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I.
INTRODUCTION (CB Chapter 1)
A. Misc.
i. Start-up companies often prefer local incorporation over DE friendly atmosphere.
1. Reason: Local incorporation is simple, avoids record keeping and other issues.
ii. Model Business Corporation Act: Continued liberalizing trend of DE and NJ. Intended to
serve as a drafting guide for states.
iii. Not-for-profit corporations are often regulated separately from commercial (for-profit)
corporations under state law.
B. Advantages & Disadvantages of Different Enterprises
i. Proprietorships: Individually owned businesses that have no separate legal status apart from
their owners (i.e. mom and pop grocery store).
1. Advantages
a. Control – Owner controls and operates the business allowing owner to exercise
direct control over business and safeguard assets (corporations: ownership and
control are separate).
b. Simplicity – Lack of a separate legal structure means that the proprietorship is
easy to operate and more flexible than other forms of business associations (no
shareholder meetings, no reports, no registering w/state).
c. Expenses – Less expense to operate b/c there is no need to comply w/expensive
reporting and registration requirements under the federal securities laws,
accounting may be less formal and hence cheaper, and there will be fewer and
simpler legal issues than for other forms of business.
d. Taxes – Not taxed separately, income and expenses are passed directly through to
the owner.
2. Disadvantages
a. Unlimited liability for contractual or tort damages caused by the business or its
agents (even personal assets, such as person bank accounts, may be seized by
creditors of the business).
b. Management – usually dependent on the owner, so if the owner is unavailable to
work/manage, business might be lost.
c. Transferability – Ownership of a proprietorship cannot be readily sold. B/c the
entity is usually an integral part of its owner’s personal management and control,
there is no separate structure that can be readily transferred.
ii. Partnership: Association of 2 or more persons carrying on a business for profit as co-owners.
1. Advantages
a. Control – Like proprietorship, no separation of ownership and control. Both are
simply dispersed among the partners by agreement. This allows the owners
directly to control the business and safeguard its assets.
b. Simplicity – The partnership has a separate legal entity but partners can agree
conduct business in manner they wish (flexibility). This may make more
complicated than proprietorship since partnership agreement should be
negotiated. Also, affairs must be conducted in accordance w/state law.
c. Expenses – Less than corporation (no shareholder reporting or disclosure and
accounting requirements). However, ending partnership may be expensive and
complicated
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d. Taxes – Not taxed separately. An information return required, but income and
expenses are passed directly through to owners.
2. Disadvantages
a. Unlimited liability – Partners responsible for contractual or tort damages incurred
by partners or agents in course partnership’s business.
b. Transferability – Partner cannot sell ownership interest.
iii. Limited Partnership: Entity has a general partner that operates the business and 1 or more
limited partners that contribute investment capital but do not participate in management.
1. Advantages
a. Limited Liability – Limited partners’ liability is limited to the amount of their
investment, thereby protecting their other assets. The general partner remains
subject to unlimited liability.
b. Separation of ownership and control – Limited partners may invest capital in
enterprise w/out becoming involved in management, which allows limited
partners to invest in enterprise they don’t have time or expertise to manage.
c. Expense – Simplicity in management still available since business can be
structured freely under the agreement. A filing w/state must be made upon
commencement of business and accounting for limited partners may be more
complicated than simple partnership. Taxes are also complicated b/c broadly
held LPs can be taxed like corporations.
2. Disadvantages
a. Unlimited Liability – General partner subject unlimited liability for any contract
or tort damages incurred in the partnership’s business (can be limited by making
general partner a corporation).
b. Transferability – A limited partner cannot readily sell ownership interest unless
registered under (or exempt from) federal securities laws (extra expense and
liabilities involved).
iv. Limited Liability Companies (LLC): Basically an incorporated partnership allowing
members to actively participate in management or to be passive if they wish.
1. Advantages
a. Limited Liability – Liability of members of LLC is limited to amount of their
investment, thereby protecting their other assets.
b. Separation of ownership and control – Can invest in without becoming involved
in management, or can manage company (if operating agreement permits) w/out
incurring unlimited liability. Allows members maximum flexibility in
management and operation of business.
c. Expenses – Simplicity in management b/c business can be structured freely under
operating agreement. A charter must be obtained from state upon
commencement of the business of the LLC; however, accounting might be more
complicated than in a simple partnership.
d. Taxes – Taxes can be passed through to members, thereby avoiding double
taxation imposed on large corporations.
2. Disadvantage
a. Transferability – Ownership interest of a member transferable, but transfer might
be restricted by terms of the operating agreement. The sale of ownership interest
in LLC also subject to state and federal securities laws.
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v. Limited Liability Partnerships (LLP): Another form of incorporated partnership (popular
w/law firms).
1. Advantages
a. Limited Liability – Liability limited to the amount of investment. But, w/law
firms, a partner is subject to unlimited liability for his or her own acts. The
partner is protected from personal liability for acts of other partners but
partnership interest can be seized by creditors of the partnership.
b. Expenses – May structure operations in whatever manner they deem fit under
their partnership agreement.
c. Taxes – May be passed through to members, thereby avoiding double taxation
imposed on large corporations.
2. Disadvantage
a. Transferability – Ownership interest of a member in a LLP not easily transferred.
vi. Corporations: Business that have a separate legal status apart from their owners.
1. Advantages
a. Limited Liability – Liability of investors (stockholders) is limited to the amount of
their investment. This encourages risk taking that is necessary for society to
advance.
b. Separation of management and control – Stockholders may invest w/out
becoming involved in management, which allows an efficient allocation of capital
and professional management of the company’s operations.
c. Transferability – Stockholdings are transferable, but such sales may be subject to
requirements of federal securities laws. And, there might not always be ready
market for the stock.
d. Perpetual Life – Unlike proprietorship or partnership, the corp. continues to exist
until dissolved (death of owner doesn’t terminate life of corp.).
2. Disadvantages
a. Double Taxation – Corporation’s profits are separately taxed. The shareholders
are then taxed again if remaining income is distributed to them. This may be
avoided in smaller corporations through subchapter S status which allows a passthrough of profits directly to shareholders in smaller corps.
b. Management – Managers can manage for their own interests (e.g., higher salaries,
perquisites) instead of seeking to maximize shareholder wealth.
c. Expenses – More than other enterprises. Publicly held corporations must comply
w/expensive reporting and registration requirements under federal securities law.
Accounting and legal issues will be more frequent and more complicated.
vii. Notes:
1. Limited Liability Benefit – Encourages risk taking that is necessary for social
advancement.
2. Separation of management and control Benefit – Allows an efficient allocation of
capital and professional management of company’s operation.
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II.
AGENCY (CB Chapter 2)
A. Agency Definition: Fiduciary relation resulting from manifestation of consent by 1 person, the
principal, to another, the agent, that the agent shall act on the principal’s behalf and subject to the
principal’s control, and consent by the agent so to act.
i. Agency relationship is a fiduciary one, based on consent.
ii. As a general matter, the principal will be responsible for the acts of the agent where the agent is
acting within scope of the agent’s authority.
iii. When is there an agency relationship?
1. Has to be a manifestation of consent by the principle and the agent to the relationship,
and agent has to be active on the principle’s behalf.
2. Note: If you find that there’s control of the agent, you’re likely going to find that the
principle had control over the agent. Cases are primarily going to be about the control
exercised by the principle.
B. Identifying the Agency Relationship
i. Jenson Farms Co. v. Cargill – de facto agency relationship implied from parties’ conduct
1. Facts: The creditor, Cargill, financed Warren, the debtor’s grain elevator operation and
purchased the majority of the debtor’s grain. At issue was whether the creditor, by its
course of dealing with the debtor, became liable as a principal on contracts made by the
debtor with the farmers.
2. Holding: An agency relationship was established b/c Cargill, by its control and
influence over Warren, became a principal w/liability for transactions entered into by
its agent Warren. First, a creditor who assumes control of his debtor’s business may
become liable as principal for the acts of the debtor in connection with the business. A
creditor becomes a principal when he assumes de facto control over the conduct of his
debtor, whatever the terms of the formal contract with his debtor may be. Here, the
creditor was an active participant in the debtor’s operations rather than simply a
financier. The creditor and the debtor had a paternalist relationship, with the creditor
making the key economic decisions and keeping the debtor in existence. Second, under
the modern view adopted by the court, since the farmers did not indicate to the creditor
that the debtor had settled accounts with them, the creditor, as principal, was not
discharged from liability to the farmers by making a settlement payment to the debtor.
