CORPORATIONS Prof. James Feinerman (Powerpoint Fall 2011) o
Agency Principal and Agent Master and Servant; Independent
Contractors o o o o o o o o o Agents As Fiduciaries Creation Of
Authority -- General Rule Apparent Authority How Agencies Are
Created Express agency Implied agency Ostensible agencies Agency by
estoppel Agency by ratification Dual agency
of trust incident to that employment, even though those engaged
in the practice of accountancy would regard as unusual the
collecting and disbursing of a client's funds by an accounting
firm. Reversed and remanded. Agent can impose liability upon his
principal even where there is no actual or apparent authority or
estoppel, as the agent may have an inherent agency power to bind
his principal. General agent for disclosed or partially disclosed
principal subjects his principal to liability for acts done on his
account which usually accompany or are incidental to transactions
which the agent is authorized to conduct if, although they are
forbidden by the principal, the other party reasonably believes
that the agent is authorized to do them and has no notice that he
is not so authorized. If third person reasonably believes that
service he has requested of member of an accounting partnership is
undertaken as part of the partnership business, the partnership
should be bound for breach of trust incident to that employment
even though those engaged in the practice of accountancy would
regard as unusual the performance of such service by an accounting
firm. Reasonableness of third person's belief in assuming that
partner is acting within scope of partnership should not be tested
by profession's own description of the function of its members, but
question must be answered upon basis of facts in particular case.
In view of fact that it was reasonable for accounting firm client,
who dealt exclusively with one partner of the firm, to assume that
the added assignment she delegated to the partner of collecting and
disbursing her funds delegated to the partner was an integral part
of the proper functions of the partner who kept the accounts
reflecting the income and disbursement of those funds, the
accounting partnership was liable for the partner's breach of trust
incident to that employment, even though those engaged in the
practice of accountancy would regard as unusual the collecting and
disbursing of a client's funds by an accounting firm. Accounting
partnership client whose affairs were handled exclusively by one of
the partners did not act unreasonably in trusting the partner
further after learning of his unauthorized payment of the client's
funds to the client's husband, and accordingly, client was not
estopped from asserting against the partnership her claim for
subsequent breaches of duty by the partner in paying out money to
himself and to his client's husband.
Proof of Agency Authority of Agents Express authority Implied
authority Delegation of agents authority Duties of an Agent
Fiduciary duties Full disclosure Due care Loyalty Honesty Integrity
Obedience Agents duty Fiduciary Duties Obedience Loyalty Disclosure
Confidentiality Duty to Account Reasonable Care CROISANT V. WATRUD
Suit in equity for an accounting brought against copartners in firm
of certified public accountants and against executrix of a deceased
partner. The Circuit Court rendered judgment in favor of
defendants, and plaintiff appealed. The Oregon Supreme Court held
that, in view of fact that it was reasonable for an accounting firm
client, who dealt exclusively with one partner of the firm, to
assume that the added assignment she delegated to the partner of
collecting and disbursing her funds was an integral part of the
proper functions of the partner who kept the accounts reflecting
the income and disbursement of those funds, the accounting
partnership was liable for the partner's breach
1
TARNOWSKI V. RESOP Action by principal against agent for damages
which resulted when principal had been compelled, by agent's breach
of duties, to sue third parties for rescission of sale on ground of
fraud. The District Court entered judgment for plaintiff, and
defendant appealed. The Minnesota Supreme Court held that election
by principal to sue third parties for rescission did not bar action
against agent to recover expenses and losses resulting from agent's
wrongful conduct. Affirmed. All profits made by an agent in course
of an agency belong to principal, whether they are fruits of
performance or of violation of agent's duty, and it is immaterial
that principal has suffered no damage, or even that transaction
concerned was profitable to him. Where agent of buyer received
secret commission from seller of business, election by buyer, upon
discovery of fraud in transaction, to rescind contract of sale and
recover from seller that with which he had parted, did not preclude
subsequent action by buyer against his agent to recover secret
commission obtained in violation of duties of agency. If agent has
received benefit as result of violating his duty of loyalty,
principal is entitled to recover from agent what he has so
received, its value, or its proceeds, and also the amount of damage
thereby caused, except that if violation consisted of wrongful
disposal of principal's property, principal cannot recover its
value and also what agent received in exchange therefor. A
tort-feasor is answerable for all injurious consequences of his
tortious act which, according to usual course of events and general
experience, were likely to ensue and which, when the act was
committed, might reasonably be supposed to have been foreseen and
anticipated. Where violation by agent of buyer of fiduciary duties
necessitated suit by buyer against sellers of business to recover
amount with which buyer had parted as result of fraud, buyer was
entitled to recover in separate suit against his agent, amount
expended for attorney's fees and expenses of suit against seller,
as well as such other expenses and losses which were direct
consequence of agent's wrongful conduct. Dismissal of action by
buyer against sellers for rescission of sale upon cash payment by
sellers did not bar subsequent action by buyer against his agent to
recover elements of damage in relation to sale transaction which
were recoverable against agent and which were not involved in
action for rescission. Directors and officers have a fiduciary duty
to the corporation and its stockholders
Directors and officers have a fiduciary duty to the corporation
and its stockholders. A mere employee of a corporation does not
ordinarily occupy a position of trust or confidence, unless he is
also its agent. Fiduciary duties result from the nature of the
employment, and without any stipulation to that effect. No act of
the directors, in violation of their own duties, and in fraud of
the stockholders, will justify an officer in violating his
fiduciary duties. The fiduciary duty extends to existing
stockholders, but not to prospective stockholders, although, it has
been held that the confidential relation extends not only to
existing stockholders, but also to persons invited to purchase
stock, and subscribers. The duty extends to pledgees of stock. It
has been held both that directors and officers do and do not owe a
fiduciary duty to individual shareholders, as distinct from the
shareholders collectively. Where there is only one shareholder, a
decision in the interest of that shareholder which does not harm
any creditor is not a breach of the duty to the corporation. A
shareholder may not complain of acts of corporate mismanagement if
he acquired his shares from those who participated or acquiesced in
the allegedly wrongful transactions. DUTIES -- LOYALTY In
discharging their function of managing the business and affairs of
the corporation, directors owe fiduciary duties of care and loyalty
to the corporation. The duty of loyalty is a broad encompassing
duty, that in appropriate circumstances, is capable of impressing a
special obligation upon a director in any of his or her
relationships with the corporation. The duty of loyalty mandates
that the best interest of the corporation and its shareholders take
precedence over any interest possessed by a director, officer or
controlling shareholder and not shared by the shareholders
generally. The duty of loyalty is fiduciary in nature, by reason of
which the officer is held to something stricter than the morals of
the market place. The duty obtains most directly when the officer
is interested personally in a matter affecting the corporation. The
concept of interest is broadly defined and includes cases where the
officer has a relationship with a party to the transaction that may
reasonably be expected to affect the officer's judgment or is
subject to the influence and domination of such a party. Yet, the
duty goes beyond this and is coextensive with the legitimate,
enduring interests of the corporation. DUTIES - CARE In addition to
their duty of loyalty, discussed in the previous slide, directors
and officers of a corporation are required by law to perform their
obligations in accordance with a minimum standard of care. Courts
apply the duty of care in cases involving alleged 2
negligence, mismanagement, or intentional decisions to commit
unlawful acts. Cases involving fraud, self-dealing, and conflicts
of interest are covered under the duty of loyalty. The standard of
care for directors and officers of business corporations is derived
from common law and state business corporations codes. This
standard is tempered by the business judgment rule (BJR), a
common-law doctrine under which courts generally refuse to
second-guess a business decision, so long as management made a
reasonable effort to make an informed decision. We will examine
many cases adumbrating the BJR, especially in the courts of
Delaware. PARTNERSHIP Partnerships are governed both by common law
and by statutory laws. Agency Concepts and Partnership Law: Each
partner is deemed to be an agent of the other. There may be
imputation of liability. Each partner is a fiduciary of the other.
Law Governing Partnerships Partners are agents and fiduciaries of
one another, but differ from agents in that they are also co-owners
and share in profits and losses. Sources of Law: State common law.
Uniform Partnership Act (UPA), adopted by all states in some form.
Revised Uniform Partnership Act (RUPA): adopted by some states.
Definition of Partnership Partnership is created when two or more
persons agree to carry on business for profit as co-owners with
equal right to manage and share profits (UPA). Disadvantages
Partners are personally liable for all torts/contracts Dissolved
upon death Difficult to raise financing
The Nature of Partnerships At common law, the partnership was
not a separate legal entity from its owners. Today, partnership law
in many states recognizes a partnership as an independent entity
for some purposes. Partnership as an Entity Today, many states
recognize the partnership as a separate legal entity for the
following purposes: To sue and be sued (for federal questions, yes;
for state questions, differs). To have judgments collected against
its assets, and individual partners assets. Partnerships are
recognized as separate legal entities (contd): To own partnership
property. To convey partnership property. At common law -- property
owned in tenancy in partnership, all partners had to be named and
sign the conveyance. Under UPA partnership property can be held and
sold in firm name. Partnership as an Entity [3] Partnerships are
recognized as separate legal entities (contd): For marshaling of
assets. Federal Bankruptcy changes marshaling of assets. To keep
its own books. File its own federal/state tax returns. Aggregate
Theory of Partnership. Partnership pays no federal income tax.
