Business Organizations
2010-2009 Lectures
PARTNERSHIPS,
CORPORATIONS
AND THE VARIANTS
PROF. BRUCE MCCANN
LECTURE 14
REVIEW
What are we talking about?
 Two Umbrella Types of Entities:
 Limited personal liability for owners
Limited partnership
 Limited Liability Company
 Corporation


No protection from personal liability:
General partnership
 Sole proprietorship

Some Basic Terms
 Partnership









Two or more persons (and by “person” we also mean other entities)
Share power
Share profits
Share losses
Partnership reports its profits and losses to the partners who each
take their percentage on their own tax return (pass through)
Partnership itself is not taxed
Each partner personally liable
Dissolves on death of partner or other
No formal registration required with State
Corporation
 One or more owners
 No personal liability (assuming formalities met)
 Registered with Secretary of State
 Managed by its Board of Directors who are elected by
the owners
 Board names officers who run day-to-day operations
 Separate existence from its owners (perpetual life)


Pays taxes
Distributes profits via dividends to owners
AGENCY
PRINCIPALS AND AGENTS
AGENCY
 Elements of relationship:
 1. Principal manifests assent that agent act for
principal and be subject to principal’s control
 2. Agent manifests consent or otherwise consents to
act.
Lec. 2, pp. 31-74
Corporations
Prof. McCann
Scope of Authority of Agent
Derived From
 Actual authority: that authority which principal has
expressly granted to the agent or which agent
reasonably believes was granted.
 Apparent authority: that authority which principal
has informed third party has been vested in agent
 Implied authority: that authority reasonably
required to accomplish the objectives of the agency
Lec. 2, pp. 31-74
Corporations
Prof. McCann
Corp Code 313
 Subject to the provisions of subdivision (a) of Section
208, any note, mortgage, evidence of indebtedness,
contract, share certificate, initial transaction statement
or written statement, conveyance, or other instrument in
writing, and any assignment or endorsement thereof,
executed or entered into between any corporation and
any other person, when signed by the chairman of the
board, the president or any vice president and the
secretary, any assistant secretary, the chief financial
officer or any assistant treasurer of such corporation, is
not invalidated as to the corporation by any lack of
authority of the signing officers in the absence of actual
knowledge on the part of the other person that the
signing officers had no authority to execute the same.
Lec. 2, pp. 31-74
Corporations
Prof. McCann
Importance of Disclosure of Agency
 Example of Disclosed Principal:
 Alpha Corporation, Inc.

 By: ____________________
George Smith, Pres.
 Other party aware of agency and principal.
 Principal alone is liable to third party.

Lec. 2, pp. 31-74
Corporations
Prof. McCann
FYI : California and Agent Liability
 … California courts generally do not employ the Restatement
analysis, but appear to hold the agent liable, regardless of his
or her disclosure of the fact of agency, unless the name of the
principal is disclosed so as to make it appear on the face of the
instrument that the parties intended to bind the principal and
not the agent. (See Patterson v. John P. Mills Organization
(1928) 203 C. 419, 421, Gambord Meat Co. v. Corbari (1952)
109 C.A.2d 161, 162, 240 P.2d 342 [agent liable on personal
check sent in payment of principal's obligation];
 And a disclosure only of the principal's trade name is not a
sufficient disclosure of identity to relieve the agent of personal
liability. (W.W. Leasing Unlimited v. Commercial Standard
Title Ins. Co. (1983) 149 C.A.3d 792, 796.)

Lec. 3, pp. 75-119
Corporations
Prof. McCann
Partially Disclosed Agency
 Aka “unidentified principal” in Restate. 3rd Agency
 Real estate agent represents anonymous purchaser.
 Why? To keep secret identity of purchaser because
of publicity or in order to maintain negotiation
advantage.
 Other party is aware of agency but not identity of
principal.
 Both agent and principal liable to third party.
Lec. 2, pp. 31-74
Corporations
Prof. McCann
Undisclosed Agency
 Real estate agent represents that she is purchasing
the property for herself.
 Why? Take advantage of personal relationship with
seller to get better price.
 Other party unaware of agency or existence of
principal.
 Both principal and agent liable.
Lec. 2, pp. 31-74
Corporations
Prof. McCann
Principal’s Liability for Torts of Agent

Liable if agent has actual or apparent authority.

Liable if principal ratifies the agent’s acts.