3. Law: For agency, there needs to be an agreement but not necessarily a contract.
Agency can occur though parties don’t call it such and did not intend its legal
consequences. Existence may be proved by circumstantial evidence, and principal must
be shown to have consented to agency.
4. Analysis: By directing Warren to implement its recommendations – Cargill manifested
its consent to agency. Warren operated on behalf of Cargill in procuring grain for
Cargill and operations were totally financed by Cargill. Further, Cargill interfered with
internal affairs of Warren, which constituted de facto control over them.
5. Important Factors indicating control:
a. Cargill’s constant recommendations by phone,
b. Cargill’s right of 1st refusal on grain,
c. Warren’s need of approval to enter contracts,
d. Cargill’s right of entry to carry out periodic audits,
Cargill was
e. Cargill’s determination that Warren needed strong
active participant in
paternal guidance,
operations & made key
f. Warren forms w/Cargill’s name,
economic decisions.
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g. Cargill financed of all Warren’s purchases of grain and
operating expenses, and
h. Cargill’s power to discontinue financing.
6. Cargill contended that the relationship was one of buyer/supplier not principal/agent.
Buyer Supplier vs. Agent Analysis: Supplier (1) receives fixed price for property
irrespective of price paid by him; (2) acts in his own name and receives title to property
which he thereafter is to transfer; and (3) has an independent business in buying and
selling similar property. In this case, all of Warrens operations were financed by Cargill,
and Warren sold almost all of grain to Cargill. Therefore, the relationship was not
merely buyer/supplier. Further, Cargill did not think of Warren as an operator who
was free to become a competitor of Cargill, but rather conceded that it believed Warren
owed a duty of loyalty to Cargill.
ii. Notes:
1. Cargill situation can be prevented by avoiding informal arrangements in favor of tightly
drawn agency agreements.
2. Important factor in case: Cargill exerted significant control over day to day operations
of Warren
C. Fiduciary Obligations
i. An agent is a fiduciary, which means agent is held to high standards, the “morals of the
marketplace” are not sufficient.
ii. Fiduciary duties fall into 2 basic categories:
1. Duty of Care (counterpart of common law negligence)
2. Duty of Loyalty. The following rules apply unless otherwise agreed upon:
a. Undivided loyalty – Agent under duty act solely for the benefit of the principal.
b. Conflict of interest – Agent may not deal w/principal as an adverse party.
c. Profit – Agent who makes a profit while working for a principal is under duty to
give that profit to the principal (w/exception of customary gratuities).
i. Basis for duties not to compete and duties not to appropriate opportunities
belonging to principal.
ii. Related rule: law against insider trading.
iii. Notes:
1. B/c of nature of relationship and accompanying liabilities, principal can terminate
agency at any time, even if to do so would breach an employment contract w/agent.
But, principal will be liable for damages
2. 3rd parties dealing with agent will be bound to principal, even if didn’t know agency
exist.
a. Exception: Agent misrepresents relationship and third party would not have dealt
with principal if knew identity.
b. Agent will also be liable on contract where principal’s identity is not disclosed.
Otherwise, agent is generally not liable for the principal’s obligations.
3. Agent is liable to principal for principal’s liabilities imposed on the principal where
agent acted w/o actual authority.
4. Unless otherwise agreed, principal must indemnify agent for expenses and other
payments made by agency where agent acting within scope of agency.
D. Authority – determines which of agent’s acts fall within agency relationship so as to bind the
principal.
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i. Actual Authority (may be express or implied):
1. Runs from principal to agent (can flow from contract, title, job description, past course
of dealing b/t principal and agent, etc.).
2. Express authority = Specific authorization of agency.
3. Implied authority = Flows from an express grant (e.g., title “cashier” carries implied
authority such as accepting checks and cash for deposits as agent for the bank).
ii. Apparent Authority
1. Can exist in absence of actual authority where principal gives a 3rd party reason to
believe that actual authority exists.
2. Analogous to doctrine of estoppel, but agency by estoppel is not always coincident
w/apparent authority.
iii. Ratification is principal’s after the fact approval of the agent’s unauthorized act.
1. May occur where principal affirms act expressly or acts in a manner showing
affirmation or acquiescence.
2. Ratification binds principal and relates back to the time of unauthorized acts.
3. Agent cannot create apparent authority, but where agent acts and principal acquiesces
then apparent authority exists.
4. An agent who creates impression of authority may be held accountable to 3rd party on
basis of estoppel or breach of warranty of authority.
iv. Vicarious Liability
1. Principal is vicariously liable for acts of agent if shown (by plaintiff) that agent was
acting within scope of agency (determined on case-by-case basis).
2. Butler v. McDonald’s – apparent authority
a. Facts: Plaintiff pushed on door to McDonald’s restaurant and glass shattered
resulting in injury. Plaintiff sued defendant franchisor for injuries he sustained as
the result of the alleged negligence of defendant, its agents, servants, and/or
employees in maintaining the premises of a franchised restaurant and in training
and supervising its agents, servants and/or employees.
b. Holding & Rationale: Court denied defendant’s motion for summary judgment
b/c factual dispute as to whether defendant franchise restaurant operator is an
agent of defendant. Under the facts alleged, a reasonable jury could find that an
agency relationship existed and that defendant could be held vicariously liable.
Defendant’s argument for no agency: franchise license agreement stated no
agency created. However, parties cannot simply rely on statements in an
agreement to establish or deny agency. Key element of an agency relationship is
the right of the principal to control the work of the agent vs. independent
contractor – not subject to control of employer.
c. Relevant agency factors (signaling control) include:
i. Principal’s beneficial interest in the agent’s undertaking,
ii. Written agreements between the parties, and
iii. Instructions given to agent by principal relating to how to conduct
business.
Court stated that plaintiff offered aforementioned evidence to demonstrate
defendant’s right to control the franchise restaurant. Doctrine of apparent
agency exists to (1) allow third parties to depend on agents w/out investigating
their agency before every transaction, and (2) also promotes responsible business
practice and protects third party’s reliance on reasonable perception of agency. If
doctrine was applied, plaintiff would have to prove that:
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Apparent
Agency Test
i. The franchisor acted in manner that would lead a reasonable person to
conclude that the operator and/or employees of the franchise were
employees or agents of defendant (franchisor);
1. Examples of behavior that could lead to reasonable belief
include all means and methods that would maintain“image of
uniformity” among defendant’s restaurants, including national
advertising, common signs, uniforms, menus and appearance.
ii. The plaintiff actually believed operator and/or employees of restaurant
were agents of franchisor; and
iii. The plaintiff thereby detrimentally relied upon care and skill of allegedly
negligent operator and/or employees of franchise restaurant.
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III. PARTNERSHIPS (CB Chapter 2 cont.)
A. Basics of Partnerships
i. Association of 2 or more persons carrying on a business for profit as co-owners. Partnership
does not provide owners w/limited liability shield. The LLP allows limited liability for passive
partners, provided certain conditions are met. B/c of the broad definition, remains the default
form of doing business w/multiple owners.
ii. Partnerships long predate corporations, ancient forms of business associations but a dying
breed. Very rare that a standard partnership is going to be the right form for clients b/c don’t
have limited liability. You can get special tax treatment (not double taxation) AND limited
liability from another form. Corporate tax is much less than you would pay if there was passthrough taxation and the taxes went right to you – corporate rate might be 15% vs. personal
rate of 30%.
iii. Can be created without the intention of the parties.
iv. Partners jointly and severally liable.
v. Has to have more than one person, but it can be a mere association with someone else.
vi. Also has to be a business, can’t be a hobby for profit.
vii. In order to be a partner, need to be co-owners – able to exercise some control over the entity.
viii. If partner leaves, partnership dissolves.
ix. Need now written agreement or filing with state. No written agreement – then subject to
state’s default rules.
x. Default Rules:
1. Partner’s actions will be binding on all of the other partners.
2. All partners have to agree on new partners.
3. All partners have equal management ranks.
4. All partners share equally in profits and losses and have equal votes.
5. Day to day business matter have to be decided by the majority, while major matters
have to be decided unanimously.
B. What is a Partnership?
i. Martin v. Peyton
1. Facts: A firm was in financial trouble, and one of partners obtained a loan from Peyton
for the firm to use as collateral for bank advances. Peyton was offered partnership but
refused and formed agreement at issue, expressed in 3 documents. The general
purpose was for respondents to loan the firm liquid securities for use in the business. In
compensation for the loan, Peyton was to receive a percent of the firm’s profits (40%)
and an option to join the firm. Agreement lasted as long as loan outstanding.