MARTIN V. PEYTON Partnership results from contract, express or
implied. Where contract as a whole contemplates association of two
or more persons to carry on business for profit as co-owners, there
is partnership, notwithstanding statement that no partnership is
intended, in view of Partnership Law. A contract which, taken as a
whole, contemplates anything less than an association of two or
more persons to carry on as co-owners a business for profit does
not create a partnership. In determining whether contract between
parties creates partnership, arrangement for sharing profits should
be considered and given due weight, but it is not decisive, since
it may be merely method adopted to pay debt or wages, interest on
loan, or for other reasons. Agreement expressed in three documents,
whereby securities were loaned to partnership and lenders acquired
supervisory powers with option to enter firm and to accept
resignation of any member, held not to create partnership. Where
written contract between parties is complete and expresses in good
faith full understanding and obligation of parties, it is for court
to say whether partnership exists. 3
Advantages Easy to create and maintain Flexible, informal
Partners share profits and losses equally
Definition of Partnership If a commercial enterprise shares
profits and losses a partnership will be inferred. Exceptions:
Partnership not inferred if profits received as payment in the
following situations: Debt by installments of interest on a loan.
Wages of an employee. Rent to a landlord. Annuity to a widow or
representative of a deceased partner. Sale of good will.
NATIONAL BISCUIT CO., INC. V. STROUD Proceeding by seller of
bread against former partners who had operated food store for value
of goods sold and delivered. The Superior Court rendered judgment
for seller, and partner appealed. The Supreme Court majority held
that purchase of bread by food store operated as going concern by
two partners was an ordinary matter connected with partnership
business within statute to effect that any difference arising as to
ordinary matter connected with partnership business may be decided
by majority of partners, and although partner told bread seller he
would not be personally responsible for additional bread sold to
store, partner and partnership were liable for such purchase by
copartner. Affirmed. Rodman, J., dissented. At the close of
business on 25 February 1956 Stroud and Freeman by agreement
dissolved the partnership. By their dissolution agreement all of
the partnership assets, including cash on hand, bank deposits and
all accounts receivable, with a few exceptions, were assigned to
Stroud, who bound himself by such written dissolution agreement to
liquidate the firm's assets and discharge its liabilities. It would
seem a fair inference from the agreed statement of facts that the
partnership got the benefit of the bread sold and delivered by
plaintiff to Stroud's Food Center, at Freeman's request, from 6
February 1956 to 25 February 1956. But whether it did or not,
Freeman's acts bound the partnership and Stroud. MEINHARD V. SALMON
A joint venture with terms embodied in a writing. Meinhard was to
pay to Salmon half of the money requisite to reconstruct, alter,
manage, and operate the property. Salmon was to pay to Meinhard 40
per cent of the net profits for the first five years of the lease
and 50 per cent for the years thereafter. If there were losses,
each party was to bear them equally. Salmon, however, was to have
sole power to 'manage, lease, underlet and operate' the building.
There were to be certain pre-emptive rights for each in the
contingency of death. They were coadventurers, subject to fiduciary
duties akin to those of partners. Questions What was Meinhards
theory of liability? What was the basis of Salmons defense? (Hint:
difference between partnership and joint venture); Why did Cardozo
side with Meinhard? In particular, where did Salmon go wrong?
Hypotheticals Suppose Salmon disclosed Gerrys proposal to Meinhard,
but then competed vigorously with Meinhard for the contract and
won. Result? Suppose the new lease was for different plot of
land
and hadnt come from Gerry. Result? What if Salmon could prove
that Gerry hated Meinhard, and wouldnt have dealt with him? What if
the opportunity came to Meinhard (the silent partner)? What if they
both managed? Rationale for the Outcome? Does this holding make
sense from a property rights perspective? Does outcome support both
parties investment backed expectations of their property rights?
What about from a contractarian perspective? How long do you think
Meinhard & Salmon envisioned their relationship lasting?
Suppose M & S anticipated this potential contingency in April
of 1902. Would they have favored a rule mandating disclosure by
Salmon? Fiduciary Duty Judge Cardozos words Many forms of conduct
permissible in a workaday world for those acting at arms length,
are forbidden to those bound by fiduciary ties. A trustee is held
to something stricter than the morals of the market place. Not
honesty alone, but the punctilio of an honor the most sensitive, is
thenthe standard of behavior. How did Salmon breach his fiduciary
duty to Meinhard? Elf Atochem North America, Inc. v. Jaffari and
Malek Member of limited liability company (LLC) brought purported
derivative suit against LLC and its manager, alleging, inter alia,
breach of fiduciary duty. The Court of Chancery dismissed suit for
lack of subject matter jurisdiction. Member appealed. The Delaware
Supreme Court held that: (1) limited liability company was bound by
agreement defining its governance and operation, even though
company did not itself execute agreement, and (2) contractual
provisions directing that all disputes be resolved exclusively by
arbitration or court proceedings in California were valid under
Limited Liability Company Act. A limited liability company
agreement will only be invalidated when it is inconsistent with
mandatory statutory provisions Limited liability company was bound
by agreement defining its governance and operation, and derivative
claims brought on its behalf were therefore subject to arbitration
and forum selection clauses of the agreement, even though the
agreement was only signed by the members and not by the company,
itself. In the corporate context, the derivative form of action
permits an individual shareholder to bring suit to enforce a
corporate cause of action against officers, 4
directors and third parties. The derivative suit is a corporate
concept grafted onto the limited liability company form. Members of
a limited liability company may contract to avoid the applicability
of statutory provisions giving Court of Chancery subject matter
jurisdiction over certain claims. While Limited Liability Company
Act allowed members of limited liability company to bring actions
involving removal of managers and interpretation of limited
liability company agreements in the Court of Chancery, it did not
afford Court of Chancery special jurisdiction to adjudicate
member's breach of fiduciary duty and removal claims despite a
clear contractual agreement to the contrary. DUTIES AND LIABILITIES
OF AGENT TO PRINCIPAL
District Court certified a question to the Supreme Court. The
Supreme Court held that the equitable remedy of piercing the veil
is an available remedy under the Limited Liability Company Act.
N.B. Advisory Opinion (Certified question answered). Available in
STATE court!
As a general rule, a corporation is a separate entity distinct
from the individuals comprising it. Piercing the corporate veil is
an equitable doctrine. The concept of piercing the corporate veil
is a judicially-created remedy for situations where corporations
have not been operated as separate entities as contemplated by
statute and, therefore, are not entitled to be treated as such.
COMMON BUSINESS ENTITIES
376. General Rule The existence and extent of the duties of the
agent to the principal are determined by the terms of the agreement
between the parties 377. Contractual Duties A person who makes a
contract with another to perform services as an agent for him is
subject to a duty to act in accordance with his promise 379. Duty
Of Care And Skill Unless otherwise agreed, a paid agent is subject
to a duty to the principal to act with standard care and with the
skill which is standard. 381. Duty To Give Information 382. Duty To
Keep And Render Accounts 383. Duty To Act Only As Authorized 385.