Liable if negligent in selecting or supervising the
agent

Liable if agent negligent in performance of act

Liable if agent is employee acting in course and
scope.
Lec. 2, pp. 31-74
Corporations
Prof. McCann
Agent Is a Fiduciary
 A fiduciary duty is the highest standard of care at
either equity or law. A fiduciary is expected to be
extremely loyal to the person to whom he owes the
duty (the "principal"): he must not put his personal
interests before the duty, and must not profit from
his position as a fiduciary, unless the principal
consents. The word itself comes originally from the
Latin fides, meaning faith, and fiducia, trust.
Lec. 2, pp. 31-74
Corporations
Prof. McCann
PARTNERSHIP
ENTITY V AGGREGATE, ETC
Aggregation vs Entity Theories
 Commonlaw (Aggregation)

Partners held undivided but separate interests in property

Partnership was not an entity distinct from its partners

Withdrawing partner entitled to piece of each asset as is her estate

Unanimous consent to admit new partner

Partnership meant one exact constellation of partners. Any change
resulted in dissolution.
Lec. 3, pp. 75-119
Corporations
Prof. McCann
Aggregation or Entity Theories
 Under Uniform Partnership Act, 1997

Partnership is an entity distinct from the partners

Withdrawing partner has no interest in partnership assets but
only right to receive pro rata share of the value of assets

Entity may continue on despite withdrawal or death of partner
Lec. 3, pp. 75-119
Corporations
Prof. McCann
Under Entity Theory
 CAL. CORP. CODE § 16502 : California Code -
Section 16502
 The only transferable interest of a partner in the
partnership is the partner's share of the profits and
losses of the partnership and the partner's right to
receive distributions. The interest is personal
property.
Lec. 3, pp. 75-119
Corporations
Prof. McCann
Under UPA, Modern P/S a Hybrid
 Still an aggregation of partners in sense that:

Each partner individually (jointly and severally) liable for
debts

Pass through entity, invisible to taxing authorities – each
partner pays on her own income from the partnership
Lec. 3, pp. 75-119
Corporations
Prof. McCann
Formation
 CAL. CORP. CODE § 16202 :
 (a)Except as otherwise provided in subdivision (b),
the association of two or more persons to carry on as
coowners a business for profit forms a partnership,
whether or not the persons intend to form a
partnership. (Emphasis added.)
 ***
Lec. 3, pp. 75-119
Corporations
Prof. McCann
Establishing a Partnership
 Majority: Intent is key, as evidenced by conduct and
circumstances.
 Minority: Requires finding all of the following:




1. A community of interest in the venture
2. An agreement to share profits
3. An agreement to share losses
4. A mutual right of control or management
Lec. 13, pp 529-576 Corps
Prof. McCann
RECAP OF PARTNER LIABILITY
 Restatement of Agency
 A Principal is liable for torts of employee if they are
committed within the course and scope of employment
 “Course and scope” requires that there be some intent in the
mind of the agent to serve the purposes of the principal
 Uniform Partnership Act
 Partnership is liable if partner is carrying on in the usual way
the business of the partnership and has actual or apparent
authority
 NO REQUIREMENT that the partner is motivated to benefit
the partnership
Lec. 4; pp. 119 -154 Corporations Prof. McCann
“The Usual Way”
 American Rule: partner must be acting consistently
with the way that particular partnership operates.
 English Rule: partner must be acting as do others in
that type of business, whether or not usual for that
particular partnership.
 UPA follows English Rule interpretation
Lec. 3, pp. 75-119
Corporations
Prof. McCann
California Corporations Code
Section 16404 [Excerpt]
 The fiduciary duties a partner owes to the partnership and the other partners
are the duty of loyalty and the duty of care set forth [below]
 A partner's duty of loyalty to the partnership and the other partners includes
all of the following: ***(3) To refrain from competing with the
partnership in the conduct of the partnership business before the
dissolution of the partnership.
 A partner shall discharge the duties to the partnership and the
other partners under this chapter or under the partnership
agreement and exercise any rights consistently with the obligation
of good faith and fair dealing.
 A partner does not violate a duty or obligation under this chapter or
under the partnership agreement merely because the partner' s
conduct furthers the partner's own interest
Lec. 5 Corporations
Prof. McCann
The End Game of a Partnership
 Dissolution (or Dissociation)
 An event triggers the end of the partnership
 Winding Up
 The affairs of the partnership are concluded
Assets liquidated or earmarked for distribution
 Taxes paid
 Creditors paid
 Partners are paid