Agreement stated that co-owners were not partners. Stated interest in profits was a
measure of compensation for loans, not profits. Stated that they were not liable for any
losses or treated as partners. Also contained provision giving respondents option to
buy into partnership or form a corporation if respondent and members agreed.
Members put resignation in hand of trustees and they could demand resignation if
desired. Martin claimed that they became partners in a firm doing business as bankers
and brokers. His claim depended on the interpretation of the instruments of the
agreement.
2. Holding: The court found that the documents did not associate Peyton (and other
lenders) with the firm so that they and it together carried on as co-owners of a business
for profit. The measures taken as precautions to safeguard the loan were ordinary
caution and did not imply an association in the business (i.e. taken together the
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provisions did not create a partnership). Rather, the court described the arrangement as
a joint venture – an ad hoc, one-shot partnership limited to a specific undertaking.
a. NOTE: Majority of jurisdictions disagree and view “joint ventures” as a type of
partnership with same rules.
3. Law on Partnerships:
a. Partnership results from contract, express or implied.
b. If partnership denied, it may be proved by:
i. The production of some written instrument,
ii. By testimony by some conversation, or
iii. By circumstantial evidence. If nothing else appears, the receipt by
defendant of share of profits of business enough to establish partnership.
c. “Mere words will not blind us to realities.” Statements that no partnership
intended are not conclusive.
d. Existing contracts can be modified by subsequent agreements (written or oral),
therefore arrangement can be changed – to create a partnership, for example,
where there was none before. Agreement can be proven by conduct of the
parties.
C. Fiduciary Obligations
i. Meinhard v. Salmon – fiduciary duty in partnerships greater than in corporations
1. Facts: Salmon leased premises from third party for which he needed money to do
renovations. He then entered into a joint venture with Meinhard where Salmon would
manage place, and Meinhard would help set up costs in exchange for % of profits.
Reversion on property went to a fourth party, Gerry. Gerry and Salmon came to an
agreement to lease the property (leasehold estate), but Salmon did not tell Meinhard.
When Meinhard learned of lease, he demanded that the agreement be placed in trust as
an asset of joint venture. His demand was refused by Salmon. Meinhard subsequently
sued for breach of the joint venture agreement.
2. Holding: Court held that plaintiff was entitled to proceeds resulting from defendant’s
purchase of a leasehold estate b/c defendant would not have been in the rewarding
leasehold position if it were not for the joint venture – the lucrative position arose from
the creation of a joint venture.
3. Rationale: Joint adventurers, like copartners, owe each other duty of the finest loyalty,
stricter than morals of marketplace. Salmon had a duty to inform Meinhard of the
offer, b/c:
a. Had he known of the partnership, Gerry would have laid plan before both of
them (might have preferred Meinhard to Salmon);
b. By not informing, Meinhard could have assumed that leasor intended to extend
lease.
c. Since Salmon in control of management had duty of disclosure b/c only
Meinhard had opportunity to be involved.
Not disclosing was violation of duty of loyalty (undivided, unselfish). The very fact that
Salmon was in control w/exclusive powers of direction charged him even more
obviously with the duty of disclosure, since only through disclosure could opportunity
be equalized. If Salmon had learned of an opportunity outside his position of manager
or for another building at a location far removed, the duty would not have existed.
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D. Partners’ Authority and Governance
i. UPA & RUPA: Partner is an agent of partnership and has authority to bind
partnership/copartners when acting in ordinary course of business. Acts outside ordinary
course of business need to specifically authorized by other partners.
1. Differences arising as to matters in ordinary course of business may be decided by
majority.
2. An act outside ordinary course of business and an amendment to the partnership
agreement require unanimous consent of all partners.
ii. Summers v. Dooley – partner’s liability to co-partners for acting beyond actual authority
1. Facts: Despite defendant’s repeated objections to plaintiff’s request to hire a third man
to work for the partnership, plaintiff hired a new employee, paid him $11,000 out of his
own pocket, and sought reimbursement from defendant via law suit.
2. Holding & Rationale: The court held that, because the parties’ partnership agreement
did not specify otherwise, the business differences between the parties should have
been resolved by a by a majority of the partners – where no other agreements speak to
an issue within the ordinary course of business it must be decided by a majority of the
partners. Where one of two partners continuously objects to a decision by the other
party and does not acquiesce, the needed majority is not present. Therefore, by hiring
an extra worker without defendant’s permission the plaintiff acted outside of his actual
authority. Thus, the court determined that plaintiff was not entitled to full
reimbursement of the expenses he incurred when unilaterally hiring the new employee
over defendant’s objections because it would have been manifestly unjust to permit
recovery of an expense that was incurred individually and not for the benefit of the
partnership but rather for the benefit of plaintiff.
iii. National Biscuit Company v. Stroud:
1. Facts: Flip side of Dooley case. The assenting and non-assenting partners had entered
into a partnership to sell groceries. The non-assenting partner advised the company
that he was no longer responsible for any additional bread sold by the company to the
partnership. After that, the assenting partner requested additional deliveries of bread
from the company and the company provided the bread.
2. Holding & Rationale: The court found that the assenting partner’ purchases of bread
from the company as a going concern bound the partnership and the non-assenting
partner, for such a purchase was an “ordinary matter connected with the partnership
business,” for the purpose of its business and within its scope. The court stated that
activities within the scope of the business of the partnership could not be limited
except by the expressed will of a majority decision on the disputed question and that
half of the members were not a majority. Both partners have the power to bind the
partnership.
iv. Notes:
1. A majority vote required to change the normal course of business, either by expanding
or narrowing that business.
2. While the partnership agreement can vary the default rules governing partner’s actual
authority, the only way to vary the rule vis a vis liability to a 3rd party is to provide
notice to the 3rd party of limitations on what otherwise would be a partner’s apparent
authority to bind the partnership (and other partners) to acts within the ordinary course
of business. (Gabe’s: If one partner go to a third person to buy an article on time for
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the partnership, the other partner cannot prevent it by writing to the third party not to
sell to him on time.)
v. When do the actions of one partner make the other partners or the partnership liable? Inquiry:
1. Actual authority
2. Apparent authority
3. Within scope of partnership
4. Within acting partner’s authority
5. Engaged in ordinary business activities
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IV.
LIMITED PARTNERSHIPS, LLP, AND LLC (CB Chapter 3) – Popular because permit
partnership type of organization with limited liability. Different from a partnership in that they are
subject to organizing documents that are filed with the state. 2 or more people in business can fall into
partnerships inadvertently, but not a LP, LLC or LLP.
A. Limited Partnership (Cox reading, CB page 53+)
i. Used to provide the flexibility of a partnership while allowing passive investors to avoid
unlimited liability for the obligations incurred by the operating partners. Permits investors to
share profits of a business, with their risk of loss limited to their investment if the investors
comply w/certain legal formalities.
ii. A LP has 2 classes of partners:
1. 1 or more general partners – have complete control, manage the enterprise, subject to
unlimited liability – the liability passes through them just like in a partnership, and
2. 1 or more limited partners – are passive investors who are very similar to creditors, but
subordinate to creditors if the firm becomes insolvent or is liquidated, normally do not
take part in the day-to-day control of the business.
iii. Formed only by complying w/statutory formalities similar to those for creating a corporation.
1. Verified certificate (similar to articles of incorporation) must be filed w/public official
in county of principal place of business.
2. RULPA requires filing with secretary of state.
iv. Unlike partners in general partnerships, limited partners are not ordinarily agents of the
partnership and thus – no authority to bind limited partnership.
v. General partners, as managers of the business, owe fiduciary obligations to the limited
partnership. Such fiduciary duties can be limited by the partnership agreement.
vi. Limited partners who take active role in the business will incur same fiduciary duties as general
partners. However, where the limited partner is not exercising managerial control, fiduciary
duties to other partners will be much lower, if any.
vii. Limited partnership agreement can impose additional fiduciary duties on even passive limited
partners.
viii. Gateway Potato Sales v. G.B. Investment Co. (AZ, 1991)
1. Facts: Gateway, the creditor, sold goods on credit to a limited partnership (formed by
the defendant and another corporation). When the partnership defaulted, the creditor
sought recovery from the limited partner, the defendant (the general partner did not
have means to pay).
2. Holding: The court held that the relevant state statute imposed liability on a limited
partner whenever the limited partner exercised substantially the same control as a
general partner, even if the creditor had no contact with the limited partner and no
knowledge of the limited partner’s control.