Duty To Obey 386. Duties After Termination Of Authority Duties Of
Loyalty 387. General Principle Unless otherwise agreed, an agent is
subject to a duty to his principal to act solely for the benefit of
the principal in all matters connected with his agency 388. Duty To
Account For Profits Arising Out Of Employment 389 390 Acting As
Adverse Party Without (With) Principal's Consent 391 392 Acting For
Adverse Party Without (With) Principal's Consent 393 396
Competition, Conflicts of Interest, Uses of Confidential
Information during and after Agency
Sole Proprietorship Partnership S Corporation C Corporation
Limited Liability Company Single Member Limited Liability Company
Factors to Consider in Selecting an Appropriate Business Entity
Liability - Limited Liability v. Personal Liability Tax
Implications Complexity of Formation and Management Capital -
effect on ability to raise capital through angel investment,
venture capital, or initial public offering (IPO) Credibility in
the business world Sole Proprietorship An individual (or husband
and wife team) carrying on a business for profit Unlimited personal
liability Single level of income tax - all income and expense items
reported on Schedule C of the owners 1040 Relatively simple to
start If business conducted other than under the name of the sole
proprietor, assumed name publication needed Managed by the sole
proprietor Any transfer of the business would be of the underlying
assets as opposed to a transfer of shares in the business Capital
needs - addressed through loan to sole proprietor General
Partnership Association of two or more co-owners carrying on
business for profit Partners have unlimited personal liability for
partnership debts 5
KAYCEE LAND AND LIVESTOCK v. FLAHIVE Landowner brought action
for damages against limited liability company (LLC) and its
managing member, alleging that the LLC had caused environmental
damage to the land when exercising its contractual right to use the
surface of the land. The
Pass through tax treatment (partnership files form 1065 but all
income and expense items pass through to individual partners on
schedule K-1) Relatively easy to start - partnership agreement is
typically entered into but is not legally required Managed by the
partners or as described in the partnership agreement; Problem: any
partner can bind the partnership Ability to raise capital limited
since most investors would prefer to invest in an entity offering
limited liability LLC is almost always the better choice if
partnership tax treatment is the goal S Corporation Limited
liability for shareholders even if they participate in management
Pass-through tax treatment under most circumstances but not as
complete as for the LLC Formation steps include filing Articles of
Incorporation with the Secretary of State, filing sub S election
with the IRS, adoption of bylaws, and, usually, adoption of a
shareholder (buy-sell) agreement Limitations on the number of
shareholders and the type of shareholders limits ability to raise
capital Limit of 75 shareholders Only one class of stock is allowed
so ability to give priority return of capital to investors
compromised Differences in voting rights is allowed Partnerships
and corporations cannot be shareholders Only citizens or residents
of USA can be shareholders Is easier to convert S corp to C corp
than it is LLC to C corp in event venture capital is sought C
Corporation Limited liability for shareholders even if they
participate in mgmt Tax at both corporate and shareholder level.
This double level tax can be avoided to some extent by payment of
reasonable salaries to shareholders in exchange for services
actually rendered Formation similar to S corporation except sub S
election not filed with IRS Typically required for publicly traded
corporations, businesses that require venture capital, or if a
broad based stock option program is utilized No limits on type or
numbers of shareholders Different classes of stock allowed thus
enabling different priority for return of capital Common Stock
Preferred Stock Limited Liability Company Combines limited
liability provided by a corporation with pass-through partnership
tax treatment LLC files a partnership tax return with all income
and expenses being passed through to individual owners of the
LLC Formation steps include filing articles of organization with
the Secretary of State, contributing an appropriate amount of
capital, and adopting an operating agreement Can be managed by the
members or, more often, by managers selected by the members. Can
also elect officers Self-employment tax treatment less favorable
than for S corporation Offers several advantages over the S
corporation: 1. No limitation on the number of members 2. No
limitation on who may invest (corporations, partnerships, and non
US residents can invest) 3. Treatment of gain on distribution of
appreciated property more favorable 4. Different classes of
ownership are allowed so there is the flexibility to provide for a
priority return of capital to investors Single-Member Limited
Liability Company Limited liability for owners makes it a better
choice than a sole proprietorship unless cost of formation or
maintenance is a controlling factor Disregarded entity from an
income tax perspective All income and expenses are reported on the
sole members tax return and no income tax return need be filed by
the LLC Formation process similar to multiple-member LLC, except
that the operating agreement will likely be less complex In
addition to circumstances where a sole proprietorship would be
considered, a single-member LLC is often used by a corporation or
LLC to insulate the liability associated with a particular line of
business DODGE v. FORD MOTOR CO. A business corporation is
organized primarily for the profit of the stockholders, and the
discretion of the directors is to be exercised in the choice of
means to attain that end, and does not extend to the reduction of
profits or the non-distribution of profits among stockholders in
order to benefit the public, making the profits of the stockholders
incidental thereto. Where a corporation had on hand about
$54,000,000 cash with a constant income of over $60,000,000 per
year profits, and proposed improvements and extensions would not
exceed $24,000,000, the court did not err in requiring that
directors declare an extra dividend of $19,000,000, in an action by
minority stockholders. Where a corporation had a surplus of
$112,000,000, about $54,000,000 cash on hand, and had made profits
of $59,000,000 in the past year with expectations of $60,000,000
the coming year, refusal of directors to declare a dividend of more
than $1,200,000 was, in the absence of some 6
justifiable reason, an arbitrary exercise of authority which
would give a court of equity the right to interfere. BUT It is a
well-recognized principle of law that the directors of a
corporation, and they alone, have the power to declare a dividend
of the earnings of the corporation, and to determine its amount.
Courts of equity will not interfere in the management of the
directors unless it is clearly made to appear that they are guilty
of fraud or misappropriation of the corporate funds, or refuse to
declare a dividend when the corporation has a surplus of net
profits which it can, without detriment to its business, divide
among its stockholders, and when a refusal to do so would amount to
such an abuse of discretion as would constitute a fraud, or breach
of that good faith which they are bound to exercise towards the
stockholders.'
More than half a million business entities have their legal home
in Delaware including more than 50% of all U.S. publicly-traded
companies and 58% of the Fortune 500 Corporate Chartering in US
Federalism Federal Government Regulates Stock Offerings, Protects
Investors, and Sets Standards for Financial Disclosures State
Governments Regulate Corporation Actions Under Civil and Common Law
Regimes State of Incorporation Very Important Why Delaware? First
mover advantage History lesson on Incorporations Primary Corporate
Market has been in New York as Commercial Capital of US th In late
19 Century States Began to Experiment with Corporate Law to become
more flexible in regulating incorporations and rules governing the
separation of ownership and management New Jersey was the first
successful state to move into corporate charter business Delaware
entered into the market after New Jersey enacted a series of
anti-trust laws Delaware Law Features Allows flexibility of
drafting corporate charters Law sets basic structure Respecting the
right to free contract Shareholder franchise Board initiation Basic
Principles duty of due care to shareholders duty of loyalty duty of
good faith Delaware Who decides? Delaware Court of Chancery
Delaware's court of original and exclusive equity jurisdiction, and
adjudicates a wide variety of cases involving trusts, real
property, guardianships, civil rights, and commercial litigation
Delaware Supreme Court Delaware's court of final appeal to which
appeals from the Delaware Court of Chancery immediately proceed
Institutions are Important! Courts and regulators have played an
important role to ensure that corporate governances mechanisms are
effective and efficient Management, General Directors, CEOs,
Individual directors and the board as a whole need to be held to
their duties of care and loyalty to the firm and to apply business
judgment in their decisions 7
A. P. SMITH MFG. CO. v. BARLOW Action brought by corporation for
judgment declaring its contribution to a privately supported
educational institution to be within its powers, where defendants
asked for judgment declaring the contribution to be a
misappropriation of corporate funds and an ultra vires act in
violation of property and contract rights of defendants and of
other stockholders of the plaintiff corporation. The Superior
Court, Chancery Division, held the donation to be intra vires. An
appeal taken to the Appellate Division was certified directly to
the Supreme Court which held that the corporate power to make
reasonable charitable contributions exists under modern conditions
even apart from express statutory provisions. Where justified by
advancement of public interest, reserved power of State to alter
corporate charter may be invoked to sustain later charter
alterations even though they affect contractual rights between
corporations and its stockholders and between stockholders
Charitable contribution statutes were within powers reserved by
State in granting corporate charter, and therefore such statutes
did not unconstitutionally impair obligations of charter of
pre-existing corporations or operate as a deprivation of property
without due process of law Corporate power to make reasonable
charitable contributions exists, under modern conditions, even
apart from express statutory provision. Thus, a business
corporation's contribution of funds for general maintenance of
privately supported educational institution was not an ultra vires
act. Delaware Corporate Governance Influence Why is Delaware
Important? State based incorporation statues of the US Delaware
Corporate Law tradition Delawares Corporate Registry
The strength of a joint stock company in a market system is the
underlying principles of rule of law and fairness to the interest
of all stockholders Delaware Code General Corporation Law
Subchapter IV. Directors and Officers 141. Board of directors;
powers; number, qualifications, terms and quorum; committees;
classes of directors; nonprofit corporations; reliance upon books;
action without meeting; removal (a) The business and affairs of
every corporation organized under this chapter shall be managed by
or under the direction of a board of directors, except as may be
otherwise provided in this chapter or in its certificate of
incorporation. If any such provision is made in the certificate of
incorporation, the powers and duties conferred or imposed upon the
board of directors by this chapter shall be exercised or performed
to such extent and by such person or persons as shall be provided
in the certificate of incorporation.
CAMPBELL V. LOEW'S, INC. Action by a stockholder against a
corporation, where stockholder requested a preliminary injunction
restraining the holding of a stockholders' meeting, or
alternatively, restraining the meeting from considering certain
matters, or voting certain proxies. The Court of Chancery held,
inter alia, that in view of fact bylaws of corporation authorized
president to call special meetings of the stockholders for any
purpose or purposes, president of the corporation was authorized to
call a stockholders' meeting to fill director vacancies, amend the
bylaws to increase the number of the board of directors, and to
remove certain directors and fill such vacancies, even though such
purposes were not in furtherance of routine business of
corporation, and notwithstanding fact that such matters might have
involved policy matters not defined by the board of directors, and
therefore, court would not issue a preliminary injunction enjoining
the holding of such meeting. A corporate bylaw giving corporate
president the power to submit matters for stockholder action, could
be presumed to only embrace matters which were appropriate for
stockholder action, and so construed, such bylaw would not be
deemed to impinge upon statutory right and duty of a corporate
board of directors to manage the business of the corporation. Call
of a stockholders' meeting, by corporate president, to fill
director vacancies, to amend the bylaws to increase the number of
the board, and remove certain directors and fill such vacancies,
was not action of a character which impinged upon power of
management given board of directors by statute.
