., obtains merger info and buys stocks of target corp. Even if no fiduciary duty to target SH, D has duty to his employer and GMet corp. He stole info and traded secretly so is liable.

D could be deemed constructive insider but since he didn’t buy GMet’s shares he is not liable under this theory (his firm and all who work there would be constructive insiders).

o Misappropriation Theory: A person commits fraud in connection with a securities transaction when he misappropriates confidential info for securities trading purposes is in breach of duty owed to source.

o 2 requirements: Steal Info Secretly (trade): Not disclose your theft to owner of information.

o If D disclosed his firm and GMet and traded, then not liable (brazen misappropriator.) He could still be sued for breach of fiduciary duty although he will avoid insider liability.

o If GMet started buying shares of target before acquisition? No liability, that’s what they are supposed to do to acquire a corp.

o NOTE: Target co.’s SH can’t sue D because he didn’t breach duty to them.

48

o Compared to Classical: insider’s breach to shareholders when dealing with their own stock (limited scope) where misappropriation theory prohibits trading on the basis of nonpublic information by a corporate outsider in breach of a duty owed not to a trading party, but to the source of the information.

o Full Disclosure forecloses liability under misappropriation theory HYPO: What if X had been authorized to trade b/c Client Corp wanted to amass large amounts of

shares in friendly hands? There would be no stealing of info and there would have been disclosure so no liability under misappropriation theory—

o Theories of finding insider liability (may need to use more than one) 1) Classic insider liability2) Constructive insider3) Tipping 4) Misappropriation of info (sometimes may also be tipper/tippee)

Rule 16b of 1943 Securities Exchange Act: Prohibition of short swing transactions: Corporation may recover the profits that an insider (officer, director, owner of more than 10% of its shares) gained from a purchase or sale of its shares within any six-month period – provided that the owner held more than 10% both at the time of purchase and sale (or sale and purchase).

1. See if there is purchase and sale (sale and purchase) w/in 6 months 2. look to see if there is gain from transaction. If no gains or offset of loses –then no liability. 3. See if more than 10% SH or officer/director

o More than 10% SH Snapshot one must own more than 10% at both times before the purchase and before the sale (or before the sale and before the purchase)

o For Officer/director regardless of how much% he owns as long as there is profit made Rationale for prohibiting “short-wing trading” by insiders: If there are insiders making these types of trades within 6

months, it is probably an indication that there is something suspicious going on. This is a strict liability standard and no proof is necessary—profits will just be given up.

Corp. could have taken that opportunity instead of the insider. There is no requirement to prove that insider relied on public info.

o Summary of Regulation of Short-Swing Profits/Transactions by Insiders: Insiders include officers, directors and shareholders of over 10%. 16(b) also only applies to really large companies that have to be registered 16b Does not apply to tipping, misappropriation, constructive insider cases (though 10b-5 does) b/c only

applies to officers, directors and SH with 10% -- these insiders may/not be liable under 10-5 depending on whether there was secret info and traded on that.

Reliance Electric Co. v. Emerson Electric (US 1972) SH more than 10% Emerson buys 13% b/c wants to take over Dodge. Then soon they sell 9.96%, then the rest (5.04%). Law today: Had 0% before purchase and sale (I.e 0% 13% to 5.04%) -- not liable since started with 0%. Then it only had

5.04% before it made the next transaction, so not liable. o Here, Reliance didn’t argue for the first transaction so it was liable for the first, not the second. o If it was director of Emerson or Reliance, not liable. If they were director of Dodge liable b/c insider & officer – only

look to either purchase OR sale. Rule 16(a): directors or officers must reveal when they make trades.

Examples: o (1) Jan. 20, X (not officer or director) buys 200,000 of 1 million shares for $10/share. May 1, X sells all shares for

$30/share. Liability? NO, b/c X owned zero shares before his purchase of the 200,000 shares. (*pair the two transactions – i.e. 1 +2, 2+3)

Jan 20 buys 20% $10May 1 Sells 20% $ 30

o (2) Same facts as above, but on May 1, sells 110,000 shares at $30/share. May 10, X sells 90,000 shares at $40/share. No liability again.

Jan 20 buys 20% $10 May 1 Sells 11% (so left 9%) $ 30 May 10 sells 9% $ 40

49

o (3) If X = director, 10% rule would not apply. In above, X would have been liable b/c he made gains. For May 1 sale, which is $20 profit per share (b/c he bought at $10 and sold at $30)($20 x 110,000=what X owes corporation). For May 10 sale, X would owe profit of $30 per share ($30 x 90,000=what X owes corporation). total $4.9 million.

o (4) X, an officer, purchases 200,000 shares in 1912 for 1 cent/share. In Jan 1, 2005, X sells 100,000 for $30/share. on Mar. 1, buys 110,000 shares at $20/share. Trans. 1: No liability b/c purchase and sale were not w/in 6 months. Trans. 2: He sold 100,000 shares, so all you can “match” in the 2nd transaction is 100,000 shares out of 110,000

shares. He would be liable, b/c there’s a sale and a purchase w/in 6 months. He would be liable for $10/share times 110,000 shares ($1,000,000)

1912 Buys 20% 1 cent Jan 1 Sells 10% (so left 10%) $ 30 Mar 1 Buys 11% $ 20

o (5) Same facts as above, except he’s not an officer. Trans 1: No liability still b/c no purchase and sale w/in six months. Trans 2: Right before the Jan. 1 sale, he owned more than 10%, but right before the Mar. 1 purchase, he owned

exactly 10% so no liability (has to be more than 10%).o (6) Same facts as (5), but on April 5, X sells 110,000 at $10/share.

If he’s an officer, the Mar. 1 buy and the April 5 sell match up. But, since the sale price is LOWER than the purchase price, then no liability. BUT, if the sale price was HIGHER, there would be liability.