 Termination
 All affairs are wound up
Lec. 4, pp. 119-154
McCann
Corporations
Prof.
Dissociating Partner
 Within Rights Under Agreement
 Share as per agreement or per UPA

Price if all assets sold as of date of dissociation at greater of
liquidation value or going concern value, with interest
 In Violation of Agreement or Wrongful
 Same less
Value of Goodwill (discretionary)
 Offsets for damage caused by wrongful dissociation
 Any other amounts owed by departing partner

Lec. 3, pp. 75-119
Corporations
Prof. McCann
LIMITED PARTNERSHIPS
 Form allows limited liability to limited partners
provided they do not manage
 1976 ULPA provided “safe harbor” if acts of limited
confined to such things as:




Consulting with general partner re partnership affairs
Requesting or attending meeting of partners
Voting on matter relating to business affairs if subject of vote is
one allowing approval or disapproval of limiteds
Serving as agent or employee of LP
Lec. 13, pp 529-576 Corps
Prof. McCann
LLC
LIMITED LIABILITY COMPANIES
California Corporations
Code Section 17153
The fiduciary duties a manager owes to
the limited liability company and to its
members are those of a partner to a
partnership and to the partners of the
partnership.
Lec. 5 Corporations
Prof. McCann
California Corporations Code
Section 17001
 (z) "Membership interest" means a member's rights
in the limited liability company, collectively,
including the member's economic interest, any right
to vote or participate in management, and any right
to information concerning the business and affairs of
the limited liability company provided by this title.
Lec. 5 Corporations
Prof. McCann
California Corporations Code Section
17001
 (n) "Economic interest" means a person's right to
share in the income, gains, losses, deductions, credit,
or similar items of, and to receive distributions from,
the limited liability company, but does not include
any other rights of a member, including, without
limitation, the right to vote or to participate in
management, or, except as provided in Section
17106, any right to information concerning the
business and affairs of the limited liability company.
Lec. 5 Corporations
Prof. McCann
LLC Re-Cap
 Creature of Contract
 Variation between states as to what the operating
agreement can do with respect to:

Eliminating fiduciary duties, namely
Duty of Care
 Duty of Loyalty

 California, for example,
 Cannot entirely eliminate duty of loyalty in operating
agreement

But can specify certain acts which will not constitute breach if not
“manifestly unreasonable.”
Lec. 6 pp. 196-238
Corporations
Prof. McCann
Duty of Loyalty
 Duty to account for property or profit or benefit
derived by the member from LLC property.
 Duty not to appropriate an LLC opportunity
 Duty to avoid conflicts of interest
 Duty to refrain from competing
 Acts in violation require consent of the members.
Lec. 6 pp. 196-238
McCann
Corporations
Prof.
Duty of Care
 Duty to refrain from grossly negligent or reckless
conduct, intentional misconduct, or a knowing
violation of law.
 Agreement cannot unreasonably reduce this duty of
care.
Lec. 6 pp. 196-238
McCann
Corporations
Prof.
CORPORATIONS
THE REST OF THE STORY
Promoters and Pre-incorporation Liability
 Liability that of promoters until corporation adopts
pre-incorporation agreements and other party agrees
to novation, replacing promoter with corporation
 Contract language indicating promoter not to be
personally liable may exonerate promoter
Lec. 13, pp 529-576 Corps
Prof. McCann
Overview of Corporate Structure
Shareholders
Directors
President
Secretary
Treasurer
Incorporation Process Review
Lec. 7, pp 239-286 Corps
Prof. McCann
Incorporation Process Review
 Articles filed
 By laws prepared
 First meeting held of shareholders
 Elect Directors
 Make subchapter S election
 Directors meeting
 Adopt pre-existing agreements
 Appoint officers
 Authorize issuance of stock
 Authorize banking relationships
Lec. 7, pp 239-286 Corps
Prof. McCann
The Debt-Equity Relationship
Control
(Equity)
Liquidity
(Debt)
Lec. 7, pp 239-286 Corps.
Prof. McCann
Why Capitalize with Debt?
 You can keep (i.e., leverage) the cash you have.
 You retain ownership (control) of the business
 Interest payments are tax-deductible
 Generally easier to sell debt because you don’t have
to convince someone that the company will grow,
only have to convince them that they’ll get paid back
(and they get paid first).