Where corporate bylaws authorized president to call a
stockholders' meeting for any purpose, mere fact that another
section of the bylaws provided that stockholders might, on their
initiative, call a meeting for the purpose of filling vacancies on
board of directors, did not mean that president was deprived of
power to call a stockholders' meeting for such purpose. Statute
providing that not only vacancies, but newly created directorships
of a corporation may be filled by majority of directors in office,
unless it is otherwise provided in the certificate of
incorporation, or by-laws, is not exclusive and does not prevent
stockholders from filling new directorships between annual
meetings. The board of directors of a corporation, acting as a
board, must be recognized as the only group authorized to speak for
"management" in the sense that by statute, they are responsible for
the management of the corporation. Where a certain corporate
faction was in charge of a corporation's facilities, and symbolized
existing policy, it had sufficient status to justify reasonable use
of corporate funds to present its position to the stockholders, and
to expend reasonable sums of corporate funds in solicitation of
proxies, although, to assure equal treatment between such faction
and opposing faction in event of a proxy contest, such faction
would be enjoined from using corporate facilities and employees in
connection with its proxy solicitation. PIERCING THE CORPORATE
VEIL
In General - Personal Liability for Corporate Debt
Non-functioning of other officers and directors Siphoning of funds
Absence of corporate records Corporation acts as faade for
owners/shareholders Elements of injustice or fundamental unfairness
General rule: The rule is the court may disregard the corporate
entity if 1. there is Fraud or 2. Alter Ego Doctrine Unity of
Interest: there is such a unity of interest and ownership such that
the separate personalities of the corporation and the individual no
longer exist the company is "a mere instrumentality or alter ego of
its owner, and Injustice: Allowing shareholder to avoid liability
would promote an injustice
Perception v. Reality Perception It is nearly impossible to
pierce the corporate veil. Because limited liability holds such an
esteemed place in our law, courts frequently opine that their power
to pierce the veil should be exercised reluctantly, cautiously, or
only in exceptional circumstances. 8
A Colorado Example: Insulation from individual liability is an
inherent purpose of incorporation; only extraordinary circumstances
justify disregarding the corporate entity to impose personal
liability. Leonard v. McMorris, 63 P.3d 323 (Colo. 2003). Reality
Courts will pay homage to the exceptional circumstances tradition,
but do what they believe is right. An analysis of nearly 1,600
reported decisions revealed that courts pierced the corporate veil
more than 40% of the time. Thompson, Piercing the Corporate Veil:
An Empirical Study, 76 Cornell L.Rev. 1036 (1991). Development of
the Piercing Doctrine When a plaintiff has a valid cause of action
against an insolvent corporation, the Court must weigh two
competing values. The first is societys desire to uphold the
principle of limited liability, and the second is the desire to
achieve an equitable outcome. Early decisions relied on equitable
principles, and typically involved allegations of fraud. See, Booth
v. Bunce, 33 N.Y. 139 (1865) General Rule If any general rule can
be laid down, in the present state of authority, it is that a
corporation will be looked upon as a legal entity as a general
rule, and until sufficient reason to the contrary appears; but,
when the notion of legal entity is used to defeat public
convenience, justify wrong, protect fraud, or defend crime, the law
will regard the corporation as an association of persons. A Remedy
Not a Cause of Action Most Courts hold that piercing the corporate
veil is an equitable remedy not a cause of action. Piercing the
corporate veil is an equitable remedy, requiring balancing of the
equities in each particular case. Great Neck Plaza, L.P. v. Le Peep
Restaurants, LLC, 37 P.3d 485 (Colo. App. 2001); See also, Equinox
Enterprises, Inc. v. Associated Media Inc., 730 SW2d 872 (Tex. App.
1987) BERKEY v. THIRD AVE. RY. CO.
required to be complete, in order for the parent company to be
treated as liable for the debts of the subsidiary. It was needed
that the subsidiary be merely the alter ego of the parent, or that
the subsidiary be thinly capitalized, so as to perpetrate a fraud
on the creditors. BARTLE v. HOME OWNERS COOPERATIVE Action to
compel corporation to meet obligations of its subsidiary. The
Supreme Court, Appellate Division, affirmed judgment of Supreme
Court, Equity Term, dismissing complaint, and plaintiffs appealed.
The Court of Appeals held that trustee of bankrupt subsidiary
corporation could not maintain action to compel parent corporation
to meet obligations of its subsidiary, where there had been neither
fraud, misrepresentation nor illegality involved in incorporation
of such subsidiary or its subsequent operation. Judgment affirmed.
Doctrine of piercing corporate veil is invoked to prevent fraud or
to achieve equity. The law permits incorporation of a business for
very purpose of escaping personal liability. Trustee of bankrupt
subsidiary corporation could not maintain action to compel parent
corporation to meet obligations of such subsidiary, where there had
been neither fraud, misrepresentation nor illegality involved in
incorporation of such subsidiary or its subsequent operation.
WALKOVSZKY v. CARLTON Action against corporation in name of which a
taxicab was registered, driver of the taxicab, nine other
corporations in whose names other taxicabs were registered, two
additional corporations, and three individuals for injuries
sustained by plaintiff when struck by the taxicab. The Supreme
Court granted motion of an individual defendant who was claimed to
be a stockholder of ten corporations, including corporation in name
of which taxicab was registered, to dismiss the complaint as to him
for failure to state a cause of action, and plaintiff appealed. The
Supreme Court, Appellate Division reversed and denied the motion
and individual defendant appealed by leave of the Appellate
Division on a certified question. The Court of Appeals held that
complaint containing allegations that individual defendant
organized, managed, dominated and controlled a fragmented corporate
entity and that fleet ownership of taxicabs had been deliberately
split among many corporations was insufficient to state a cause of
action against individual defendant as a stockholder in such
corporations, where there was no allegation that individual
defendant was conducting such business in his individual capacity.
Order of Appellate Division reversed, certified queston answered in
the negative, order of the Supreme Court, Richmond County,
reinstated with 9
Actions by Minnie Best Berkey and Charles P. Berkey against the
Third Avenue Railway Company, from an order of the Appellate
Division reversing a judgment of the Trial Term, which dismissed
complaints, and granting new trial, defendant appealed. Order
reversed, and judgment of the Trial Term affirmed. The New York
Court of Appeals held that the Third Avenue Railway Co was not
liable for the debts of the subsidiary. It was necessary that the
domination of the parent company over the subsidiary was
leave to serve an amended complaint. Courts will disregard the
corporate form or pierce the corporate veil whenever necessary to
prevent fraud or to achieve equity. Incorporation of a business is
permitted for the purpose of enabling its proprietors to escape
personal liability, although the privilege is not without limits.
In determining whether liability should be extended to reach assets
beyond those belonging to the corporation, courts will be guided by
general rules of agency. Whenever anyone uses control of a
corporation to further his own rather than the corporation's
business, he will be responsible for the corporation's acts upon
principle of respondeat superior applicable even where the agent is
a natural person, and such liability extends not only to the
corporation's commercial dealings, but to its negligent acts.
Although either the circumstance that a corporation is a fragment
of a larger corporate combine which actually conducts a business,
or that a corporation is a dummy for its individual stockholders
who in reality are carrying on a business in their own personal
capacities for purely personal rather than corporate ends would
justify treating the corporation as an agent and piercing the
corporate veil to reach the principal, in the first circumstance
only a larger corporate entity could be held financially
responsible, while in the other circumstance the stockholders would
be personally liable. In ascertaining whether a complaint states a
cause of action, the entire pleading must be considered. Complaint
containing allegations that an individual defendant organized,
managed, dominated and controlled a fragmented corporate entity and
that fleet ownership of taxicabs had been deliberately split among
many corporations was insufficient to state a cause of action in
tort against individual defendant as a stockholder in such
corporations, where there was no allegation that individual
defendant was conducting business in his individual capacity. The
corporation form could not be disregarded merely because the assets
of corporate owner of a taxicab together with mandatory insurance
coverage on the taxicab which struck plaintiff were insufficient to
assure plaintiff recovery sought.
MORRIS V. NEW YORK STATE DEPT. OF TAXATION AND FINANCE Board
member of corporation brought action for judicial review of
determination of Tax Appeals Tribunal regarding compensating use
tax assessment. The Supreme Court, Appellate Division confirmed.