1912 Buys 20% 1 cent Jan 1 Sells 10% (left 10%) $ 30 Mar 1 Buys 11% (left 21%) $ 20April 5 Sells 11% $10

o (7) Feb. 1, X buys 1000 shares at $8/share. May 1, sells 1000 shares at $10. 1 million shares outstanding. If X = director, there would be liability b/c (1) buy and sell w/in 6 months AND sold for a higher price than he bought

it for. If X ≠ director, no liability b/c X never owned greater than 10% of the company.

Prohibitions on the sale of controlling block control premium: A buyer will be willing to pay an extra amount –over the bare value of the stock—because ownership of

this block of stock carries with it the power to control the direction of the corporation. Law allows one to get premium for block of their shares. With 10% of shares, you can control publicly traded corp.

Good Reason: Someone thinks that they can run the corporation much better and make it more profitable. Bad Reason: Corporate looter.

When a controlling shareholder sells his interest, there is a duty to make a reasonable investigation of the buyer (act in good faith and fairness) due diligence (and prevent selling to looter)o DeBaun v. First Western Bank (CA): Bank executor of majority SH sells block to a looter and disregards risks, allows him

to pay premium to bank with corp. assets. Minority bring derivative suit against bank (not looter b/c he was bankrupt, no BJR defense would apply since self dealing).

o Holding: if you sell to a looter you are liable for all damage done, unless you have performed a reasonable investigation. duty to make a prudent, reasonable investigation of the buyer.

Ct. can award lost net worth, lost future earnings, $ for valid claims against corp. (that would have been paid off in ordinary course of business).

Problem with a derivative suit, is the money is given to the looter (who owned 70%)—direct claims better because they only go to unfairly injured shareholders.

o Looters gain even if value of corp. goes down and his shares become zero – because he gets corp. assets at the detriment of SH and creditors

Sale of Corp. Assets: Perlam v. Feldman (2 nd Cir): Steel seller corp’s president sells majority shares to buyers of steel corp. Make a deal to pay

premium to president and sell as much steel to themselves w/out giving interest free loans conflict transactions, not BJR defense. Ds have heavy burden to prove fair transaction.

o Ct holds that premium received by Ds in essence was like looting corp. assets. Derivative action but carves out remedy so buyers of steel corp. don’t get anything.

Sale of Board : if BOD resigns after sale, it will be suspicious, though the new owner could appoint a new board anyway. Some cts do not allow majority SH selling his block to arrange old directors resign as part of transactions, but other cts allow since new majority SH could have done this anyway through voting power.

50

Equal Access Rule: every SH entitled to the same deal from corp. whether minority or majority (MA) o Donahue v. Rodd (MA)– corp. directors (sons) bought back retiring president’s (father) stocks giving him lucrative

deal, while refused to buy back minority shares. Direct action: same deal or rescind K o Equal access rule: a closely-held corporation that had decided to repurchase some of its stock cannot

discriminate among its shareholders in repurchasing its stock. If there were no such rule, a majority could buy back their own shares for an excessive price. In a

public corporation, if a board of directors buys back their own shares for exorbitant amount, it is not covered by the business judgment rule b/c of self-dealing. Self-dealing is a violation of duty of loyalty.

The corporation may not discriminate in repurchasing shares. General principle: stockholders do not owe each other a duty—a ct. may impose fiduciary duties in a

closed corporation to protect minority stockholders. Ct. might find the closed corp. is functionally like a partnership, the same duties are imposed

Note: If this is like a partnership though, maybe an owner could force either a buy-back or dissolution of corp.

Minority SH contracting protection agreement:Minority shareholders could construct some sort of shareholder agreement or contract for preferred shares or redemption rights (have corp. buy back SH). Greenmail where directors try to quiet minority by offering to buy their shares. Buy-Sell Agreements (common for close corporations):

o Defined: A contract that requires the corporation or majority shareholders to purchase shares in specified situations at a specified price. (governed by MBCA 7.32 SH agreement)

o Requirement: To be effective must include means to ensure that funds are available to comply w/ terms.o Value: A properly structured agreement should include means of establishing the value of the business.o Reasons for Buy-Sell Agreements:

1. It matters who shareholders are—keeps shares with people the close corporation wants to have it. 2. There is no ready market for shares—create a market for the stock or at least find a way for shareholders to sell

their stock. o 4 types of Buy-Sell Agreements:

1. One-way agreements: enables a third party to acquire a deceased or departing owner’s interest in the business. But, to make sure that the third party has the money to purchase the stock, make the third party take out a life insurance policy on the original stockholder. Otherwise, a savings or money-market account is sufficient.

2. Cross-purchase agreements: obligates surviving owners of a business to purchase a deceased owner’s (or an owner who leaves) interest (directly from the decedent’s heirs in the instance of death). Normally, each remaining owner purchases enough of the deceased or departed owner’s interest to maintain his proportionate interest in the business. But, proportionate purchases are not required. To make sure there is enough money, life insurance policies or separate savings funds are typical. Note that here there would be lots of life insurance policies—pretty much for each owner.

3. Entity or Stock Redemption Agreements: Here, the corporation actually buys the interest of the deceased or departed owner. Each remaining owner’s relative share of the business stays the same with respect to each owner, but control of the business may shift. Any funding vehicle used must be for the benefit of the business rather than the owners.

4. Wait and See Agreement: flexible agreements giving the business entity the option of redeeming any ownership interest upon a triggering event. o How would stock dividend/redemption affect the balance sheet? :

redemptionwill show up as loss of cash (-36 assets) but it will not be an outstanding liability. Same as dividend.

Redemption Assets LiabilitiesPre deal $36k 36k shareholder equityRedeem -36 No more liability

Buy-Sell Agreements - Closed Corp.