3. Rationale & Discussion of Law:
a. Arizona law – If the “substantially the same as” test is met, direct contact
between the creditor and the limited partner is not a requirement. The test states
that if a limited partner’s participation in the control of the business is
substantially the same as the exercise of the powers of a general partner, he is
liable to persons who transact business with the limited partnership even though
they have no knowledge of his participation and control.
b. RULPA – The court contrasts the AZ statute with the Revised Uniform Limited
Partnership Act (RULPA) which states that if limited partner participates in the
control of the business, he is liable only to persons who transact business with
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the limited partnership reasonably believing, based upon the limited partner’s
conduct, that the limited partner is a general partner. No direct conduct with
creditor then no liability to limited partner. The rationale of RULPA: Difficult to
determine when “control” line overstepped and bad policy to hold limited
partner liable to someone who didn’t believe party was a general partner.
c. The court also stated that the statute did not provide a list of types of activities
that might be undertaken by a limited partner which would amount to “control of
the business,” however it does contain a list of activities that are permissible
w/out being deemed to be taking part in “control.” “A limited partner does not
participate in the control of the business within the meaning of subsection (a)
solely by doing one or more of the following:
i. Being a contractor for or an agent or employee of the limited partnership
or of a general partner;
ii. Consulting with and advising a general partner with respect to the business
of the limited partnership;
iii. Acting as surety for the limited partnership;
iv. Approving or disproving an amendment to the partnership agreement; or
v. Voting on one or more of the following matters: (i) The dissolution and
winding up of the limited partnership; (ii) The sale, exchange, lease,
mortgage, pledge or other transfer of all or substantially all of the assets of
the limited partnership other than in the ordinary course of its business; (iii)
The incurrence of indebtedness by the limited partnership other than in the
ordinary course of its business; (iv) A change in the nature of the business;
or (v) The removal of a general partner.”
The court noted that the creditor had produced an affidavit by the debtor’s
president describing several ways in which the limited partner exercised control
over the operation of the partnership, some of which did not fall within the
protected areas listed in the “safe harbor” provision (above) of the limited
partner liability statute. They are as follows:
i. Employees from limited partner controlled day-to-day affairs of the limited
partnership, which included approval of most significant operational
decisions and expenditures and the use and management of partnership
funds;
ii. These employees were at the partnership’s office on a frequent basis; and
iii. The president of the other corporation in the partnership (the general
partner) reported directly to these employees and had to get their approval
before making certain business decisions.
ix. Notes:
1. As noted in Gateway, RULPA establishes “safe harbors” for activities that will not
expose a limited partner to unlimited liability for participating in the control of the
business. This does not mean that all other activities will result in liability. Rather, if
the activity does not fall within the safe harbor, the court must examine the activity and
make a decision on whether liability should attach b/c the activity constitutes
participation in control.
2. A general partner can be a corporation. RULPA also provides a safe harbor for limited
partners acting as “an officer, director or shareholder of a general partner that is a
corporation.”
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B. Limited Liability Partnership
i. Lewis v. Rosenfeld
1. Members of a limited liability partnership are not liable for the debts or liabilities of the
partnership solely by reason of their membership.
2. But, a partner may be liable for any negligent or wrongful act committed by that partner
or anyone under his direct supervision and control, while rendering professional service
on behalf of the limited liability partnership.
ii. History: LLP statutes vary in their terms. Some require a minimum amount of capital or
insurance for the firm before limited liability is available. Initially, many of the LLP statutes
insulated the partners from tort but not contract liability. Later, many states, and the most
recent version of RUPA, provide that partners in LLPs are not liable for either the tort or
contract obligations of the partnership or other partners.
iii. Procedures for LL registration vary, but most states permit a general partnership to register as a
LLP upon a majority vote of the partners and upon filing of registration form w/Secretary of
State.
iv. Personal liability may be imposed in a limited liability partnership situation where the “veil”
created by the LLP is pierced in the same manner as that of a corporation.
C. Limited Liability Companies
i. Elf Atochem North America v. Jaffari
1. Facts: Plaintiff attempted to bring suit on behalf of LLC against other party to LLC
agreement. The LLC agreement contained an arbitration clause that covered all
disputes, and a forum selection clause giving CA exclusive jurisdiction.
2. Holding: Plaintiff’s attempt to circumvent the arbitration and forum selection clause in
LLC Agreement between the LLC and the defendant failed.
3. Rationale:
a. Parties creating agreements creating limited liability companies are free to include
whatever provision they desire in the agreement. Statutes governing these
agreements serve as default provisions where the agreements are silent and
provide some mandatory provisions.
b. Only where an agreement is inconsistent with mandatory statutory provisions will
the members’ agreement be invalidated.
i. Mandatory provisions are usually designed to protect third parties not
contracting parties.
c. In member managed LLCs, each member is an agent with the authority to bind.
d. It is the members not the LLC who are party in interest to LLC. The LLC is
merely their joint vehicle.
ii. LLC Basics
1. Participants referred to as “members”
2. The “interests” of the members of an LLC are not represented by stock; members hold
interests much like partners in a partnership.
3. Do federal securities laws apply to LLCs?
a. An ownership interest in an LLC will likely be treated as a security when its
members’ involvement in management is akin to than of limited partners or the
member is otherwise so dependent on the promoters or active managers as to be
essentially a passive investor – i.e., the more a members ownership interest is
similar to a limited partner and the more reliant they are on management, the
more likely securities law will apply.
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4.
5.
6.
7.
8.
9.
b. The more similar interest is to a general partnership, where more members
participate in management, the less likely it will apply.
Members of an LLC usually enter into an “operating agreement” that functions much
like a partnership agreement. Under most LLC statutes, the authority to manage rests
with the firm’s members, unless the members allocate managerial authority so that
some members can be assured of being active while others are passive. In member
managed LLCs, each of the members is an agent of the LLC and has the authority to
bind it in the ordinary course of business.
Many LLC defer to the operating agreement to define the parties’ respective rights and
involvement and some may define the fiduciary obligations present. In the absence of
such an agreement, courts may apply fiduciary obligations found in other business
enterprises, which usually include the duties of care and loyalty.
Operating agreements can define voting rights. In the absence of such an agreement,
some states
a. Following the partnership model, grant members of LLC equal voice,
b. Others set voting rights based on proportional ownership.
The LLC was designed to assure the limited liability of its members. Creditors may try
to avoid that limitation by asking a court to ignore or pierce the corporate veil.
a. As w/corporations, it will be the exceptional case in which a court will be willing
to pierce the veil of a LLC.
b. Among other things, would have to prove that LLC was a sham and really the
alter ego of the members or that it was a mere instrumentality of the owners.
Switch to LLC does not shield from liability arising prior to formation.
Notes from class: have to file with the state to form, default rules apply when not
specified, members can generally bind the LLC with respect to 3rd party claims, have
almost complete liability in LLC.
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V.
CORPORATIONS – FORMATION AND FINANCES (CB Chapter 4)
A. Role of the Corporate Lawyer
i. Client needs to be advised by the corporate lawyer of the risks of particular courses of action
and the uncertainties.
ii. Role of corporate lawyer is to avoid exposing client to unnecessary legal risk and to avoid costly
litigation and damages.
iii. Corporate lawyers shouldn’t tell clients how to run their business.
iv. Instances where the law is unclear are perfectly acceptable if client is fully aware of risks and
willing to assume them.
v. Activities of the corporate lawyer:
1. Organizing corporation for its promoters,
2. Drafting corporate minutes,
3. Advising corporate directors on their fiduciary duties, and
4. Advising clients on the requirements of the federal securities laws when public
offerings.
B. Forming the Corporation
i. Promoter’s Liability
1. A pre-incorporation concern. Potential liability of founders or promoters of the
enterprise for activities they engaged in before incorporation.
2. When faced with the issue of pre-incorporation liability, the owners cannot simply
claim that they were acting as the agents for the corporation because there was no
corporation in existence, i.e., no agency relationship can exist in the absence of a
principal.
3. As a result, those acting on behalf of the pre-incorporation business will be held
personally accountable for their acts, b/c at time no agency relationship existed.
4. In addition, they are without power to bind the non-existent principal (i.e., the yet-to-be
formed corporation), raising the issue of the enforceability of contracts entered on
behalf of the yet unformed corporation.
5. Those acting on behalf of a corporation to be formed are generally called promoters.
6. Categories of major issues arising out of pre-incorporation activities:
a. Personal liability of the promoters for their acts;
b. Determining when corporate liability attaches to pre-incorporation activities; and
c. Liabilities of the corporation to investors for fraudulent promoter activities.
ii. O’Rorke v. Geary
1. Facts: Contract executed b/t plaintiff and “D.J. Geary for a bridge company to be
organized and incorporated.” Geary wanted O’Rorke to build a bridge. Defendant
contends that, in executing the contract, he did not act for himself, but for a
corporation to be formed, and that the corporation, and not D. J. Geary, is now liable
to the plaintiff for what is due him on the contract.