Lender is first in line to get paid if must liquidate assets
Have a good return on investment (ROI)
Lec. 7, pp 239-286 Corporations
McCann
Prof.
Advantages of Selling Equity
 Motivate buyer to pull for the success of the company
 Doesn’t use precious cash
 No obligation to re-pay
 Can “print” more when needed
Lec. 7, pp 239-286 Corporations
McCann
Prof.
Disadvantages of Selling Equity
 Usually requires giving up at least some control
 Allows “camel’s nose under the tent”
 Dividends are not deductible from corporate tax
Lec. 7, pp 239-286 Corporations
McCann
Prof.
Types of Equity
 Common Stock
 Preferred Stock
 Convertible preferred stock
 Warrants
Lec. 7, pp 239-286 Corps
Prof. McCann
Status of Shares
 Validly Issued
 Board has authorized and Dept of Corporations has issued
authorization
 Fully Paid
 All consideration has been received
 Non-assessable
 The holder of the shares has no obligation to honor any
assessments against the shares
Lec. 13, pp 529-576 Corps
Prof. McCann
Common Stock
 Required to be issued
 Usually carries voting power
 May or may not have “par” value
 First in line in terms of control, last in line in terms
of getting paid on liquidation
Lec. 7, pp 239-286 Corps
Prof. McCann
Preferred Stock
 Preference given as to
 Dividends
 Liquidation of the company’s assets
 May also allow certain rights if the dividends are not paid
(such as electing a number of directors)
Lec. 7, pp 239-286 Corps
Prof. McCann
Convertible Preferred Stock
 Preferred stock that carries with it right to convert to
common stock
Lec. 7, pp 239-286 Corps
Prof. McCann
Warrants
 Are issued by the corporation
 Give the owner the right to acquire common stock in
the future for a specified price
 Usually added as an enticement to lenders but may
be sold independently
Lec. 7, pp 239-286 Corps
Prof. McCann
Capital Contribution Issues
 Watered Stock
 Shareholder liable to creditors to extent stock has not been
paid for
 Measured by difference between share’s value and what was
(was not) paid

Comes up where:
Did not pay par for the stock or
 Value of the consideration given was overstated

Lec. 13, pp 529-576 Corps
Prof. McCann
Concept of Par
 Originally a tool to control maximum and minimum
capitalization of the corporation
 Evolved into baseline reserve to protect creditors
 Today largely meaningless
Lec. 13, pp 529-576 Corps
Prof. McCann
THE PLAYERS, REVISITED
 SHAREHOLDERS
 Elect directors
 Usually must ratify certain acts of directors
Resolution to dissolve
 Resolution to merge with another entity
 Resolution to sell principal assets
 Resolution to change corporate purpose
 Resolution to amend by-laws or charter

Lec. 8, pp 286-342 Corps
Prof. McCann
VOTING
 Statutory (or Regular) Voting
 One vote per share, each directorship voted on independently

i.e., Jim has 500 shares, there are 3 directorships up for election.
Jim can vote his 500 shares for each of the 3, but cannot
accumulate his “1500” votes and put all on one directorship.
 Cumulative Voting
 One vote per share multiplied by the number of directorships
up for election. Total number of votes can be allocated as
shareholder wishes

i.e., Jim can cast all 1500 votes for one director.
Lec. 13, pp 529-576 Corps
Prof. McCann
THE PLAYERS, REVISITED
 DIRECTORS
 Charged with day-to-day operations of entity
 Hire and Fire Officers
 Bear ultimate responsibility for conduct and misconduct of the
corporation
Lec. 8, pp 286-342 Corps
Prof. McCann
The Corporation’s Foundational Documents
 Articles (Charter)
 By Laws
 Shareholder Agreements Between Themselves
 Buy-sell Agreements
 Aka Cross-purchase Agreements
 Survivor Purchase Agreement
 Corporations Agreements To Repurchase Stock
 Stock purchase Agreement
 Aka Redemption Agreement
Lec. 8, pp 286-342 Corps
Prof. McCann
“Closely Held” vs Statutory Close Corporation
 Any corporation can be held by a small number of
shareholders. One shareholder is not uncommon.
 A “closely held” corporation is a term with no
particular legal significance other than to mean:




Few shareholders
Most of whom participate in management
No general market for the stock (because of limitations on
control and liquidity) and
Some limitations on transfer of the stock
 Courts now widely allow shareholders to control
management via controlling director’s powers.
Lec. 8, pp 286-342 Corps
Prof. McCann
Statutory Close Corporation
 Specifically so-identified in Articles
 Limited as to number of shareholders possible, usually