Jordan v. Duff & Phelps (7th Cir. 1987) closed corp. has fiduciary duty to SH, must disclose material info EE buys shares of ER corp. but when he quits he must sell them as per articles. Corp. engages in merger negotiation with

another corp. but does not tell EE, who sells his SH back to corp. but could have gotten more if he knew about merger and held on to them longer. (company transacting, not insider)

51

o Ct holds that closed corp. has duty to disclose material info face to face + material (like Goodwin)o What reasonable investor would find importanto Material info: look at probability that merger will occur & magnitude of transaction

NOTE : articles of incorporation, bylaws, or EE k – can’t waive 10b-5 and any other applicable SEC rules (e.g. can’t say that “this transaction will not be covered by 10b-5,” “there is no duty to disclose to SH”…)

Berreman v. West Publishing (MN) EE would have gotten more if he had waited and not exercised his redemption rights. Company had been thinking about

financing options, and year after EE sold shares, decided to merge. State claim not 10b-5, but Ct applies 10b-5 factors. Factors of a closed corp.:

1. Few Shareholders – in this case, 200SH but ct considers closed corp.2. No ready market for stocks – there was no ready market, since only way to sell was through redemption3. Active participation of shareholders in business – Ees active in corp.

If closed corp. fiduciary duty exists (like P-ship, heightened duty); if not, then no heightened duty. Scope of fiduciary duty: must disclose material info.

o ER has fiduciary duty to reveal material fact to SH – not only can’t they lie, but they have affirmative duty to disclose material info (under 10b-5, it’s different – can’t lie, and limited duty to disclose only if you made prior statement and need to give additional info to not mislead SH)

probability & magnitude: ct finds probability was very low, uncertain, (though magnitude high), so not material.

Dissolution Who can get the corporation dissolved?1. Shareholders and Board: Majority of directors recommend dissolution and then approved by majority of quorum of SH (or

2/3 majority in some states). 2. Shareholders: If the shareholder can convince the judge that the directors have acted in a manner that is illegal, oppressive

or fraudulent (governed by state law); or if director’s commit corporate waste (involuntary dissolution). Additionally, if a shareholder can show that the directors are deadlocked regarding a major issue. MBCA §14.30

3. Creditors: If a creditor gets judgment and the corporation cannot pay the creditor, the creditor establishes an interest as to how corporation is run. Can’t give dividends to SH when creditors have not been paid their dues)

4. Administrative Dissolution: State can shut down a corporation if it fails to pay taxes, etc. remember that corporations are creature of state law.

Following Dissolution, Winding Up Period (MBCA § 1405): Must follow procedures of winding up & dissolution b/c corporation continues as an entity.

Otherwise, liability could extend to personal assets (pierce veil for not following formalities) See also MBCA §§ 14.03, 14.06, 14.07, 14.33.

There are limitations in dissolving Cannot dissolve to usurp corporate opportunity. See Meinhard. For example, 2 of 3 shareholders vote to dissolve to freeze out 3rd guy. This is not permitted.

Technically, they can pay all debts and then majority SH can vote for dissolution – but there is fiduciary duty not to exploit each other

Mergers (MBCA § 11.06):o Debts (MBCA § 11.07): all liabilities of “disappearing corporation” are assumed by “surviving corporation.” Surviving

corp. gets all assets.o Majority Shareholders of “Disappearing Corporation”: majority shareholders of disappearing corporation better off

after a merger usually b/c there are favorable deals/agreements for them that go down. They would not have agreed to a deal if they thought it would make them worse off.

o Triangular Mergers: A creates a subsidiary X. Then, B mergers with X. Here, A would own 100% of X. Why?

1. Liabilities: Although X assumes liabilities of B, this is a way to shield A from liability of B—means of limiting liability. Owners of corporation A will not be personally liable.

2. Regulations: A may be subject to various regulations and B might be subject to various regulation. To avoid regulations, create subsidiary.

3. Voting: (MBCA § 11.04): (a) board of both merging corps. have to approve merger and (b) disappearing corp.’s SH vote to approve (majority of quorum must approve)— in a big merger deal, where surviving corp. has to issue 20% additional shares to SH of the disappearing corp., then both SH have to approve merger, not just disappearing corp.’s SH (if not big deal, then they don’t need to approve)

o Requirements for merger=½ approval of shares entitled to vote + 1.

52

o SH can sue board members who approve merger when board makes uninformed decisions, breaches duty of loyalty (conflict interest – sitting in both corps).

Vote Against Merger (MBCA § 11.04(e)&(g): o Minority Oppressing Majority:

Hold-Out Problem: Mergers used to require unanimous approval (traditional rule, not so anymore) One shareholder can hold out and demand more money in the situation where unanimous approval

required and prevent the merger. He can ruin it for everyone else by holding out for more money. Solution to Hold-Out Problem: If a majority wants a merger, minority is forced to go along with the merger

regardless. The minority is granted “appraisal rights” right for minority SH to just compensation for their shares, fair amount

o Majority Oppression of Minority: “cash-out merger” effectively “freezing out” minority shareholders. Gets majority shares of target corp

and then proposes merger, and acquires control of board, approves merger, and then offers low price to buy outstanding shares. Law allows Cash-out if there is appraisal and offer of fair price per share

If deal is for 100K and merger parties deem fair price, but later court finds appraisal price $500k, then minority SH bringing claim must be paid appraisal price (not what the deal was)

Appraisal remedies are in place to prevent this type of oppression. No harm done if adequately compensated. Not always bad, can get rid of opposing minority SH.

o Rule before was that publicly traded corp. is not protected. Now, the rule is: no appraisal for publicly traded corp. (MBCA 15.02.b.1) in general, but if acquirer owns more than 20% of shares of target, then appraisal rights are available for minority SH due to potential abuse & cash-out merger (20% may be enough for effective control of corporation )

HMO v. SSM (WI) o SSM who are SH of HMO opposed merger. They voted against merger and perfected their appraisal rights. Corp. had used

high valuation of corp. prior to merging so that acquiring corp. could give high pay out. Then when minority sought appraisal rights, they used a new appraisal value much lower than before. They also wanted to apply minority discount since the shares did not reflect controlling value and marketability discount since the shares were worth less due to illiquidity. Ct holding: NO minority discount (give going concern value). Minority SH need to be protected, should give them proportionate value of their shares. If there had been no sale, then they would have been paid dividends in proportion.

o Also lower appraisal amount can change, not estopped – normal for corp. to value high price before merger, to benefit all SH

o MBCA 13.01 – no minority discount Remedy for Minority shareholders of publicly owner corporations:

MBCA § 13.04 (b)(4): Grants appraisal rights if acquiring shareholder owns more than 20% of the target.