Board member appealed. The Court of Appeals held that corporate
veil could not be pierced so as to hold board member personally
liable for compensating use taxes allegedly incurred by
corporation.
Concept of "piercing the corporate veil" is limitation on
accepted principles that corporation exists independently of its
owners as separate legal entity, that owners are normally not
liable for debts of corporation, and that it is perfectly legal to
incorporate for express purpose of limiting liability of corporate
owners. Attempt of third party to pierce the corporate veil does
not constitute cause of action independent of that against
corporation; rather it is assertion of facts and circumstances
which will persuade court to impose corporate obligations on its
owners. Although there are no definitive rules governing
circumstances when corporate veil may be pierced, generally showing
is required that: (1) owners exercised complete domination of
corporation in respect to transaction attacked; and (2) such
domination was used to commit fraud or wrong against plaintiff
which resulted in plaintiff's injury. While complete domination of
corporation is key to piercing corporate veil, especially when
owners use corporation as mere device to further personal rather
than corporate business, such domination, standing alone, is not
enough; some showing of wrongful or unjust act toward plaintiff is
required. Party seeking to pierce corporate veil must establish
that owners, through their domination, abused privilege of doing
business in corporate form to perpetrate wrong or injustice against
that party such that court in equity will intervene. Even assuming
that sole board member of closely held corporation owned by board
member's brother and nephew dominated corporation, corporate veil
could not be pierced so as to hold board member personally liable
for compensating use taxes allegedly incurred by corporation; there
was no evidence of intent to defraud and thus board member did not
misuse corporate form for personal ends so as to commit wrong or
injustice on taxing authorities, and there was no corporate
obligation to be imposed on board member since corporation was
entitled to nonresident exemption and thus owed nothing. Even if
federal rule, recognizing that corporation may have separate
taxable identity, were to be applied to question of whether
corporate veil should be pierced so that sole board member of
closely held corporation could be held personally liable for
compensating use tax allegedly incurred by corporation, board
member would not be liable since corporation had legitimate
business purpose of owning and chartering boats, and there was no
evidence that corporation was set up as sham or for purpose of tax
avoidance.
UNITED STATES v. BESTFOODS Compensation and Liability Act
(CERCLA) against parent corporations of chemical manufacturers for
costs of cleaning up industrial waste generated by chemical plant.
The United States District Court for the Western District of
Michigan imposed operator 10
liability on parent corporations. On appeal, the Court of
Appeals for the Sixth Circuit reversed in part. After grant of
certiorari, the Supreme Court held that: (1) when the corporate
veil may be pierced, a parent corporation may be charged with
derivative CERCLA liability for its subsidiary's actions; (2) a
participation-and-control test looking to the parent corporation's
supervision over subsidiary cannot be used to identify operation of
a facility resulting in direct parental liability under CERCLA; and
(3) direct parental liability under CERCLA's operator provision is
not limited to a corporate parent's sole or joint venture operation
with subsidiary. Judgment of Court of Appeals vacated and case
remanded with instructions. It is a general principle of corporate
law deeply ingrained in our economic and legal systems that a
"parent corporation," so-called because of control through
ownership of another corporation's stock, is not liable for the
acts of its subsidiaries. The exercise of the control which stock
ownership gives to the stockholders will not create liability on
the part of parent corporation for acts of subsidiary beyond the
assets of the subsidiary, with "control" including the election of
directors, the making of bylaws, and the doing of all other acts
incident to the legal status of stockholders. Duplication of some
or all of the directors or executive officers will not create
liability on part of parent corporation for acts of subsidiary,
beyond the assets of the subsidiary. Corporate veil may be pierced
and the shareholder held liable for the corporation's conduct when,
inter alia, the corporate form would otherwise be misused to
accomplish certain wrongful purposes, most notably fraud, on the
shareholder's behalf. CERCLA gives no indication that the entire
corpus of state corporation law is to be replaced simply because a
plaintiff's cause of action is based upon a federal statute, and
the failure of the statute to speak to a matter as fundamental as
the liability implications of corporate ownership demands
application of the rule that in order to abrogate a common-law
principle, the statute must speak directly to the question
addressed by the common law. When, but only when, the corporate
veil may be pierced, a parent corporation may be charged with
derivative CERCLA liability for its subsidiary's actions. If a
subsidiary that operates, but does not own, a facility is so
pervasively controlled by its parent for a sufficiently improper
purpose to warrant veil piercing, the parent may be held
derivatively liable under
CERCLA for the subsidiary's acts as an operator. District
court's focus on the relationship between parent corporation which
disputed direct CERCLA operator liability and its subsidiary,
rather than on the parent and the subsidiary's polluting facility,
combined with the court's automatic attribution of the actions of
dual officers and directors to the corporate parent, erroneously,
even if unintentionally, treated CERCLA as though it displaced or
fundamentally altered common law standards of limited liability.
THE DUTY OF CARE
The duty of care requires that directors make decisions based
upon reasonably adequate information and deliberation Discharge
duties with the care that an ordinarily prudent person in a like
position would exercise under similar circumstances; Discharge
duties in a manner they reasonably believe is in the best interest
of the corporation. Requires the directors to attend board
meetings; obtain and review adequate information concerning actions
taken by the board; and generally supervise the corporations
business and its major policies THE BUSINESS JUDGMENT RULE The
business judgment rule is a presumption of the courts that in
making a business decision the directors fulfill their fiduciary
duties of care and loyalty to the corporation by: Acting on an
informed basis; In good faith; In the honest belief that the
decision was in the best interest of the company. APPLICATION OF
THE BUSINESS JUDGMENT RULE The business judgment rule protects only
informed decisions To come under the rules of protection, directors
must inform themselves of all information reasonably available to
them and relevant to their decision; The proper standard for
determining whether a business judgment was an informed one is
gross negligence. The Business Judgment Rule does not protect the
directors when they have either abdicated their functions or failed
to act THE DUTY OF CARE The duty of care requires that directors
make decisions based upon reasonably adequate information and
deliberation Discharge duties with the care that an ordinarily
prudent person in a like position would exercise 11
under similar circumstances; Discharge duties in a manner they
reasonably believe is in the best interest of the corporation.
Requires the directors to attend board meetings; obtain and review
adequate information concerning actions taken by the board; and
generally supervise the corporations business and its major
policies THE BUSINESS JUDGMENT RULE The business judgment rule is a
presumption of the courts that in making a business decision the
directors fulfill their fiduciary duties of care and loyalty to the
corporation by: Acting on an informed basis; In good faith; In the
honest belief that the decision was in the best interest of the
company. APPLICATION OF THE BUSINESS JUDGMENT RULE The business
judgment rule protects only informed decisions To come under the
rules of protection, directors must inform themselves of all
information reasonably available to them and relevant to their
decision; The proper standard for determining whether a business
judgment was an informed one is gross negligence. The Business
Judgment Rule does not protect the directors when they have either
abdicated their functions or failed to act FRANCIS v. UNITED JERSEY
BANK Action was brought by trustees in bankruptcy of corporation to
recover funds paid by corporation to principal stockholder for
benefit of his estate, and to members of his family. After judgment
was entered in favor of plaintiffs, the Superior Court denied
motion for new trial or alternatively for amendment to judgment,
and appeal was taken. The Superior Court, Appellate Division
affirmed and administrator and executrix of estate appealed. The
Supreme Court held that decedent was negligent in not noticing and
trying to prevent misappropriation of funds held by corporation in
an implied trust and her negligence was proximate cause of
trustees' losses. Affirmed. As a general rule, a corporate director
should acquire at least a rudimentary understanding of business of
corporation and accordingly, a director should become familiar with
fundamentals of business in which corporation is engaged and
because directors are bound to exercise ordinary care, they cannot
set up as a defense lack of knowledge needed to exercise the
requisite degree of care and if one feels that he has not had
sufficient
business experience to qualify him to perform the duties of a
director, he should either acquire the knowledge by inquiry, or
refuse to act. Directors of corporations are under continuing
obligation to keep informed about activities of corporation;
otherwise, they may not be able to participate in overall
management of corporate affairs. Shareholders have right to expect
that directors will exercise reasonable supervision and control
over policies and practices of a corporation Corporate directors
may not shut their eyes to corporate misconduct and then claim that
because they did not see the misconduct, they did not have a duty
to look Directorial management of corporation does not require a
detailed inspection of day-to-day activities but, rather, a general
monitoring of corporate affairs and policies and accordingly, a
director is well advised to attend board meetings regularly. While
directors of corporations are not required to audit corporate
books, they should maintain familiarity with financial status of
corporation by regular review of financial statements and, in some
circumstances, directors may be charged with assuring that
bookkeeping methods conform to industry custom and usage. Corporate
director was personally liable in negligence for failure to prevent
misappropriation of trust funds by other directors who were also
officers and shareholders of the corporation where negligence was
proximate cause of loss. Usually a corporate director can absolve
himself from liability by informing the other directors of
impropriety and voting for proper course of action; conversely, a
director who votes for or concurs in certain actions may be liable
to the corporation for the benefit of its creditors or
shareholders, to the extent of any injuries suffered by such
persons, respectively, as a result of such action. In most
instances an objecting director whose dissent is noted in
accordance with applicable statute will be absolved after
attempting to persuade fellow directors to follow different course
of action. Director is not an ornament, but an essential component
of corporate governance; consequently, a director cannot protect
himself behind a paper shield bearing the motto, "dummy director."