2. Holding: Court ruled that Geary became liable personally on the contract, taking the
chances of the incorporation of the company and of its indemnifying him.
3. Rationale: When a party is acting for a proposed corporation, he cannot bind it by
anything he does at the time. He may
a. (1) take on its behalf an offer which if accepted after the formation of the
company becomes a contract;
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b. (2) make a contract at the time binding himself, with the
understanding/stipulation that if a company is formed it will assume
responsibility; or
c. (3) bind himself personally w/o more and looked to proposed company for
indemnity.
Geary falls under #3. It wasn’t a contract where the company would take responsibility
b/c work was begun and probably finished before it was possible for the corporation to
come into existence. Geary intended to pay the monthly sum under the contract. The
fact that the corporation was formed before the bridge was finished is irrelevant. What
is important is whether or not the corporation was formed by the date of completion
contemplated in the contract. Ratification did not occur b/c there would have needed
to be a principal in existence to give agent authority.
iii. Note:
1. The fact that a contracting party knows that a corporation is nonexistent does not
indicate any agreement to release the promoter, but rather such knowledge indicates
that the third party intended to make the promoter a party to the contract.
iv. Theories of Liability of Corporation through Promoter (Cox article, page 77)
1. The mere existence of a promotional relationship is not sufficient to establish the
liability of a corporation subsequently formed for pre-incorporation promoters’
contracts. 5 theories have been advanced as to how the liability of the corporation on
the promoters’ contracts can arise:
a. Adoption: Corporation’s assent to a contract made in its contemplation –
corporation takes the contract rights and obligations of the promoter and makes
them its own.
b. Ratification: Corporation’s acceptance of an act purportedly made on its behalf
by an agent. Principal must been existence at time of contract, therefore only
properly applicable to post-incorporation contracts.
i. Note: Adoption and ratification may be shown by any words or acts of
responsible corporate officers showing assent or approval, such as by
their knowingly accepting benefits of the contract or proceeding to
perform obligations imposed on it.
ii. Courts often use ratification and adoption interchangeably. Distinction
made by some courts: Ratified contract relates back to date the
promoter made it. Adopted contract becomes binding at date of
adoption.
c. Acceptance of continuing offer: Theory that promoter’s contract is a continuing
proposal which corporation may accept once formed.
d. Formation of a new contract: Corporation’s adoption of promoter’s contract is
making of a new contract for new consideration.
e. Novation: Whenever parties to a promoter’s contract anticipate that the
corporation when formed will accept the contract and take over its performance,
the contract is viewed as contemplating a novation.
v. Old Dominion v. Lewisohn
1. Facts: Lewisohn and partners bought property worth $1 million and formed a
corporation. They then issued themselves $3.25 million in stock and held all of the
shares. Next, defendants sold the corporation property in exchange for stock in the
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corporation at an inflated price – they issued stock to the public, 20,000 shares, and
they received $500,000. “Watered stock” – inflated value. The plaintiff corporation
sought to rescind its purchase of certain mining rights and land from the stockholders.
2. Holding: For the defendants…The United States Supreme Court stated that:
a. (1) the corporation had assented to the transaction with full knowledge of the
facts;
b. (2) at the time of the sale, there was no wrong done to anyone as the
stockholders were on both sides of the bargain and could issue to themselves as
much stock in their corporation as they liked in exchange for the conveyance of
their property (no breach of duty);
i. If the property was sold after the offer to the public then there might
be a breach of duty and the new shareholders would have a cause of
action.
c. (3) the corporation remained unchanged and unaffected in its identity by
changes in its members due to the purchases of the stock by the innocent
public; and
d. (4) if the corporation succeeded, the guilty as well as the innocent would profit.
3. Rule: Ratification by a corporation upon full disclosure will preclude corporate
complaints when the shares changes hands. Only possible wrong that could have been
done was when shares sold to public. The possible cause of action in that case would
be fraud. Corporation has identity separate from its shareholders and that identity does
not change when the shares do.
C. Mechanics of Incorporation
i. The client should have developed a business plan that will include, at minimum, a description
of the capitalization of the business. Other concerns include:
1. Allocation of the ownership interest in the business.
2. Company management.
3. Note: these business issues are best handled in a pre-incorporation shareholder
agreement that will be available in the event of a dispute.
ii. The client should then select a corporate name.
1. The name must be cleared with the Secretary of State in the state of incorporation to
assure that it does not conflict with an existing corporation. Copyright check.
2. The new corporation must maintain an office in the state of incorporation.
3. The company must also have a registered agent in the state that is authorized to accept
service for the corporation.
iii. Next, the corporate charter (also called the articles of incorporation or certificate of
incorporation) must be prepared and filed with the Secretary of State.
1. Simple form; usually a one-page document that contains the name of the business, the
address, the number of shares of stock authorized to be issued and the name and
addresses of its incorporators.
a. Incorporators would normally be advised to specify that the company’s
business is “any lawful activity” to avoid unintended restrictions on future
activities.
2. May also address the power to adopt and amend by-laws, simple rules of order that
govern the operations of the corporation.
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a. Under Delaware law, the power to adopt or amend the by-laws lies solely with
the corporation’s shareholders, unless the certificate of incorporation allows the
board of directors to share that power with the shareholders.
b. Conversely, the Model Bus. Corp. Act provides that the board of directors
shares with the shareholders the power to adopt or amend the corporation’s
by-laws unless the articles of incorporation provide otherwise.
iv. If the corporation plans to have operations in other states, it may qualify for doing business by
filing with the Secretary of State in that state.
1. The corporation must also obtain a tax identification number from the IRS and any
required business licenses from the local government where it has offices.
v. The newly formed corporation should conduct an organizational meeting. The meeting will
be used to:
1. Issue stock to the owners of the corporation,
2. Appoint the corporation’s initial directors,
3. Decide compensation of officers and directors,
4. Ratify any contracts and other obligations incurred on behalf of the corporation by the
incorporators before its existence was formalized, and
5. Approve the necessary resolutions for opening bank accounts, entering into leases, etc.
6. Note: Minutes of the organizational meeting and of any board or shareholder meeting
must be created and maintained.
D. DEFECTIVE INCORPORATION
i. Pocahontas Fuel Co. v. Tarboro Cotton Factory (1917)
1. Facts: Action by the Pocahontas Fuel Company against the Tarboro Cotton Factory.
No case facts available…but it seems that the Pocahontas Fuel Company is trying to
hold individual shareholders of the Tarboro Cotton Factory personally liable because
the Factory was operating under a defective charter.
2. Holding: The court cites the Board of Education v. Berry case where it was held,
among other things:
a. If there has been a bona fide effort to comply with the law to effectuate an
incorporation and the persons affected thereby have exercised the functions
pertaining to the corporation, a de facto corporation comes into existence.
And if a de facto corporation exists, the individual shareholders cannot be held
personally liable. Elements:
i. bona fide effort to comply with law to effectuate incorporation,
ii. acquiescence by persons affected by incorporation, and
iii. exercise of functions pertaining to incorporation.
3. Rationale & Law:
a. De facto – existing in fact, having effect even though not formally or legally
recognized vs. de jure – “as a matter of law,” existing by right or according to
law.
b. The court also distinguishes the argument of incorporation by estoppel, which
seemed to be a second argument forwarded by the defendants. The court
stated that the doctrine usually arises in cases where a person received value
(money) from an assumed corporation and are obligated for the value received,
but is seeking to resist fulfilling those obligations on the grounds that the
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corporation did not exist. It is an equitable doctrine resting in part on the fact
that since value has passed, it would be unjust to uphold such a defense.
However, no estoppel arises from the mere fact that a creditor or claimant has
dealt with the defendant as a corporation, and unless there is one either de jure
or de facto, the member can, ordinarily, be held liable as partners.
ii. Cranson v. International Business Machines Corp. (1964)
1. Facts: Cranson was asked to invest in a new business corporation which was about to
be created. He met with other individuals and an attorney, and he agreed to purchase
stock and become an officer and director. After being advised by the attorney that the
corporation had been formed under the laws of Maryland, he paid for and received a
stock certificate evidencing ownership of shares in the corporation and was shown a
corporate seal and minute book. Thereafter, the business of the new venture was
conducted as if it were a corporation. Cranson was elected president and all
transactions conducted by him for the corporation, including the dealings w/IBM, were
made as an officer of the corporation. At no time did he assume any personal
obligation or pledge his individual credit to IBM. However, due to a mistake made by
the attorney, of which Cranson was not aware, the certificate of incorporation, which
was signed prior to May 1, 1961, was not filed until November 24, 1961. During the
interim, the Bureau purchased 8 typewriters from IBM and made partial payments on
the account. Initially, IBM brought suit against Cranson for the balance due on electric
typewriters purchased by the Real Estate Service Bureau, a business which IMB argued
was neither a corporation de jure or de facto and for which Cranson was a partner.