MBCA § 13.02(b)(1) & Delaware: Minority shareholder of publicly traded corporation, normally has no appraisal rights.

MBCA § 13.02(d): minority shareholder can only challenge through appraisal. Usually, must be before vote on merger.

o MBCA - Appraisal only option for minority SHs challenging merger except when there’s fraud or misrepresentation, doesn’t include breach of fiduciary duty.

o DE code includes breach fiduciary duty as well so if it didn’t demand appraisal before voting, then later they may assert breach of fiduciary duty

Weingberger v. UOP, Inc. (DE 1983) breach of fiduciary duty in merger o Acquiring corp. (majority SH) engaged in cash-out merger of target corp.’s SH. Some directors served both target corp &

acquiring corp. Interested directors negotiated merger and did not reveal their report that showed value of $24 and did not vote. Disinterested directors thought $21 was good deal so approved merger and SH also approved. Disinterested SH did not seek appraisal right, but they sued for breach of fiduciary duty – to undo merger. Ct held: breach of fiduciary duty and granted rescission rights. No BJR because self-dealing; burden for Ds to show fairness – price & dealing. Valuation – ct discards Delaware Block method (which looks at assets, earnings, etc & gets average). Must determine fair price.

NOTE: Acquiring co. does not have to reveal “bottom line” info unless the acquiring co. has insiders in target co.

For approval:

53

o Shareholder Vote: 2/3 requirement o Board of Directors Vote: disinterested directors must approve.

Alternate Avenue for Minority to Contend Payment for Merger: Although no request for appraisal rights, Minority shareholders might sue for breach of fiduciary duty in a direct action.

Minority Shareholders could sue for rescissory damages; valuation of shares as if merger never occurred. Business Judgment Rule: Not applicable b/c of breach of duty of loyalty self-dealing. Liability is not

automatic here. Rather, burden shifts to corporation to prove fairness: 2 part test: no 3rd requirement that there be legit business purpose b/c the fairness test affords minority

adequate protection—compensated adequately. 1. Procedural Fairness or Fair dealing: when the transaction was timed, how it was initiated,

structured, negotiated, disclosed to directors and how the approvals of the directors and stockholders were obtained. Factors weighing against fairness:

a. Denial of critical info.b. Procedures were rushed.

2. Fair price: economic and financial considerations of proposed merger, including all relevant factors: assets, market value, earnings, future prospects, and any other elements that affect the intrinsic or inherent value of company’s stock.

a. The method of valuation was rejected.b. Correct way to evaluate would be to use methods generally considered acceptable in the

financial community. o NO additional requirement to show business purpose – DE

o Short Form mergers – available in some states cash-out mergers in which acquiring company owns more than 90% of target company, cashes-out 10% fewer protections: no lawsuits allowed, only appraisal rights. MBCA does not have any special rules for short-form mergers

o Valuation: Present Discounted Value: looking at future income stream of business and discounting it based on how far in the future you expect to receive the money.

Hypo: Market interest rate is 7%. Would not pay $1.07M to get $70yr. Can get more by investing in bank. Value of corp. goes up if interest rate goes down, becomes less attractive to investors compared to investing in corp.

Market Price is the most that anyone will pay for something. X=value of corporation Y=interest rate (X)(Y)=market value ( company pay / market interest rate = wouldn’t want to pay more than this)

Mergers: Legitimate Business Purpose Cash-out merger where majority needs to get rid of the minority. Does there need to be a legitimate business purpose?Coggins v. N.E. Patriots (MA): Sullivan bought right to franchise w/ 9 other people; each of the 10 investors received 10,000 shares of voting stock. Shortly thereafter, 120,000 shares of nonvoting shares were sold at $5 to encourage public loyalty. Sullivan was initially in control as president, but other stockholders ousted him from presidency and from operating control of corp. He thereafter obtained loans to purchase shares from shareholders with future income from corporation to be devoted as collateral (bank had lien so they could act directly against those assets).

This would be not allowed. He would be using corporate assets for his own personal purposes/interest and this is a breach. So, Sullivan needed to eliminate the interest of the nonvoting shares to become sole shareholderCash-Out Minority Shareholders. (and become 100% SH)

Non-voting Shares: only in terms of choosing directors, but for purposes of merger, there does need to be a vote by these shares.

To effectuate Freeze-Out/Cash-Out Merger: Sullivan created New Patriots with his shares from Old Patriots, as well as excess cash. Then, Sullivan had New Patriots approve of a merger between New and Old Patriot. Old Patriots agreed b/c for Old Patriot to formally approve Old Patriot Board needed to vote, which Sullivan controlled, and shareholders had to approve. There were 2 classes of shareholders: voting & nonvoting. Both groups had to approve. Sullivan owned 100% of voting shares so they obviously approved. Also, majority of non-voting shares approved. Thus, they were all cashed out.