NURSING HOME BUILDING CORPORATION v. DeHART Action was brought by
corporate nursing home against former sole shareholders of
corporation for alleged fraudulent misappropriation of corporate
funds. The Superior Court, King County entered judgment for
plaintiff for $9,914.85, an obligation conceded by defendants, and
plaintiff appealed. The Court of Appeals held that former
shareholders were not liable to corporate nursing home for
disbursements, which were ratified by all shareholders, of
corporate assets to sellers of 12
corporate stock as installment payments for purchase of stock,
that evidence supported finding that challenged expenditures by
former sole shareholders were made by such shareholders within
scope of proper exercise of their business judgment in running
corporate nursing home, and that evidence supported finding that
use of corporate funds by former sole shareholders for payment of
expenses other than taxes constituted valid exercise of business
judgment. Affirmed. Corporation's separate legal identity is not
lost merely because all of its stock is held by members of single
family or by one person and thus fact of sole ownership does not of
itself immunize sole shareholder from liability to corporation, but
corporate entity will be disregarded when justice so requires.
Courts should be reluctant to interfere with internal management of
corporations and should generally refuse to substitute their
judgment for that of directors. "Business judgment rule (BJR)
immunizes management from liability in corporate transaction
undertaken within both power of corporation and authority of
management where there is reasonable basis to indicate that
transaction was made in good faith. Evidence, in action brought by
corporate nursing home against former sole shareholders of
corporation for alleged fraudulent misappropriation of corporate
funds, supported finding that challenged expenditures by former
sole shareholders, who were experienced in operation of various
types of businesses including nursing homes and who were involved
in day to day management of corporate nursing home on full time or
greater basis, were made by such shareholders within scope of
proper exercise of their business judgment. Evidence in action
brought by corporate nursing home against former sole shareholders
of corporation for alleged fraudulent misappropriation of corporate
funds supported finding that use of corporate funds by former sole
shareholders for payment of expenses other than taxes constituted
valid exercise of business judgment as to which court would not
interfere in absence of bad faith or fraud. Where disbursements of
installment payments for purchase of stock were made with corporate
assets by former sole shareholders of corporate nursing home and
such disbursements were ratified by all shareholders, former sole
shareholders were not liable to corporation for such installment
payments. Where contract for sale of stock was executed by all
parties, including corporate nursing home, contract provided that
asset of corporation would be assigned to sellers of stock,
corporation approved contract at time when sellers were sole
shareholders and constituted majority of board of directors, and
all parties consented to and ratified assignment of such
contract, ratification of such transaction by all parties in
accordance with stock purchase contract was binding on corporation
and thus former sole shareholders who purchased stock from sellers
were not liable to corporation for their subsequent transfer of
such asset. SMITH v. VAN GORKOM Class action was brought by
shareholders of corporation, originally seeking rescission of
cash-out merger of corporation into new corporation. Alternate
relief in form of damages was sought against members of board of
directors, new corporation, and owners of parent of new
corporation. Following trial, the Court of Chancery, granted
judgment for directors by unreported letter opinion, and
shareholders appealed. The Supreme Court held that: (1) board's
decision to approve proposed cash-out merger was not product of
informed business judgment; (2) board acted in grossly negligent
manner in approving amendments to merger proposal; and (3) board
failed to disclose all material facts which they knew or should
have known before securing stockholders' approval of merger. On
motions for reargument, the Court held that one director's absence
from meetings of directors at which merger agreement and amendments
to merger agreement were approved did not relieve that director
from personal liability. Reversed and Remanded. McNeilly and
Christie, JJ., filed dissenting opinions and dissented in part from
denial of motions for reargument In carrying out their managerial
roles, directors of corporation are charged with underlying
fiduciary duty to corporation and its shareholders. Business
judgment rule exists to protect and promote full and free exercise
of managerial power granted to directors of corporations. Party
attacking board of directors' decision as uninformed must rebut
presumption that board's business judgment was informed one.
Determination of whether business judgment of board of directors is
informed one turns on whether directors have informed themselves,
prior to making business decision, of all material information
reasonably available to them. Board of directors acted in grossly
negligent manner when it voted to amend merger agreement, where
directors approved oral presentation of substance of proposed
amendments, terms of which were not reduced to writing until two
days later, rather than waiting to review amendments, again
approved them sight unseen and adjourned, and even though
amendments allowed corporation to solicit competing offers,
corporation was permitted to terminate merger agreement and abandon
merger only if, prior to shareholders' meeting, corporation had
either consummated merger or sale of assets to third party or had
entered into definitive merger 13
agreement more favorable than original and for greater
consideration, and market test period for determining fairness of
purchase price was effectively reduced by amendments. Board of
directors lacked valuation information adequate to reach informed
business judgment as to fairness of $55 per share for sale of
company, notwithstanding magnitude of premium or spread between
offering price and company's current market price of $38 per share,
where market had consistently undervalued worth of stock, publicly
traded stock price represents only value of single share and not
value of whole company, board made no evaluation of company that
was designed to value entire enterprise, board accepted without
scrutiny chairman's representation as to fairness of $55 price per
share for sale of company and thereby failed to discover that
chairman had suggested $55 price and had arrived at that figure
based on calculations designed solely to determine feasibility of
leveraged buy-out. Business Judgment Rule (1) Under Delaware law,
the business judgment rule is the offspring of the fundamental
principle, codified in 8 Del.C. 141(a), that the business and
affairs of a Delaware corporation are managed by or under its board
of directors. The business judgment rule exists to protect and
promote the full & free exercise of the managerial power
granted to Del. directors
(e.g., causation): Transaction was entirely fair to corporation
Fully-informed S/hs voted to approve boards action (Van Gorkom) 3.
Process challenges may have lower threshold (e.g., ordinary
negligence) for banks or financial intermediaries
Class Actions and Their Abuse Class actions were conceived as an
expeditious way for people with similar grievances to join in a
common suit and get compensated for injuries. But class actions
have evolved into a favored means for trial lawyers to launch
predatory assaults on businesses and large institutions, often in
the name of clients who dont even know they are being represented.
Despite the absurdity of many of these suits, legitimate companies
are hard-pressed to defend themselves because they face thousands
or even millions of plaintiffs. As they watch their share prices
sink with bad publicity, companies almost always have to settle
rather than risk billions of dollars in punitive damages.
Increasingly, the end result is huge fees for the lawsuit industry
an average of over $1,000 per hour according to Class Action
Reports but relatively tiny awards for individual plaintiffs. For
example, in one Texas case, lawyers sued two auto insurers for
overbilling because the insurers rounded up premium bills to the
next dollar (a practice that was sanctioned by the state insurance
department) and pocketed almost $11 million; policyholders got a
paltry $5.50 each, a typical result in class action lawsuits.
MARKET IN SECURITIES Within days of a drop in a companys stock
price (usually a high-growth technology stock with a naturally high
shareprice volatility), trial lawyers swoop in to file a claimoften
lacking any real proof of corporate wrongdoing. Corporations faced
with the inevitable, extremely onerous discovery process must
defend themselves at great expense; little wonder that such cases
typically settle, with one-third of the proceeds going to lawyers.
These actions merely redistribute wealth from one class of
shareholders to another and thus do nothing to curb management
abuse The empirical evidence shows that securities class actions
settlement values are unrelated to the merits of the underlying
cases, so the argument that the securities class action system
offers any meaningful deterrent to corporate misconduct is wholly
unpersuasive. Despite the Private Securities Litigation Reform Act
of 1995, the securities gravy train for trial lawyers rolls on:
securities class action filings rose 31 percent in 2002, and one
prominent plaintiffs firm negotiated three recent 14
Business Judgment Rule (2) Since a director is vested with the
responsibility for the management of the affairs of the
corporation, he must execute that duty with the recognition that he
acts on behalf of others. Such obligation does not tolerate
faithlessness or self-dealing. But fulfillment of the fiduciary
function requires more than the mere absence of bad faith or fraud.
Representation of the financial interests of others imposes on a
director an affirmative duty to protect those interests and to
proceed with a critical eye. Business Judgment Rule (3) To be
protected by the BJR, managerial decisions must meet the following
criteria: made in good faith made with loyalty to the company made
with due diligence
Challenging Process: Lessons from Van Gorkom 1. While BJR
creates a presumption that the boards decision was informed
plaintiff can rebut presumption by showing that prior to making
decision, board was grossly negligent (or reckless) in informing
themselves about material information reasonably available to them.