Cranson argued that the Real Estate Service Bureau was a de facto corporation and
therefore, he was not personally liable for its debts.
2. Question Presented: Whether an officer of a defectively incorporated association may
be subject to personal liability under the circumstances of this case.
3. Holding: No.
4. Rationale: The court first examined the doctrine of de facto corporations, stating that
traditionally 2 doctrines have been used by courts to protect an officer of a defectively
incorporated association.
a. The doctrine of de facto corporations, which has been applied to cases where
there are elements showing:
i. The existence of law authorizing incorporation;
ii. An effort in good faith to incorporate under the existing law; and
iii. Actual user or exercise of corporate powers.
b. The doctrine of estoppel to deny the corporate existence, is generally employed
where the person seeking to hold the officer personally liable has contracted or
otherwise dealt with the association in such a manner as to recognize and in
effect admit its existence as a corporate body.
The court determined that even though the failure to file might have prevented the
Bureau from being either a de jure or a de facto corporation:
a. Cranson did everything in power to incorporate;
b. IBM dealt with the Bureau as if it were a corporation and relied on its credit
rather than that of Cranson; and
c. At no time did Cranson pledge individual credit or assume personal obligation.
Therefore, IBM is estopped from arguing that the Bureau was not incorporated at the
time the typewriters were purchased.
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iii. Notes:
1. 5 classes of cases where the issue of a de facto corporation may arise under
MBCA. Where:
a. The participant honestly and reasonably believes that the certificate of
incorporation has been filed by an attorney when, in fact, it has not.
b. The articles of incorporation are mailed to the Secretary of State but are delayed
or returned by the Secretary due to some error.
c. A third party agrees to enter into a contract with a company in its corporate
name even though the third party knows that the company has not filed its
charter with the Secretary of State.
d. A defendant enters into a contract on behalf of a company even though its
charter has not yet been filed. The opposite party, however, dealt with the
defective corporation and not with the defendant as an individual.
e. A passive investor provides funds with the instruction not to engage in
business until the articles of incorporation are filed, but business is commenced
anyway before incorporation.
2. The MBCA now provides that liability will be imposed only on persons who act on
behalf of a corporation “knowing” that the corporation does not yet exist. This
provision protects persons who “erroneously but in good faith” believe a charter has
been filed properly.
E. CAPITAL FORMATION – A FIRST LOOK
i. A corporation needs money to commence and carry out its operations. Those funds will
initially be borrowed, contributed by the owners of the company or acquired from the
company’s profits. The company will use these funds to pay its bills or acquire assets. The
corporation may also distribute its profits to shareholders in the form of dividends. Orders of
distributions – bondholders first (b/c bonds are entitled to fixed interest payment), preferred
stockholders, common stockholders. Common stockholders – greater risk, but could get a
greater piece of the upside, preferred or bondholders returns are fixed.
ii. What is a bond?
1. The corporation may borrow funds to commence and carry out its operations. When
the corporation is larger, it may seek to borrow funds from the public by selling bonds.
2. A bond or debenture is simply a certificate that contains a promise from the
corporation to repay the lender the principle (plus interest) at some future date.
3. The terms of the loan are set out in a separate document called a trust indenture
agreement, which is administered by a trustee that makes transfers of interest and
principal payment to the lenders.
4. Bondholders never want companies to take big risks – just enough to pay back the
bonds.
iii. What is a stock?
1. Stocks are simply certificates that reflect an ownership interest in a corporation.
2. Common stocks usually represent an aliquot (fractional) ownership position in the
corporation.
a. Usually confer the right to vote on the board of directors and other issues
submitted to shareholders.
b. Usually provide a right to a proportional amount of any dividends “declared”
by the board of directors. [Dividends represent a claim by the shareholder on
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the earnings of the corporation on a pro rata basis (proportionately, according
to an exact rate)].
c. The corporate charter may vary the rights of common stock holders in any
number of ways (see page 91).
3. Preferred stocks give their holders a preference over common stockholders in the
receipt of dividends and in liquidation. Usually preferred with respect to 2 things:
dividends, liquidation preference.
a. Usually not entitled to vote unless dividends are missed for some specified
period of time.
b. May be cumulative or non-cumulative.
i. Cumulative means that, if a preferred dividend is missed in any year or
years, the common stockholders cannot receive a dividend until any
outstanding dividends are paid to the preferred.
ii. Non-cumulative preferred simply forfeits any right to dividends if the
board of directors does not declare them in any given year. The noncumulative preferred shareholders will be the first to receive any
dividends declared in subsequent years but have no claims for dividends
missed in prior years.
4. Note: Debtors have priority over stockholders in bankruptcy. The shareholders will
share only in assets left over after all of the debts of the corporation have been paid.
Also shows way in which risk relationships can be visualized. More risk not based on
the amount of money – it’s whose money is it.
iv. The Balance Sheet – Identifies the assets of the corporation and sets forth the source of
funds for those assets. The balance sheet must balance – the assets on the left must equal the
liabilities, equity investments and retained earnings (profits not paid as dividends) on the right.
1. Assets
a. Assets may be short or long-term.
i. A short-term asset is cash or an asset that is readily convertible into cash,
e.g. accounts receivable or tax refunds.
ii. A long-term asset is one that will not be converted to cash within a year,
e.g. real property, buildings and equipment.
b. Usually the value of an asset will be its purchase price. Issues:
i. Not always easy to arrive at, particularly in the case of inventory – FIFO
and LIFO
ii. May not accurately reflect their current market value.
1. “Mark-to-market” accounting
2. Depreciation methods
iii. Issue of collection of accounts receivable.
iv. Intangible assets like patents and goodwill (arises when a corporation
purchases another business and pays more for that business than its
tangible assets will justify; the excess of the price over the value of those
tangible assets is treated as goodwill). Under the current accounting
rules, goodwill must be written off if the acquired business declines in
value.
2. Liabilities
a. The liabilities section sets forth the funds borrowed by the corporation.
b. Divided into short and long-term.
i. A short-term liability must be repaid within 1 year.
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ii. A long-term liability has a maturity of more than 1 year.
3. Equity Capital
a. May include preferred stock. Where preferred stock has been issued, its
liquidation value is listed.
4. Note on Leverage:
a. A corporation must determine what amount of funds it should borrow and
what amount should be obtained through sales of stock. Borrowing (bonds)
instead of selling stock provides shareholders w/leverage
i. Barrowing funds will require payments of interest (which are tax
deductible) and repayment of the principal.
ii. A sale of stock will raise funds, without interest charges – no pay-back
required, but the number of owners will increase and existing
shareholders will have to share future profits and control with the new
shareholders, thereby diluting the ownership interest of the existing
shareholders. For that reason, barrowing may be preferred – provides
existing shareholders w/leverage and avoids dilution.
5. Bullard: expected value analysis – want to find risks that have a positive expected
value.
a. Example A: $500k investment w/50% chance to go up to $850k and 50%
chance to go down to $350k – positive expected value
b. Example B: $500k investment w/50% chance to go up to $850k and 50%
chance to go down to $0 – no positive expected value, will not invest.
c. Management is more likely to take risk when they’re using other people’s
money.
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VI.
LIMITED LIABILITY AND ULTRA VIRES (CB Chapter 5)
A. Minton v. Cavaney (personal shareholder liability – Lexis pg. 59)
i. Facts: 2 promoters formed a corporation and carelessly operated it. A small girl drowned. Her
family sued to pierce the corporate veil and get at the assets of the atty who had formed the
corporation, acted as director and corporate secretary (as a service to his clients) and taken a
qualifying share (some states requires three shareholders, so in this case only 3 shares were
issued).
ii. Holding & Rationale: Due to an analysis of the factors the veil can be pierced, but will need to
be re-litigated to determine negligence of the corporation and the damages sustained by
plaintiffs. Alter Ego Doctrine requirements:
1. Unity of interest and ownership that the separate personalities of the corporation and
the individual no longer exists, and
2. If the acts were treated as those of the corporation alone, an inequitable result will
follow.