Despite the fact that appraisal rights only remedy in the absence of fraud/illegality, Court let case proceed. Remedy not limited to close corporations (2 part test):

1. Legitimate Business Purpose (Massachusetts) for corporation; [burden on D] and

54

2. Fairness to minority under totality of circumstances. Held: No legit business purpose; all pre-textual. So no need to proceed to fairness test. Remedy: Usually would be rescission of the merger, but that was not feasible here so damages were awarded.

Damages were valued at the time of merger. In deciding the remedy, must consider corporation’s best interest and it would not be served through rescission.

Advice to Sullivan to avoid this result? o Construct a legitimate business purpose. Get rid of minority shareholders b/c it is inefficient in running of

corp. Private corporation cheaper. Offer higher price for cash-out. o Hypo : if minority SH doesn’t think the offer price is sufficient, what remedies?

1) Perfect his right for appraisal2) Vote against 3) Sue for breach of fiduciary dutyMaybe get an injunction (only in DE, in MBCA – only fraud,

misrepresentation) Depending on jurisdiction (Mass or Del) 2 part test or just Fairness.

Sale of Assets o When a target sells all assets (cash, stock, or anything of value) to acquirer, the acquiring company will survive. Target is

liquidated, but a corporation’s sale of assets does not automatically terminate its legal existence. It could either dissolve and distribute assets, OR buy more assets and continue business. It is possible for both corporations to continue.

Why Sale of Assets over Merger?o Liability Rules : With merger, A would assume T’s liabilities, but with a sale of assets, A is not liable for the T’s debts/liabilities. o Price: For a sale of assets, A would be willing to pay more. Structure deal as a sale, and if T wants to dissolve it is responsible

for paying its creditors first. More valuable if there is sale of asset than merger (pay more for assets than to merge, since it shields from liability)

Insulating from Liability: o Sale of Assets can harm potential business creditors—Mechanism for circumventing potential tort liability

in the future. o Triangle Merger:

Franklin v. USX Corp: P was suing USX for liability from personal injury caused by asbestos. WPS sold assets to Con Cal and Con Cal assumed liability. Then, there was a sale of assets to Con Del, but no assumption of liability. Normally, we know that liability does not pass. Then, Con Del merged with USX. If this was merger, then liability would pass. Note: Con Cal’s president became Con Del’s president. P argued de facto merger.o Liability will pass if: (cts will look at diff. factors)

1. Successor agrees2. De facto Merger (something that’s like merger that should be treated as merger for liability purposes)3. Successor is a mere continuation (directors are all the same after selling assets)4. If whole thing is fraudulent.

o Possible Scam if there is no proper consideration for transaction : Court focused on adequate compensation regardless of same president in both corps, and held that there was adequate consideration.

o This type of transaction can be effective in eliminating liability. Hypo: Minority shareholder owns half the shares, starting w/ 140,000 shares. Then corporation issued another

283,000 to buy assets of another corp. She started off with half and now ended up with only about a quarter. Does there need to be a shareholder vote?

o YES—laws of every state require shareholder ratification. o Does acquiring corporation need to present sale to its shareholders? YESIf corporation is going to

issue more than 20% additional shares, there needs to be a shareholder vote. MBCA § 6.21(f).o but no approval needed if done by cash. MBCA 11.04(g). Avoid a shareholder vote with cash.

Shareholder votes are very expensive (presenting ballots, etc.). Possible End Game for Board of Directors: Buying “controlling block” or perhaps selling assets (but that

requires board approval).o MBCA 12.01 – list of sales that don’t need SH approval by targeto MBCA § 12.02 – list of sales that need SH approval by target

o if after the sale of assets less than 25% of the business would continue, SHs of the target corp. must approve. SH can seek appraisal rights if they disapprove.

o MBCA 13.02(a)(3) – Right to appraisal by target SH for sale of assets buyer corp.

55

o To protect acquirer with 51% of target co’s shares from selling of all assets for 1c (if SH is entitled to vote on disposition)

o MBCA 6.21(f) – voting by Acquiring SH if the corp. issues more than 20% additional shares

Hostile Takeovers/ involuntary merger Defined: gaining control over a corporation over the objection of that corporation’s board of directors Target of merger does not want to be taken over. Usually begins with a tender offer where acquiring company will put out a

public offer stating it will offer X dollars per share, usually there is a substantial premium. Poison-pill: directors may establish mechanisms in bylaws or agreements to fend off SH from obtaining control of corp. Managers of target company might oppose a takeover b/c:

1. they would probably be out of their jobs and 2. principal-agent conflict : it might not be in the interest of shareholders for managers to resist takeovers; especially

given that acquiring companies usually want to take over b/c they feel they can run the target company better. o Legal Response to principle agent problem: If managers succeed in fending off an acquiring companies

attempts to takeover, what can a shareholder do? Shareholders could file derivative suits b/c this could possibly reduce the value of the whole corporation. A direct suit might be appropriate too. Claims of derivative suit would be for breach of fiduciary duty (duty of loyalty & duty of care). More specifically, under duty of loyalty, officers are supposed to look out for the interest of shareholders. This could be a conflict of interest, and serve as justification for avoiding business judgment rule. BUT, for the most part, officers and directors do have discretion to erect defensive barriers.

1. Other Ways to respond to principal-agent problem So rather than bring suit, provide large stock options to directors so that they have an interest in takeover (getting bought out would be beneficial to directors). Golden parachute.

Looting? No possibility of looting when acquiring company is buying all of the shares, but when the acquiring company is only trying to obtain part, there is a possibility of looting.

Target Company Defense to Avoid Takeover: Rules set in by-laws, etc.

REVIEW: Partnerships beneficial due to tax breaks (like income tax) and avoidance of costs of registration. But, partners are personally liable. Corporations are doubly taxed, but shielded in some sense from liability.

II. The Limited Partnership (LP) o What is a Limited Partnership?

1) Defined: Partnership formed by two or more persons under the laws of this State and having one or more general partners and one or more limited partners.