2. Defendants found to have breached their Duty of Care
procedurally can still defend on other grounds
settlements of $300 million or more. Magnet Courts Unlike
traditional lawsuits, class actions tend to involve plaintiffs from
multiple jurisdictions, if not from all over the nation. Thus,
instead of filing suit at the place of residence or injury as is
normally required in the typical single plaintiff lawsuit trial
lawyers are able to shop class action suits in search of the most
favorable forum. Quite predictably, the best forum winds up being a
state magnet court well known for its hospitable treatment of class
action lawsuits. For instance, Madison County, Illinois recently
made famous by handing out a $10.1 billion verdict against Philip
Morris for allegedly insinuating that its light cigarettes were
safer has seen a tremendous upsurge in class action filings in
recent years. From 1998 to 2000, class action filings in Madison
County increased over 1,800%; over 80% of these suits were brought
on behalf of proposed nation-wide classes. Oversight of Class
Action Settlements Many judges, too, see the need to rein in the
lawsuit industrys worst excesses. In its landmark Campbell v. State
Farm decision, the Supreme Court put a constitutional limit on a
jurys ability to set punitive damages at an extreme multiple of
actual damages. And while courts have traditionally been reluctant
to enforce state codes of ethics prohibiting excessive fees, judges
may finally be cracking down in the wake of the outrageous tobacco
settlements: New York State judge Nicholas Figueroa recently threw
out as excessive a $1.3 billion claim by the Castano group for work
allegedly done on the California tobacco settlement. Magnet Courts
Unlike traditional lawsuits, class actions tend to involve
plaintiffs from multiple jurisdictions, if not from all over the
nation. Thus, instead of filing suit at the place of residence or
injury as is normally required in the typical single plaintiff
lawsuit trial lawyers are able to shop class action suits in search
of the most favorable forum. Quite predictably, the best forum
winds up being a state magnet court well known for its hospitable
treatment of class action lawsuits. For instance, Madison County,
Illinois recently made famous by handing out a $10.1 billion
verdict against Philip Morris for allegedly insinuating that its
light cigarettes were safer has seen a tremendous upsurge in class
action filings in recent years. From 1998 to 2000, class action
filings in Madison County increased over 1,800%; over 80% of these
suits were brought on behalf of proposed nation-wide classes.
Oversight of Class Action Settlements Many judges, too, see the
need to rein in the lawsuit industrys worst excesses. In its
landmark Campbell
v. State Farm decision, the Supreme Court put a constitutional
limit on a jurys ability to set punitive damages at an extreme
multiple of actual damages. And while courts have traditionally
been reluctant to enforce state codes of ethics prohibiting
excessive fees, judges may finally be cracking down in the wake of
the outrageous tobacco settlements: New York State judge Nicholas
Figueroa in recent years threw out as excessive a $1.3 billion
claim by the Castano group for work allegedly done on the
California tobacco settlement. Duties of Agent to Principal Duty of
Loyalty -- An agent: must act for the benefit of the principal. may
not receive outside benefits without approval of the principal. can
neither disclose nor use for her own benefit any confidential
information. is not allowed to compete with his principal within
the scope of the agency business. may not act for two principals
whose interests conflict. may not become a party to a transaction
without the principals permission. may not engage in inappropriate
behavior that reflects badly on the principal Principals Remedies
When the Agent Breaches a Duty The principal can recover damages
caused by the agents breach. The agent must refund any profits made
from the agency, if he breaches his duty of loyalty. The principal
may rescind a transaction with an disloyal agent. Fiduciary Duties
of Directors - Duty of Loyalty Questions about board members duty
of loyalty most often arise where: There is a conflict of interest;
or Board member takes advantage of a corporate opportunity of the
Company. Traditional Duty of Loyalty Analysis Is there a conflict
of interest? Direct Transaction between corporation and fiduciary
Indirect Transaction between corp and another corp in which
fiduciary has [substantial?] financial interest Family transactions
If yes, transaction is voidable by corporation Compare: DGCL 144
Merely a financial interest for a conflict of interest Three
Alternative ways to cleanse: Disclosure to Board of Directors &
approval No quorum requirement; but majority of minority
requirement 15
Disclosure to Shareholders & approval No apparent Quorum
requirement Transaction fair at time of approval Burden of Proof?
HOLDEN v. CONSTRUCTION MACHINERY COMPANY An action in equity was
instituted, individually and derivatively, by the holder of 49.976%
of the outstanding stock of a corporation, against the corporation,
its officers and directors. The Black Hawk District Court held in
part adverse to the defendants, and they appealed. The minority
shareholder cross-appealed. The Supreme Court held that where the
majority shareholder was found to be a constructive trustee of
another company's stock, purchased with a check from the
corporation, an award to the corporation of the shares including
shares acquired by stock split and cash dividends appropriately
stood as a judgment for restitution. The Court also held that where
the majority shareholder, as president and general manager of the
corporation, personally engineered every phase of the deal by which
the stock in the other company was acquired by a check from the
corporation, appropriated to his own use all dividends issued upon
such stock, directed falsification of corporate records and other
documents, and subsequently endeavored to impress upon the whole
transaction a coloration of honesty and also did all in his power
to isolate the minority holder from any rights or privileges
pertaining to management, assessment of exemplary damages was
compelled. Affirmed on defendants' appeal; reversed in part,
affirmed in part, affirmed in part as modified on plaintiff's cross
appeal, and remanded with instructions. Equity holds officers and
directors of corporate entity, particularly management-controlling
directors of closely held corporations, strictly accountable as
trustees. Majority shareholder of corporation who was also
president and general manager was strictly accountable to
corporation for another company's stock purchased with check from
corporation, or for fair market value of such stock, and for all
increases, income, proceeds or dividends realized.
that some legally protected right has been invaded, such as by
intentional act of fraud or other wrongful conduct. Security
Requirement In around 1/3 of states (though not Delaware), a
derivative claimant with low stakes must post security for
corporations legal expenses. Why do you think this requirement
exists? Effects on strategic or incentive problems among relevant
parties (Shareholders, Managers, Attorneys)? Demand Requirement
Most states require S/hs in derivative suits first to approach
Board of Directors and demand that they pursue legal action unless
the S/h can claim a valid excuse. When is demand requirement
excused? If not excused, what recourse does S/h have if Board
decides not to pursue? Does making the demand affect ones
subsequent rights to bring a derivative action? EISENBERG v. The
FLYING TIGER LINE, INC. Action by stockholder, on behalf of himself
and all other stockholders of corporation similarly situated, to
enjoin effectuation of plan of reorganization and merger. The
United States District Court for the Eastern District of New York
dismissed the action after stockholder failed to post security for
corporation's costs and stockholder appealed. The Court of Appeals
held that action seeking to overturn reorganization and merger the
effects of which was that business operations were confined to a
wholly owned subsidiary of holding company whose stockholders were
the former stockholders of defendant corporation was a "personal
action" and not "derivative" within meaning of New York statute
requiring posting of security for corporation's costs. Reversed.
Action by stockholder, suing on behalf of himself and all other
stockholders of corporation similarly situated, seeking to overturn
reorganization and merger the effect of which was that business
operations were confined to a wholly owned subsidiary of holding
company whose stockholders were the former stockholders of
defendant corporation, was a "personal action" and not "derivative"
within meaning of New York statute requiring posting of security
for corporation's costs. If the gravamen of the complaint is injury
to the corporation the suit is derivative, but "if the injury is
one to the plaintiff as a stockholder and to him individually and
not to the corporation," the suit is individual in nature and may
take the form of a representative class action. 16
Where majority shareholder, as president and general manager of
corporation, personally engineered every phase of deal by which
stock in another company was acquired with check from corporation,
appropriated to his own use all dividends issued upon such stock,
directed falsification of corporate records and other documents,
and subsequently endeavored to impress upon whole transaction a
coloration of honesty and also did all in his power to isolate
minority holder of 49.976% of outstanding stock from any rights or
privileges pertaining to management, assessment of exemplary
damages was compelled. In shareholder's derivative action, equity
court may, in its discretion, award exemplary damages upon
showing
Eisenbergs Complaint: Deprivation of voting rights to former
Flying Tiger S/hs with respect to operating company. FTLs
Counter-argument: Eisenbergs claim is derivative. Must post
security under NY law. Trial court: Held that Eisenberg was
required to post security (as per NYs law and FTLs pre-trial
motion) Eisenberg refused to pay. Complaint dismissed. MARX V.