Factors in courts decision:
1. Corporation had no assets of any kind.
2. Records were kept at Cavaney’s office.
3. He had one third of the shares (could be seen as equitable owner).
4. He was secretary, treasurer and director
5. Organized as a corporation but did not function as one.
6. No attempt to provide adequate capitalization.
a. It had defaulted on many loans.
b. Under-capitalization is an important factor but not alone a decisive factor in
piercing the corporate veil
iii. Dissent: This atty was performing professional services and practicing law in his help setting up
the corporations and for this he cannot be held liable. Even his advice to the clients as they run
the business is not enough to impose liability.
B. Walkovszky v. Carlton (brother-sister sibling corporations – Lexis pg. 63)
i. Facts: The same individual owner divided his twenty taxis fleet equally among 10 corporations
and obtained only the minimum amount of insurance on each cab. The plaintiff had been
injured by a cab of one of the corporations and sought to pierce the corporate veil and reach
the common owner of these subsidiaries.
ii. Holding: Plaintiff fails in stating a cause of action that adequately portrays Carlton as operating
the business as an individual in his personal capacity for purely personal rather than corporate
ends.
iii. Rationale:
1. Whenever anyone uses control of a corporation to further his own rather than the
corporation’s business, he will be liable for the corporation’s acts, which extends to
commercial dealings and negligent acts as well.
2. Piercing the corporate veil is appropriate where a corporation is a fragment of a larger
corporate combine which actually conducts business. It is also appropriate where a
corporation is a dummy for its stockholders who are in reality carrying on the business
in their personal capacities for purely personal ends, but a different result would occur.
a. In the first situation only a larger corporate entity would be found
financially responsible and in the other, the stockholders would be
personally liable.
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3. Corporate entity cannot be disregarded merely b/c by dividing taxi cabs into individual
corporations, the assets of the corporation and insurance coverage on the vehicle are
insufficient to assure recovery sought. If insurance coverage is inadequate the remedy
lies w/ legislature.
4. While there is allegation of under-capitalization and intermingling of assets of the
taxicab corporations, there isn’t sufficient evidence to show that personal funds were
being shuttled into and out of corporation w/o regard to formality. This would justify
imposing personal liability.
5. Dissent: From beginning corporations undercapitalized to avoid responsibility for acts.
Minimum required insurance cannot be used to shield defendant who intended to avoid
responsibility to the public where the operation of the corporation allowed him to
purchase additional insurance. Only corporations that would be harmed by holding
defendant liable would be those who intended to abuse the system.
6. Courts usually scrutinize smaller corporations more closely than large corporations
when it comes to piercing the corporate veil.
C. Variants of Piercing Corporate Veil (Cox article, CB pg. 107)
i. Three Variants:
1. Instrumentality Doctrine
a. Focuses on the presence of three factors
i. Control, not merely majority or complete stock control, but complete
dominance of finances, policy and business practices regarding the
transaction so that the corporate entity no separate mind, will or
existence of its own; and
b. Such control used by defendant to commit fraud or wrong, to perpetuate
violation of statutory or other positive legal duty, or unjust contravention of
plaintiff’s legal rights; and
c. Control and breach of duty must proximately cause the injury or unjust loss
complained of.
2. Alter Ego Doctrine – holds that it’s appropriate to pierce when
a. A unity of interest and ownership exists b/w the corporation and its controlling
stockholder such that the corporation has ceased to exist as a separate entity
and the corporation has been relegated to the status of the controlling
stockholder’s alter ego and
b. To recognize the corp. and its controlling stockholder as separate entities
would be sanctioning fraud or would lead to an inequitable result.
3. Identity Doctrine
a. Showing that there was unity of interest and ownership where independence of
corporation ceased or never began. Adherence to fiction of separate identity
would only defeat justice and equity by permitting economic entity to escape
liability arising out of operation of one corporation for benefit of whole
enterprise.
4. Three variants virtually indistinguishable and the courts’ decisions are highly factually
based. Factors include:
a. Commingling of funds and other assets of corporation w/those of
individual shareholders,
b. Diversion of corporate funds or assets to non-corporate uses – siphoning
of corporate funds by the dominant stockholder,
c. Failure to observe corporate formalities,
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d. Individual shareholder representing to persons outside the corporation
that he or she is personally liable for the debts,
e. Non-payment of dividends,
f. Failure to adequately capitalize a corporation for reasonable risks,
g. Sole ownership of all the stock by 1 individual or members of a single
family (close corporation),
h. Use of the same office or business location by the corporation and its
individual shareholders,
i. Insolvency of the debtor corporation,
j. Non-functioning of other officers or directors,
k. Absence of corporate records, and
l. The fact that the corporation is merely a facade for the operations of the
dominant stockholders.
m. Note: The conclusion to disregard the corporate entity may not, however, rest
on a single factor, but must involve a number of factors; in addition, it must
present an element of injustice or fundamental unfairness. But, for example,
undercapitalization, coupled with disregard of corporate formalities, lack of
participation on the part of the other stockholders, and the failure to pay
dividends while paying substantial sums to the dominant stockholder, all fitting
into a picture of basic unfairness, is regarded fairly uniformly to constitute a
basis for an imposition of individual liability under the doctrine.
ii. Luckenbach Co. v. W.R. Grace (appropriate case to pierce corporate veil – Bullard
mentioned in class)
1. Luckenbach Steamship Company has capitalization of only $10,000, 94% owned by
Luckenbach.
2. Luckenbach Company has capitalization of $800,000, 90% owned by Luckenbach.
3. Both companies had the same officers and directors.
4. Luckenbach Company leased steamships at far below rental value to Luckenbach
Steamship Company in an attempt to avoid liability from creditors – basically, they tried
to protect the assets of the ships.
5. Can the veil be protected by making them the assets of another corporation? The court
stated that the two companies were one in the same and it would be unconscionable to
allow the owner of the steamers, worth millions, to escape liability b/c it had turned
them over to a $10,000, which was simply itself in another form.
D. Equitable Subordination
i. Costello v. Fazio
1. Facts: 3 individuals ran a partnership that was losing money. Two had substantial
amount invested in company. Decided to reorganize as corporation and give
promissory notes to individuals removing their investment and leaving just $6,000 as
capitalization. After incorporation, company still suffered losses and filed for
bankruptcy. 2 individuals tried assert claim from promissory note in the same class as
unsecured creditors.
2. Holding: Defendants were not able to be on same level as unsecured creditors; because
of their actions, their claims in bankruptcy were subordinated.
3. Rationale:
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a. Promissory notes done in expectation of conversation to corporation and
knowledge partnership losing money. Primary reason for incorporation was to
protect personal interest. Corporation was grossly undercapitalized (net sales as
partnership was $390,000 and capitalization was $50,000. Corporation
capitalization was $6,000).
b. Action was done to detriment of corporation. Had to know w/ lack of
capitalization business would fail.
c. Look at shareholder investment rather than working capital when deciding
adequacy of capitalization and whether loans to shareholders should be
subordinated to creditors.
d. Bullard quote from case: “Where, in connection with the incorporation of a
partnership Where, in connection with the incorporation of a partnership, and
for their own personal and private benefit, two partners who are to become
officers, directors, and controlling stockholders of the corporation, convert the
bulk of their capital contributions into loans, taking promissory notes, thereby
leaving the partnership and succeeding corporation grossly undercapitalized, to
the detriment of the corporation and its creditors, should their claims against
the estate of the subsequently bankrupted corporation be subordinated to the
claims of the general unsecured creditors? The question almost answers itself.”
e. Court acknowledges two approaches to analyze and under either this
transaction is condemned.
i. When claim (as here) is filed by person in fiduciary relationship to
corporation another test is whether or not under the circumstances the
transaction carries the earmarks of arms length transaction.
ii. Determinative question when transaction gives is challenged as
inequitable is whether, within bounds of reason and fairness, such a plan
can be justified.
4. Deep Rock Doctrine: when the court subordinates shareholder debt to that of other
creditors in bankruptcy. (Pg. 53 in Lexis)
E. Corporations (Cox article, pg. 115)
i. Fraud and mismanagement doesn’t need to be proven to subordinate loan…?
ii. A fraudulent conveyance is voidable at the instance of creditors who are in position to attack it;
the transferred assets may be pursued into the hands of the corporate transferee without
disregarding the corporate entity.
iii. A transferee may be held personally liable for the fraudulent transferer’s debts in certain
exceptional cases.