2) Classic Example: X store decides to expand and therefore, needs more money. X approaches people to invest, but they are hesitant due to possibility of personal liability. X can prevent investors from voting them out and can shield investors from liability through limited partnership.

3) Law that governs: A limited partnership is an entity; thus, subject to both limited partnership laws and partnership laws. Additionally, limited partnerships are subject to Rule 10b-5.

o General Partner: person who has been admitted to limited partnership as a general partner in accordance with the partnership agreement and named in the certificate of limited partnership as a general partner; GP runs the company. It is required that a limited partnership have one or more general partners who have the same rights and duties as a partner in a general partnership .

o RULPA 403(a ) – general partner has the same rights & powers as in a GP-ship; and (b) liabilities. By law, general partners run the corporation. If limited partners run corp., they may lose their limited liability

o Liability : If there is an accident, LP is liable, and if its asset is depleted then general partners will be liable; limited partners are not personally liable, they are like SH in corp.

o Taxation: no entity taxation on LP. Limited partners pay only income tax. For SH of the corp. serving as general partner in LP, since they are taxed twice (corp. entity & dividends), they are also made limited partners of the LP so they get same benefits as other LPs (and most likely limited partners invested more)

o Person: a natural person, partnership, limited partnership, trust, estate, association or corporation.

56

o Limited Partner: person who has been admitted to a limited partnership as a limited partner in accordance with the partnership agreement. Not personally liable for the debts of the limited partnership. Similar to shareholders in corporations.

o Hypo: What if LP loses money in a year? Is it better for investors if this is a limited partnership or corporation? If corporation, no tax breaks for investors, but in LP, if limited partners lose, they will get tax breaks. Tax shelters aroseLP’s invested in big loss ventures to shelter much of their income. If huge profit, it depends based on tax rates.

Legal Problems in Starting an LP1. RULPA 201 Certificate of Limited Partnership: must be a public filing w/ name of LP, name and address of registered agent,

and the name and mailing address of each general partner. (Del. RULPA Act 6, 6 Del Code, Ch. 17.).2. Filing necessary: to make it public that there is limited liability. 3. No requirement for LP agreement, but there usually are which define relative roles of limited and general partners: LP

statutes require (RULPA § 201 pretty similar as Delaware (RULPA requires latest date upon which LP is to dissolve)):o Name that is used must include the words “limited partnership”; can’t use name of limited partner to misleado LP must have at least one general partnero Name and address of general partner set out. o NOTE: The general partner can be a corporation. This is a good way to limit liability!

Can register in Delaware and do business in Alabama. Of course, Delaware is favorable b/c less uncertainty as to rights and responsibilities of parties. A. Legal Problems in Operating an LP (753-784)

o Legal Problems in Operating LP: 1) Who Decides? Usually the general partner (default rule).

o RULPA § 302: does not require that limited partners vote, but permits them to if provided by partnership agreement. NO RIGHT OR POWER AS LIMITED P TO BIND LIMITED P-SHIP.

2) Liability To Third Parties: Each general partner of an LP is personally liable for the partnership’s debts to third parties as if the partnership were a general partnership.

RULPA § 403(b): Except as otherwise provided in this Act, a general partner of a limited partnership has the liabilities of a partner in a partnership without limited partners to persons other than the partnership and the other partners.

Liability of General Partners: Creditors can collect from general partners to the extent allowed under RUPA §§ 306 & 307.

Liability of Limited Partners (“safe harbor” provisions): Generally, creditors cannot collect from the limited partners; “safe harbor” provisions under RULPA § 303.

o Traditional way: as long as they are like SH in corp. and no control of LPo § 303(a) – limited liability unless you participate. You are not liable even if you

participate in business unless person suing has reasonably believed that limited partner is actually a general partner. Reliance theory: possible personal liability where people reasonably think you are a general partner. BUT

o 303(b) – even if they didn’t know you were limited partner, creditors can’t sue if you fall under safe harbors of 303(b) 303b1 – being employee, agent of LP is not controlling LP 303b2 – consulting GP with respect to business 303b3 – acting as surety or guaranteeing obligation of LP 303b4 – brining derivative suit in the right of LP 303b5 – attending meeting of partners 303b6 – Limited partners can vote on business matters 303b7 – winding up LPship You’re allowed to be SH, officer, director of general partner corp. and still

enjoy limited liability as limited partner If limited partners add more responsibility in partnership agreement, they might no longer be

passive investors. Specifically, if limited partner starts to “control” (act like general partners) they forfeit their limited liability. See § 303.

LP control liability v. “Piercing the Corporate Veil” LP limited partner reliance/liability theory sounds similar to piercing corporate veil (when shareholders who dominate a corporation might become liable). BUT, for LP’s it is pretty clear when someone is going to be liable. Note

57

that limited liability is not forfeited where a limited partner is also a director in general partner corporation.

Zeiger v. Wilf (NJ): Facts: After the sale of property to the corporation, Trenton Inc., the property interests, as well as consulting contract, were assigned to another entitya limited partnership (“Trenton LP”). Trenton Inc was the general partner, and others were limited partners. Wilf was officer in the corp. who controlled the corp. which in turn, controlled the LP.

o Wilf claimed that as VP of corp, he worked to secure state leases and mortgages, and that LP was operating through its general partner.

o P’s Claim: P sued Wilf, claiming that Wilf had become the “surviving partner and owner of the partnership assets” pertaining to the purchase and transfer of the hotel and that he was in default respecting payment of P’s consulting fees. P never brought reliance claim, that he believed Wilf or CPA were undertaking any personal responsibility or liability for any part of the project as general partner.