30 or 35.
Stock certificates must bear “legend” detailing that there
are restrictions on transfer
Prohibited from making a public offering
If adhere to rules, statutes allow exemption from claims
regarding improper limits on directors’ powers
Delaware allows shareholders to manage directly without
a board of directors.
Lec. 8, pp 286-342 Corps
Prof. McCann
When You Need Shareholder Agreements
 To maintain exemption from securities registration
requirements

i.e., a restriction that shareholder cannot transfer to a citizen
of another state (triggering interstate sales issue);
 To maintain subchapter “S” status
 i.e., a restriction that you cannot sell to a partnership or
corporation which would exceed limit of 75 shareholders
 To maintain professional corporation status
 i.e., cannot sell to unlicensed person
Lec. 8, pp 286-342 Corps
Prof. McCann
When You Need Shareholder Agreements
 To Maintain Effectiveness of a Pooling Agreement
 i.e., if parties pool shares under agreement to keep X off the
board, important no one conveys their shares to X.
Lec. 8, pp 286-342 Corps
Prof. McCann
Restrictions
 May be absolute:
 Prohibits transfer altogether (usually unenforceable)
 May require others consent
 Typically requires director or shareholder approval
 May limit class of possible transferees
 Must be family members
 Must be CPA
 Must be non-competitor
Lec. 8, pp 286-342 Corps
Prof. McCann
Examples of Restrictions
 Buy-Out Agreements
 Whereby anyone desiring to sell must offer to designated
others on same terms, so-called “right of first refusal.”
 Whereby someone who may lose control of stock in a divorce is
obliged to sell to other shareholders or to the corporation
 Whereby the estate of a deceased shareholder must sell to the
others
Lec. 8, pp 286-342 Corps
Prof. McCann
Pricing the Shares
 Three usual approaches:
 Book Value


Liquidation Value


What do the accounts show the shares are worth if you divide the
number of outstanding shares into the number you get when you
subtract the liabilities from the assets?
What would you get if you closed the doors, sold all the assets,
paid all the debts, and divided the money up?
Cash Flow or Earnings

What would an investor be willing to pay today to own a company
that generates the profits your company generates?
Lec. 8, pp 286-342 Corps
Prof. McCann
Recording the Corporate History
 All States Require Minutes be Maintained
 Calif Corps Code 314
 The original or a copy in writing or in any other form capable
of being converted into clearly legible tangible form of the
bylaws or of the minutes of any incorporators', shareholders',
directors', committee or other meeting or of any resolution
adopted by the board or a committee thereof, or shareholders,
certified to be a true copy by a person purporting to be the
secretary or an assistant secretary of the corporation, is prima
facie evidence of the adoption of such bylaws or resolution or
of the due holding of such meeting and of the matters stated
therein.
Lec. 8, pp 286-342 Corps
Prof. McCann
By Laws
 Must conform to the Articles
 Must conform to the law
 e.g., by-law prohibiting any transfer of interest would be
unenforceable
Lec. 8, pp 286-342 Corps
Prof. McCann
California Corps Code 204
 The articles of incorporation may set forth: (a) Any
or all of the following provisions, which shall not be
effective unless expressly provided in the articles:
 ***
 (5) A provision requiring, for any or all corporate
actions … the vote of a larger proportion or of all of
the shares of any class or series, or the vote or
quorum for taking action of a larger proportion or of
all of the directors, than is otherwise required by this
division.
Lec. 8, pp 286-342 Corps
Prof. McCann
Calif. Corporations Code Section 603(d)
 (d) Notwithstanding subdivision (a), directors may
not be elected by written consent except by
unanimous written consent of all shares entitled to
vote for the election of directors; provided that the
shareholders may elect a director to fill a vacancy,
other than a vacancy created by removal, by the
written consent of a majority of the outstanding
shares entitled to vote.
Lec. 8, pp 286-342 Corps
Prof. McCann
Postscript on Consents
 Model Act now allows electronic or other consents
without unanimity and without notice to all
shareholders if:


Articles of Incorporation provide for passage by majority vote,
and
The action is approved by consents signed, even electronically,
by a majority of eligible voters
 By default, Directors are to be elected by “plurality”
(rather than cumulative vote or majority vote)


True both under Model Act and Delaware law
BUT, bylaws may provide for majority or other constraint
Lec.11, PP 436-478 Corps
Prof. McCann
Pillsbury v Honeywell
 Shareholders Rights
 Right to review corporate records is not unlimited
 Must be for “a proper purpose germane to his interest as a
stockholder” Del. Code, Title 8, § 220.
“Proper purpose” means a concern relating to “investment return”
 BUT investment return can include shareholder motivated by
desire to take control of the corporation