AKERS Appeal, by permission of the Court of Appeals, from an order
of the Appellate Division of the Supreme Court in the Second
Judicial Department, entered May 15, 1995, which affirmed an order
of the Supreme Court granting motions by defendants to dismiss the
amended complaint. Affirmed. In a shareholders' derivative action,
plaintiff failed to state a cause of action with respect to the
allegations of the complaint that the board of directors wasted
corporate assets by awarding excessive compensation to the
corporation's outside directors, consisting of a retainer of
$55,000 plus 100 shares of the corporation's stock over a five-year
period which bore little relationship to duties performed or to the
cost of living. An allegation that directors have voted themselves
compensation does not give rise to a cause of action, as directors
are statutorily entitled to set those levels. Moreover, a complaint
challenging the excessiveness of director compensation must--to
survive a dismissal motion--allege compensation rates excessive on
their face or other facts which call into question whether the
compensation was fair to the corporation when approved, the good
faith of the directors setting those rates, or that the decision to
set the compensation could not have been a product of valid
business judgment. Here, there are no factually based allegations
of wrongdoing or waste which would, if true, sustain a verdict in
plaintiff's favor. Plaintiff's bare allegations that the
compensation set lacked a relationship to duties performed or to
the cost of living are insufficient as a matter of law to state a
cause of action. In a shareholders' derivative action, a demand
that the board of directors initiate a lawsuit, Business
Corporation Law 626 [c], was excused as to the allegations of the
complaint that a majority of the board was self-interested in
setting the compensation of the corporation's outside directors
because the outside directors comprised a majority of the board.
Directors are self-interested in a challenged transaction where
they will receive a direct financial benefit from the transaction
which is different from the benefit to shareholders generally.
A director who votes for a raise in directors' compensation is
always "interested" because that person will receive a personal
financial benefit from the transaction not shared in by
stockholders. Consequently, a demand was excused as to plaintiff's
allegations that the compensation set for outside directors was
excessive. ZAPATA CORP. V. MALDONADO Brief Fact Summary: Plaintiff
brought a derivative action against officers and directors of
Defendant, Zapata Corporation. Defendant appointed a special
committee that decided not to pursue the litigation proposed by
Plaintiff. Synopsis of Rule of Law: The court should first
determine if a defendant corporation proves that the appointed
committee is independent, and then determine, when applying their
business judgment standard, whether the motion to dismiss the
derivative suit should be granted. Facts: Maldonado brought the
derivative suit against ten officers and directors of Defendant,
asserting that they breached their fiduciary duties. Plaintiff did
not demand that the Defendant officers bring the action because all
the directors at the time were named in the suit. After the suit,
Defendant corporation appointed an Independent Investigation
Committee comprised of two directors who were not part of the
initial suit. The Committee decided that the derivative suits would
be harmful to the company and therefore moved to dismiss the
litigation. Issue: The issue is whether the authorized committee
should be permitted to dismiss pending derivative suit litigation.
Held: The court applied a two-step test to determine if the
Committee should be permitted to dismiss the litigation. First,
Defendant corporation has the burden to prove that the Committee is
independent and is exercising good faith and reasonable
investigation. Second, the court should apply their independent
business judgment. Discussion: The courts two-step test shifts the
burden to the corporation to prove the independence, which limits
the advantage to a company of appointing an independent group to
determine the merits of a derivative suit. AUERBACH V. BENNETT NEW
YORK rule Disposition of the case turns on the proper application
of the business judgment doctrine, in particular to the decision of
a specially appointed committee of disinterested directors acting
on behalf of the board to terminate a shareholders derivative
action.... [T]he determination of the special litigation 17
committee forecloses further judicial inquiry into this case. If
SLC is not independent, its recommendations are meaningless:
Independence Factors: Non-defendants; no nomination by named
directors; full delegation of authority to SLC Note: Decision not
clear about who bears burden here If SLC is independent: Procedures
used by SLC scrutinized under gross negligence standard Substantive
Decision of SLC gets protection of the Business Judgment Rule
Criticism of Decision: Ignores problems of structural bias in board
Analysis In Delaware, do SLCs have the power to cause dismissal of
derivative actions? Does the court distinguish between demand
excused and required cases? 2-part test for demand-excused cases in
which an SLC has recommended dismissal: Did SLC act independently,
in good faith, and with a reasonable investigation (with the burden
of proof on defendants), and Does dismissal pass independent
judicial inquiry into business judgment? Demand in Delaware Zapata
Demand made -Demand Excused Excused Aronson Futility Standard
Demand Excused In Delaware
Demand Excused Aronson Standard Burden on Board Good Faith
Reasonable investigatio n d Faith Faith If not If not Case not
Dismissed not Dismissed If not Case Case not Dismisse d not
Dismissed not Dismissed Dismissed Dismissed Independen t
good faith, independence and reasonable and reasonable
investigation investigationYES -----Court applies ITS Business ITS
Business Judgment
Derivative Case not Dismi
Board or Committee Upheld Committee Upheld Upheld Unless
Wrongful
Demand Rejected and the BJR not Dismissed The business judgment
rule provides that absent evidence of bad faith, fraud or lack of
due care, courts will defer to the business judgment of corporate
directors.
Special Committee
The business judgment rule creates a presumption that in making
a business decision, the directors of a corporation met their
fiduciary duties to the corporation, that is that that they acted
on an Committee informed basis (i.e., with due care), in good
faith, and Independent in the honest belief that the action taken
was in the best interest of the company In most circumstances, the
business judgment rule Good Faith places the burden on the party
challenging the board decision to introduce evidence that the board
either lacked good faith, acted in self-interest, or acted
Reasonable investigation without due care investigation Special
Litigation Committees A board may act as a whole in reviewing a
18
shareholder's demand or it may choose to appoint a committee to
investigate the facts underlying a demand and make a report and
recommendation regarding the suit. Cases that have rejected the
decisions of special litigation committees have largely focused on
the independence or good faith of the committee members and the
reasonableness of the investigations. A special litigation
committee may also be appointed to review and make a binding
determination with respect to a pending derivative action where a
demand has been excused.
IN RE ORACLE DERIVATIVE LITIGATION Special litigation committee
(SLC) bore the burden of persuasion on motion to dismiss
shareholder derivative action and was required to convince superior
court that there was no material issue of fact calling into doubt
its independence The question of independence turns on whether a
director is, for any substantial reason, incapable of making a
decision with only the best interests of the corporation in mind In
order to prevail on its motion to terminate the shareholder
derivative action, the special litigation committee (SLC) was
required to persuade superior court that: (1) committee members
were independent; (2) that they acted in good faith; and (3) that
they had reasonable bases for their recommendations Superior Court
must deny special litigation committee's (SLC) motion to terminate
shareholder derivative action, if there is a material factual
question causing doubt about whether the SLC was independent, acted
in good faith, and had a reasonable basis for its recommendation;
to grant the motion, the court needs to be convinced on the basis
of the undisputed factual record, that the SLC was independent,
acted in good faith, and had a reasonable basis for its
recommendation Members of corporation's special litigation
committee (SLC) could lose independence without being essentially
subservient to officers and directors under investigation for
insider trading; whether the members were under the domination and
control of the interested parties was not the central inquiry in
the independence determination necessary for ruling on SLC's motion
to terminate shareholder derivative action. A director may be
compromised and lose independence, if he is beholden to an
interested person; "beholden" does not mean just owing in the
financial sense, and it can also flow out of personal or other
relationships to the interested party
Ties among special litigation committee (SLC) members,
university where they were tenured professors, and chief executive
officer (CEO) were so substantial that they caused reasonable doubt
about the members' independence and ability to impartially consider
whether CEO should face suit for insider trading; CEO was very
wealthy, was publicly considering extremely large contributions to
university when members were being added to board, and headed a
medical research foundation that was a source of nearly $10 million
in funding to university, university's rejection of CEO's child for
admission did not keep CEO from making public statements about
consideration of huge donation, and although members claimed
ignorance, an inquiry into CEO's connections with university should
have been conducted before the SLC was finally formed and, at the
very least, should have been undertaken in connection with its
report. IN RE THE WALT DISNEY COMPANY DERIVATIVE LITIGATION This
was the Delaware Supreme Courts decision in the long-running
shareholder litigation over The Walt Disney Companys hiring and
termination of Michael Ovitz. Ovitz was hired as Disneys President
in October 1995, and shortly thereafter was appointed to its board
of directors. The terms of Ovitzs employment were largely
negotiated by CEO Michael Eisner and two members of the companys
four-person compensation committee, who were in turn assisted by an
executive compensation consultant. Terms were presented to the full
compensation committee at a meeting that lasted approximately one
hour, a substantial part of which was devoted to other matters. The
committee reviewed only a term sheet, rather than a draft of Ovitzs
contract, and did not receive any materials prepared by or a
presentation from the compensation consultant. The members of the
committee unanimously approved the terms of Ovitzs employment, and
Disneys board subsequently unanimously approved Ovitzs hiring.
Ovitz's contract compensated him handsomely. It also included a
severance provision guaranteeing him significant am