Reasoning (evolution of limited partner liability): Originally, limited partners could be liable if they took part in the control of the business. Goal of insuring certainty and predictability in defining a limited partner’s liability for actions of a limited partnership entity. Act provides that one cannot impose liability upon a limited partner for the obligations of the partnership except to persons who have done business with the limited partnership reasonably believing, based on the limited partner’s conduct, that he is a general partner. “Safe Harbor” provisions are enumerated in §303(b). Important provision: a limited partner does not participate in the control of the business . . . solely by serving as an officer, director or shareholder of a corporate general partner.

o Note: if a limited partner acts “the same as” a general partner, he will be treated as a general partner. But the “safe harbor” provision applied here.

Policy: what makes limited partnerships attractive to investors is the very concept of limited liability.

Zieger should have gotten personal guarantees from Wilf. Or maybe gone after Wilf under “piercing corporate veil.” He was only person involved in running of corp.

Note that courts are more willing to pierce the veil when tort liability at issue. B/C where someone injured, they never had a chance to negotiate as do parties in contract disputes.

o Liability to the Partnership and Partners: A general partner will also have liability exposure to the limited partnership and to the limited partners for breach of fiduciary duties. (RULPA 403b)

Limiting fiduciary duties: o Under RUPA 103 – can’t completely eliminate fiduciary duties but can specify conduct that won’t be

deemed to violate duty of loyalty (though can’t waive duty of loyalty all together )o Under LP, there’s more flexibility

Kahn v. Icahn (DE): Action brought derivatively on behalf of LP (AREP) against general partner’s (API) sole shareholder and CEO (Icahn) and a corporation affiliated with general partner and other directors for usurpation of partnership opportunities (breach of fiduciary duties). Ds failed to make partnership opportunities completely available to AREP and instead kept percentage of profits for him and other affiliates.

LP Agreement: D argued that it was allowed to compete directly or indirectly with the business of the partnership; freedom to modify traditional default rules and duties of partners.

Flexibility in Delaware: defaults, including fiduciary duties, may be modified. Relevant Inquiry: Whether or not a fiduciary has appropriated for himself something that in fairness should belong to

the partnership?1) Closely related business 2) opportunity is either essential to the corporation or is one in which it has an interest or expectancy,3) the corporation is financially able to take advantage of the opportunity itself, and4) the party charged with taking the opportunity did so in an official rather than individual capacity/

conflict with LP. Held: No breach of fiduciary duty/trust.

Partnership agreement permitted competition and was legit. Cts allow LP more eliminations of duty through K in LP than in Pship

o Limited Partners similar to shareholders: limited partnerships resemble corporations in many ways. Both attract investment capital by offering limited liability—passive ownership.

o See RUPA §103(b)(3): discusses appropriate levels for fiduciary duty.

58

o must not limit duty of loyaltyo the partners can agree to waive specific types of conduct—perhaps allowed to if specifically stated. o It is possible to waive lots of normal fiduciary duties.

o Note that partnership agreements have no impact on rights owed to third parties. o partnership agreements cannot specifically eliminate the duty of loyalty (few exceptions, but cannot be

manifestly unreasonable). What are the duties that the manager of a corporate general partner owes to the limited partners?

o Hypo: LP general partner usurps real estate opportunity. Liability is the same as that established in Meinhard (duty of loyalty not to usurp). But, what if the general partner is a corporation and usurps a corporate opportunity? Is the corporation liable? Corporation would be liable for breach of fiduciary duty and the officers and directors might be liable.

In re USACAFES: (diff. from Icahn case b/c no LP agreement)Metsa purchased LP, holders of LP bring suit for damages as a result of the sale where general partner corp. approved sale of LP for a cheap price in exchange for general partner’s officers getting kickbacks.1) Breach of duty of loyalty for sale of LP’s assets at a low price due to financial inducements to directors (they are benefiting

themselves at the expense of the partnership); and2) General Partner was uninformed when authorizing the sale to Metsa.

o Defendant, Metsa, argued: Directors owed the limited partners no duty of loyalty or care, only the general partnership owed a duty.

o Note on why P sued officers and directors in addition to just the corporation: b/c it is likely that the corporate general partner had very little assets. That is the point of setting up these corporations; to insulate partners from liability. Directors and officers probably have some cash anyway b/c they just received compensation (kickbacks) here and also b/c of coverage under director and officer insurance.

o Reasoning: Court rejected Metsa’s argument and analogized to trust cases, stating that a large number of trust cases do stand for a principle that would extend a fiduciary duty to such persons in certain circumstances. 1) Fiduciary Duty: one who controls property of another may not, without implied or express agreement,

intentionally use that property in a way that benefits the holder of the control to the detriment of the property or its beneficial owner.

2) What if corporation was undercapitalized and the corporation failed to respect normal corporate formalities? Piercing the corporate veil.

3) Aiding and Abettor liability against officers and directors: they helped corporation breach fiduciary duty. o Held: A director of a corporate general partner bears such a duty towards the limited partnership with regard to

dealings with the partnership’s property or affecting its business . Metsa is bound by the duty not to use control over the partnership’s property to advantage the corporate director at the expense of the partnership.

How the Owners Make Money (and Get Out) (784-786)1) Being employed and receiving salaries 2) Sharing in distributions of the earnings 3) Selling the ownership interest for more than it cost

o Transfer to a Third Party: RULPA § 702: partnership interest is assignable in whole or in part and does not dissolve LP or

entitle the assignee to become or exercise any rights of a partner. Only allows assignee to receive distributions. One can sell distribution rights, but no management, voting or info rights unless agreement provides otherwise.

o This makes sense b/c members who are managing and personally liable could be picky about identity of co-members.

o Arguably, limited partners are akin to shareholders in a corporation. RULPA § 504: Distributions to be allocated in line w/ partnership agreement.

o Transfer to a Limited Partnership: Remember dissociation: owner of business structured as a partnership has the power created

by statute to force the business to purchase her ownership interest. RULPA § 602: Withdrawing General Partner at any time permitted through written notice,

but if it violates partnership agreement, general partner might be held liable for breach and amount otherwise distributable to him may be offset by damages.