Lec. 9, pp 339-395 Corps
Prof. McCann
Who Has the Power to Act for Shareholder?
 Shareholder “of record”
 Proxy
 Assignee (Pledgee) if assignment or pledge so allows
Lec. 9, pp 339-395 Corps
Prof. McCann
The Powers and Duties of the Board
 It is a Board, not a gathering of Generals
 No director has any power acting alone
 Their only power derives from decisions they make acting as a
Board and which are recorded in the minutes of the
corporation
 Power of directors is “original and undelegated.” Their powers
are not granted by others but originate with their election to
the Board.
 Directors’ power comes from the state, if anywhere.
 The relation of directors to shareholders is that of trustee to
beneficiaries.
Lec. 9, pp 339-395 Corps
Prof. McCann
The Powers and Duties of the Board
 May Delegate Some of Its Duties
 Where large board, usual to allow for subcommittees to
operate with relative autonomy

“Executive Committee” is common device, organized to handle decisions or
required resolutions (such as approval of significant contract) when full
board cannot be readily convened.
 In Public Corporations, Usually See “Inside” and “Outside”
Directors


Inside: are also officers of corporation
Outside: are recruited from other corporations, public service, etc.
Lec. 9, pp 339-395 Corps
Prof. McCann
The Powers and Duties of the Board
 Key Functions:
 Provide
advice and counsel
 Instill discipline in the decision-making of
the corporation
 Oversee crises
 Monitor the conduct of Management
Lec. 9, pp 339-395 Corps
Prof. McCann
REMOVAL OF DIRECTORS
 Tension between treatment of shareholders who are
also directors

They want security against removal
 And treatment of directors who are not shareholders
 Shareholders do not want to have any impediment to voting
such directors out.
 RULE: Under Model Act statutes, cannot deny
shareholders right to remove with or without cause.

May require supermajority to remove shareholder-director
without cause, however.
Lec.10, PP 395-436 Corps
Prof. McCann
Tools for Dealing with Deadlock or Misconduct
 Judicial Dissolution
 Buyout of dissenting shareholder
 Appointment of custodial director or manager
 Arbitration provision in bylaws or other contract
Lec.10, PP 395-436 Corps
Prof. McCann
VOTING TRUSTS
• Under Model Act, requires
Writing
Setting out provisions
10 yr limit (can be extended
by some or all)
Delivery to corporation’s
principal office
Lec.10, PP 395-436 Corps
Prof. McCann
POOLING AGREEMENTS
 Widely used to “pool” smaller stock holdings into a
unit having power to influence Board or corporate
actions
 Generally provide for process to “pre-vote” an issue
put to the shareholders, then cast all shares in pool
for winner of the internal vote.
 Agreements are contracts and enforced as such


Equitable relief now available via statute
Previously courts could only remedy breach by damages
Lec.10, PP 395-436 Corps
Prof. McCann
Shareholder Agreements
 Liberally construed in closely held corporations
 BUT, under Model Act,
 Must be included in writing filed with the corporation
 Must be unanimously approved by all shareholders at time of
creation
 Must be included in articles or bylaws or in a separate writing
 BUT
 Cannot eliminate fiduciary duties of officers and directors,
 Are not binding on creditors or third parties
 Are not binding on shareholders without knowledge
Lec.11, PP 436-478 Corps
Prof. McCann
GALLER V GALLER
 Held: Shareholder agreement not violative of
public policy unless



Violates an express statement of policy or
Is “manifestly injurious” to public welfare and
Where corrupt or dangerous tendency clearly
appears on face of agreement or is part of a corrupt
scheme and disguised to conceal true nature of the
transaction
Lec.11, PP 436-478 Corps
Prof. McCann
Sea-Land Rule
 Corporate entity will be disregarded and veil of
limited liability pierced if:


There is a unity of interest and ownership such that the
separateness of the personalities of the entity and the
individual (or other entity) no longer exists;
Circumstances must be such that adherence to the fiction of
separateness would
SANCTION A FRAUD
 PROMOTE INJUSTICE

Lec.11, PP 436-478 Corps
Prof. McCann
Sea-Land Rule – “Promote Injustice?”
 Means more than that a creditor will go unpaid.
 There must be a wrong beyond creditor’s inability to
correct, e.g.,



Unjust enrichment to person or entity who looted corporation
Scheme to move assets to one entity and liabilities to another
Must be sufficient to “merit the evocation” of the court’s
equitable powers.
Lec.11, PP 436-478 Corps
Prof. McCann
Piercing Based on Agency Analysis
 Where person uses a corporation as a shield to
pursue the person’s interests and activities,
effectively same conduct as if used any other agent:


Therefore, liability imposed on principal via respondeat
superior
No matter if agent’s wrongdoing arises in contract or tort
Lec.11, PP 436-478 Corps
Prof. McCann
Declaring Dividends
 Highlights the tension between creditors and
shareholders


CREDITORS do not want money taken out of the corporation
until they have been paid
SHAREHOLDERS like dividends because
(a) represents a return on investment that is no longer subject to
market forces;
 (b) declaring a dividend signals optimism about the future and
often drives the share price higher.

Lec. 12, pp 479-528 Corporations
McCann
Prof.
Basic Policy Objective: Protect the Creditor
 Limit so that dividends can only be paid from
“surplus” after sufficient capital held in reserve to
pay debts.
Lec. 12, pp 479-528 Corporations
McCann
Prof.
Solely Within Authority of Directors
 Holders of common shares have no vested right to a
dividend

Some preferred shares carry right to a dividend and
enforcement power (such as right to name directors) if
required dividend is not paid to preferred shareholders
 Courts will not interfere with directors’ decision to
declare or withhold dividend absent showing of
fraud, bad faith or abuse of discretion by directors
 BUT once a dividend is declared, shareholders may
enforce in court
Lec. 12, pp 479-528 Corporations
McCann
Prof.
TYPES OF SURPLUS

Capital surplus
Excess portion of price received by corporation for its stock after
subtracting the par value
 Plus any amount directors deem necessary (sometimes required by
creditors)


Earned surplus


Reduction surplus


Earning of the company from operations after subtracting liabilities
and net of capital accounts
The amount directors vote to take out of Stated Capital (e.g., by
reducing par or because augmented from capital surplus and now
unwinding
Revaluation surplus

The amount of previously unrealized appreciation directors choose to
recognize (and which moves into earned surplus)
Lec. 12, pp 479-528 Corporations
McCann
Prof.
Stock Dividends
 Issue additional shares in lieu of cash.
 Reasons:
 Don’t want to spend the cash but want to appease shareholders
 Want to increase voting rights of pro-board shareholders in
case of takeover bid
 Need to issue more shares to make an offering work and must
issue stock dividends to keep voting rights intact
 Drives down stock price somewhat (because more shares over
which ratios operate, such as “earnings per share”)
Lec. 12, pp 479-528 Corporations
McCann
Prof.
Directors’ Duty of Care
 Francis v United Jersey Bank:
 Director is fiduciary of the corporation and its
shareholders
 And in the context of the business of the corporation,
may be a fiduciary to its creditors

Where there is constructive or actual trust
 Director must “discharge duties in good faith
and with that degree of diligence, care and
skill which ordinarily prudent men would
exercise under similar circumstances in like
positions”
Lec. 12, pp 479-528 Corporations
McCann
Prof.
Francis v United Jersey Bank
 Where director breaches duty, personally liable if
negligence was a proximate cause of a loss to the
creditor or shareholder or corporation
 Plaintiff has burden of showing loss would have been
avoided if defendant had performed her duties
 Analysis includes determination of “reasonable
steps” director should have taken
 BUT causation will be inferred where reasonable to
conclude particular result from a failure to act and
that result has occurred.
Lec. 12, pp 479-528 Corporations
McCann
Prof.
Caremark
 Director liability can be grounded on several
theories:


Liability following poor decision by board because
decision was negligent and ill advised
Liability based on failure to act where due diligence
would prevent the loss
 BUT, “absent cause for suspicion there is no
duty…to install and operate a system of
corporate espionage to ferret out wrongdoing
that they have no reason to suspect exists.”
Lec. 13, pp 529-576 Corps
Prof. McCann
Caremark cont’d
 There must be a system in place adequate to
assure the board that appropriate
information will come to its attention in a
timely manner
 Failure to insist upon and maintain such a
system may render a director liable
Lec. 13, pp 529-576 Corps
Prof. McCann
Caremark cont’d
 Plaintiffs must show:
 Director knew or
 Should have known were violations of law
 Took no steps to prevent or remedy
 Failure proximately caused the loss
Lec. 13, pp 529-576 Corps
Prof. McCann
The Business Judgment Rule
 Applies when what is at issue is a business decision
made by the directors
 Does not come into play where directors are accused
of failing to monitor or similar derelictions of the
duty of care, only when making a business decision
Lec. 13, pp 529-576 Corps
Prof. McCann
The Rule
 Absent fraud, illegality or conflict of interest, a
director who acts in good faith is not personally
liable for mere errors of judgment short of CLEAR
AND GROSS NEGLIGENCE
• Shlensky v Wrigley 237 N.E. 2d 776 (Ill. 1968)
 Unless director(s) had an interest in the subject of
the decision or
 Unless decision constitutes illegal conduct (e.g.,
decision to pay a bribe)
Lec. 13, pp 529-576 Corps
Prof. McCann
ALI Version
 No liability for a business judgment reached in good
faith provided:
 1. Director or officer was disinterested
 2. Director or officer was informed as to the subject
of the decision to a degree the director or officer
reasonably believes appropriate; and
 3. Rationally believes decision is in the best interests
of the corporation
Lec. 13, pp 529-576 Corps
Prof. McCann
SMITH V VAN GORKOM
 "Informed" within meaning of "due care" means
board reviewed all material information reasonably
available
 Liability under Business Judgment Rule
arises only where there is a showing of gross
negligence, meaning something more
careless than ordinary negligence.

E.g., failure to even read a report which was itself
deficient
Lec. 13, pp 529-576 Corps
Prof. McCann
Delaware Gen Corp Law Sec. 141
(e) A member of the board of directors, or a member of any
committee designated by the board of directors, shall, in the
performance of such member's duties, be fully protected
in relying in good faith upon the records of the
corporation and upon such information, opinions,
reports or statements presented to the corporation
by any of the corporation's officers or employees, or
committees of the board of directors, or by any other
person as to matters the member reasonably
believes are within such other person's professional
or expert competence and who has been selected
with reasonable care by or on behalf of the corporation.
Lec. 13, pp 529-576 Corps
Prof. McCann
Shareholder Ratification
 Shareholders may ratify acts of even interested
directors PROVIDED shareholders are “fully
informed”

Burden is on directors to establish shareholders were fully
informed
Lec. 13, pp 529-576 Corps
Prof. McCann
Model Act
SECTION 8.30. GENERAL STANDARDS FOR DIRECTORS
(a) A director shall discharge his (sic) duties as a director, including his (sic) duties as a
member of a committee:
 (1) in good faith;
(2) with the care an ordinarily prudent person in a like position would exercise under similar
circumstances; and
(3) in a manner he (sic) reasonably believes to be in the best interests of the corporation.


(b) In discharging his (sic) duties a director is entitled to rely on information, opinions, reports,
or statements, including financial statements and other financial data, if prepared or presented
by:
 (1) one or more officers or employees of the corporation whom the director reasonably believes
to be reliable and competent in the matters presented;
(2) legal counsel, public accountants, or other persons as to matters the director reasonably
believes are within the person's professional or expert competence; or
(3) a committee of the board of directors of which he (sic) is not a member if the director
reasonably believes the committee merits confidence.

(c) A director is not acting in good faith if he (sic) has knowledge concerning the matter in
question that makes reliance otherwise permitted by subsection (b) unwarranted.
 (d) A director is not liable for any action taken as a director, or any failure to take any action, if
he (sic) performed the duties of his (sic) office in compliance with this section.

Lec. 13, pp 529-576 Corps
Prof. McCann
Calif. Corp Code Sec. 309
 (a) A director shall perform the duties of a director, including duties
as a member of any committee of the board upon which the director
may serve, in good faith, in a manner such director believes to be in
the best interests of the corporation and its shareholders and with
such care, including reasonable inquiry, as an ordinarily prudent
person in a like position would use under similar circumstances.
 (b) In performing the duties of a director, a director shall be entitled
to rely on information, opinions, reports or statements, including
financial statements and other financial data, in each case prepared
or presented by [officers, consultants, etc].
 (c) A person who performs the duties of a director in
accordance with subdivisions (a) and (b) shall have no
liability based upon any alleged failure to discharge the
person's obligations as a director. In addition, the liability
of a director for monetary damages may be eliminated or
limited in a corporation's articles to the extent provided in
paragraph (10) of subdivision (a) of Section 204.
Lec. 13, pp 529-576 Corps
Prof. McCann