RULPA § 603: Limited partner may withdraw at a time or upon events specified in partnership agreement. If nothing specified in agreement, limited partner must provide six

59

months’ prior written notice to each general partner at his address on the books of limited partnership.

RULPA § 604: fair value requirement

III. The Limited Liability Company (LLC) A. Defined (787-788)

o LLC’s were not allowed for a while due to IRS rules (someone needed to be personally liable), but changed rules to allow both limited liability and pass through taxation.

o Defined: An LLC offers all of its owners, generally referred to as members, both (i) protection from liability for the business’s debts similar to the liability protection of

shareholders of a corporation and (ii) the same pass through income tax characteristics of a partnership (prevents double taxation).

o Considerations for deciding business structure: Limited liability, tax purposed, ease and expense in creating, existence other than just its members or partner.

o Note: Corporation had limited liability, but no pass through taxation; whereas, a regular partnership, no limited liability, but pass through taxation. Limited partnerships, through corporate general partners, achieve limited liability and pass through taxation

o Contract Law Governs: o Operating Agreements: sets out the rules that govern the firm, but need not be in writing. (See ULLCA § 103:

not many states have adopted this). o Note: ULLCA § 103(b) lays out matters an operating agreement may not control. BUT, Delaware LLC §

1101(b) provides for greater deference to operating agreement in favor of freedom of contract. Still cannot waive duty of loyalty.

B. Legal Problems in Starting an LLC (788-790) Certificate of Formation: Upon its filing, LLC is formed. Under ULLCA § 202(b), an LLC begins when articles of

organization are filed. All business structures that limit liability are all required to file with state. Articles of Organization laid out in ULLCA § 203.

o ULLCA § 203 Articles of Organization must include: name of company must be mentioned, manager managed or member managed.

LLC must be included in name of business under ULLCA § 105 and DLLCA § 18-102. Public must know company is a limited liability entity. (abbreviations are fine under model act).

C. Legal Problems in Operating an LLC (790-799) Decision-making authority: Owners can elect to have member managed (similar to partners in general partnership)

company or manager managed (similar to board of directors of corporation) company. o Member managed: operating agreement will specify (i) how to determine how many votes each

member has and (ii) how to determine what matters require more than majority vote.o Manager managed: operating agreement will specify (i) how many members elect and remove

managers and (ii) what issues require member vote. Implications: This is required b/c if member managed, everyone is an agent and can contract,

but manager managed limits agents to only managers.o Members in manager-managed LLC have no binding power to enter to K (unless otherwise agreed)

Liabilities to Third Parties: an LLC is an entity. Members are not liable at all; whereas in LP, a general manager is liable. What about “piercing the veil?” ULLCA 303(b): failure of LLC to observe corporate formalities is not

grounds for imposing personal liability. This is an attempt to eliminate a way of imposing personal liability. ULLCA § 203(a)(7): some members of LLC will voluntarily accept liability. Sounds like LP. This illustrates the

flexibility concerning liability with LLCs. Hypo: what if a member in member managed LLC, in negotiating a contract w/ third party, does not

indicate involvement with LLC? LLC is liable b/c he probably has authority to bind. Regarding personal liability, the member, who has not disclosed that he is acting in LLC capacity, is also liable. Rationale is that third party did not know about LLC and if he had known, might have contracted differently to achieve more protection. Some states disagree and say it is available public info.

Race to the bottom argument w/ LLCs: o Liability of Members and Managers to LLC

60

In manager-managed LLC: Members are assumed to be passive shareholders and therefore, do not owe fiduciary duty to LLC or other members. Managers have fiduciary duty to members and LLC (Like Corp.)

In a member-managed LLC, all members have fiduciary duties to each other and LLC. Note: all these liabilities can be altered through operation agreement.

o Lynch v. Carson: 3 different owners formed media LLC and had an operating agreement establishing a right of first refusal. Manager managed LLC. P argued he violated fiduciary duty.

o If this were a corporation and Carson allegedly usurped an opportunity, so long as he offered it first, he would be free to exploit the opportunity, so no liability.

o Here, court examined whether he had really offered it. Agreement had right of first refusal and also that member manager could engage in other business ventures. This clause exploited flexibility of LLC law regarding the duty of loyalty.

o This case is about interpreting a contract-Operation Agreement.

D. Making Money and Getting Out (799-813) 1. Salaries2. Distributions ULLCA default: everyone gets equal share (if not otherwise agreed)3. Sell your interest

o Restrictions in selling interests (default rules): Management rights are not transferable. The most one can sell is the right to receive distributions. Third party (buyer) could gain rights through a unanimous vote of other members. Rationale: identities of partners matter. Free transferability might make an interest more valuable (b/c voting rights included). Downside is

that buyer may be a MORON. In manager-managed LLC, dangers of transferability are not as great b/c members do not get to vote

under this rubric of decision making. o Lieberman v. Wyoming: Member of LLC contributed $20k to company for a 40% interest and withdrew. LLC gave

him $20k representing capital contribution, but he wants the fair market value of his 40% interest. Court ruled that there can be dissociation with entity continuing, so long as remaining partners agree

unanimously, whereas with a partnership, following dissociation, partnership must dissolve. Court also held that there must be a way for withdrawing member to get compensation for his

interest. Problem with operating agreement: Existence of membership certificates akin to stock certificates and

implied that members were entitled to value of their interest. Courts have no experience with LLC’s so it is dangerous in that there is great uncertainty. If this case were brought under Delaware Law: Unless company dissolved, members could not get

their money back. It would be dangerous to an LLC to allow people just to withdraw at anytime (they might go under).

o ULLCA: provides for member dissociation and the lls’c purchase of the dissociating member’s distributional interest at “fair value” unless the operating agreement otherwise provides.

61