F. Ultra Vires – results when a corporation has acted beyond its purpose (the object of the
incorporation) or powers (the means by which the corporation carries out the object).
i. Wiswall v. Greenville and Raleigh Plank Rd.
1. Management could not use corporate funds to carry the mail because the stated
purpose of the corporation was the maintenance of a road between the cities (not
necessary and proper to affect purpose).
ii. Corporations (Cox article, pg. 119)
1. At common law, a corporation had the powers enumerated in its purpose clause as well
as the implied powers necessary to the accomplishment of its purpose. If a corporation
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2.
3.
4.
5.
engaged in conduct not authorized by its express or implied powers, the conduct was
deemed ultra vires and void.
Courts overtime have come to interpret corporate powers broadly. Legislatures also
address these concerns by authorizing a corporation’s articles to broadly enable the
corp. to engage in “any lawful purpose.”
Corporate purposes and Corporate Powers are fundamentally different. A purpose
Clause refers to the statement describing the business the corporation is to conduct.
The term “corporate powers” refers to the methods the corporation may use to achieve
its purpose.
MBCA – states that unless otherwise provided, corp. has power to conduct all lawful
business.
In addition to the broadening purpose clauses, many states adopted statutes restricting
the defense of ultra vires. Under MBCA, ultra vires claims can only be brought in three
contexts: An action by shareholders challenging the act (injunction or damages), Action
by corporation against officers, directors, or employees, or An action by the state (quo
warranto).
iii. Cross v. Midtown Club
1. Corporation can only engage in acts that are necessary and convenient to achieve their
stated purpose.
2. Facts: Luncheon club didn’t want to allow women members in. If the corporation had
listed a narrower purpose of providing lunches for men then it would have been able to
exclude women.
3. By-laws have to be reasonable and germane to the purpose of the corporation.
G. CORPORATE RESPONSIBILITY
i. A.P. Smith MFG. Co. v. Barlow
1. Corporations have power to make charitable donations to institutions though not
expressly permitted in certificate of incorporation b/c it benefits the corporation.
2. As time passed wealth pasted from individuals to corporations. Public has called upon
corporations to make philanthropic donations like entrepreneurs once did.
3. Substantial indirect benefits supporting donations. Corporations benefit from
donations through advertisement, and goodwill of patrons of recipient institutions who
want to see them succeed.
4. If corporation wants to make donation, it can take it from earnings but it shouldn’t be
able to increase its earnings in order to do so.
5. Bullard – The court definitely seems to think that there’s a greater responsibility held by
corporations. The baton has somewhat been passed from government to corporations
to support/fund charities and universities. Black letter: Make sure there is some greater
connection between the charitable donation and your bottom line and you’ll be fine.
ii. Notes:
1. Under MBCA, donations can be made for charitable, scientific, or educational
purposes.
2. Tillman Act prohibits contributions to candidates in federal elections (PACs = loophole
in election law).
iii. Bullard – Purpose of the Corporation:
1. Create wealth.
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2.
3.
4.
5.
Take risks for progress.
Limited liability enables the risk taking that leads to increased wealth.
Wealth-maximizing users of capital.
Maybe the most charitable purpose the corporation serves is to be the wealth
maximizer, to create the profits for their shareholders as Milton Friedman espouses.
iv. Adams v. Smith
1. Majority of stockholders could not make payments to widow of president over the
objection of one stockholder without consideration or allowance through express
provision in charter (lack of valid consideration).
v. Dodge v. Ford Motor Co.
1. Facts: Defendant, Ford Corporation’s directors thought the company had been making
too much money so wanted to hold back part of the company’s capital earnings for
reinvestment to reduce the price of cars to public (this involved denying dividend
payments to plaintiffs). The plan would have led to decrease in value of shares and less
profitable business. Plaintiffs contend that the director’s motives were semihumanitarian and not authorized by the company’s charter.
2. Holding: The appellate court held that the accumulation of so large a surplus
established that there was an arbitrary refusal to distribute funds to stockholders as
dividends and ordered that such dividends, plus interest, should be paid by defendant
corporation.
3. Rationale: It is not within the powers of a board of directors to conduct business for
incidental benefit of shareholders and primary purpose of benefiting others. Directors
had a duty to distribute the sum of money in question to shareholders
vi. Notes:
1. Seeking to avoid ultra vires issues, etc. 28 states enacted “stakeholder” or “other
constituency” statutes, which specifically enables the board of directors to consider
interests other than shareholder wealth maximization in making corporate decisions.
2. Milton Friedman has asserted that corporate managers should have as their exclusive
goal to make as much money as possible for shareholders while conforming to legal
and ethical standards.
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VII. MANAGEMENT OF CORPORATIONS (CB Chapter 6)
A. Corporate Structure
i. Subsidiary – one corporation controls another through stockownership
B. Board of Directors
i. Charlestown Boot & Shoe v. Dunsmore
1. Directors shall manage the affairs of a corporation with the by-laws and voting being
the only limitation upon their judgment or discretion.
2. Other officers and agents are subordinate to the management of the board. When
statute or charter grants powers to certain officers of a corporation the powers shall be
exercised only by them.
3. Shareholders could not choose a committee to act with board in performing board’s
duties
ii. Auer v. Dressel
1. Where by-laws impose positive duty on president to call a stockholder meeting
following proxy request by majority of stockholders the president has no discretion in
deciding whether to call the meeting.
2. Stockholders who have power to elect directors have the power to remove them for
cause
a. Necessary: service of specific charges, adequate notice, full opportunity of
meeting the accusations.
3. Giving directors the power to remove other directors through certificate of
incorporation did not remove power from stockholders.
iii. Campbell v. Loew’s Incorporated
1. A by-law can give the president to call a stockholder meeting as long as the
matters addressed by the stockholders does not conflict with express statutory
authority given to the board.
2. Though unusual, the by-laws of a corporation can allow a president to propose
amendment enlarging the size of the board
3. Stockholders have inherent right b/t annual meetings to fill newly created
directorships
4. Stockholders should have the power to remove directors from office with
cause.
a. Otherwise director allowed to commit worst sort of violation of duty.
b. Raises concerns where directors elected by cumulative voting and
removal is by a mere majority vote. Situation can lead to minority
shareholders having no representation on board.
5. When shareholders attempt to remove a director for cause there must be the
service of specific charges, adequate notice and full opportunity of meeting the
accusation.
a. But, matters for stockholder consideration need not be conducted with
same formality as judicial proceeding. Proxy statements sufficient
where stated that the removal of two stockholders sought for the
reasons stated in accompanying letter.
6. Charges of desire to take control and lack of corporation are not sufficiently
legitimate reasons for ouster.
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7. While can director has right to examine books and ask questions in the
discharge of his duty a point can be reached when his action exceed the call of
duty and become deliberate obstruction. If constitute real burden on
corporation then stockholders are entitled to relief.
8. Directors seeking ouster of other directors cannot keep from them the list of
stockholders. This prevents reasonable opportunity to be heard.
9. By providing voting proxy which contained only a statement from group of
directors seeking ouster the group violated rules of equity and fair play.
C. Board Functions and Compensation
i. Functions normally associated with the board
1. Monitoring management: Select and evaluate the CEO. Determine
management compensation. Review planning for future.
2. Review and approve financial objectives, strategies and plans. Provide advice
to shareholders on votes concerning strategic issues facing the corporation (i.e.
mergers)
3. Provide advice and counsel to top management
4. Select and recommend to shareholders for election the slate of directors
5. Review adequacy of internal controls and other systems to assure compliance
w/applicable laws and regulations.
D. Housekeeping Requirements:
i. State statutory requirements imposed upon board (i.e. mandate board members meet
as group, notice requirements for such meetings, quorum provisions, rules setting out
number of directors needed to approve corporate action). Breach of requirement
might invalidate corporate action.
ii. Action by a board must be taken at duly convened meeting. Believed directors should
act only after complete airing of all views. Reason why directors cannot vote by
proxy. (Directors can use two-way communication such as telephones)
1. Where there is unanimity meetings may not be required.
iii. Regular meetings do not require notice. Unless by-laws or articles of incorporation
provide otherwise, for special meeting 2 days notice is required (MBCA).
1. Notice may be waived by director
a. Notice is waived by director through appearance unless appearance is
for the purpose of protesting lack of notice and director doesn’t vote
for or assent to action taken.
iv. Quorum: Usually majority of total number of board directors. Articles or by-laws
might require super majority. Articles can fix quorum at less than majority but no
lower than 1/3 (MBCA)
1. A special quorum requirement for shareholder meetings must be stated in
articles.
2. An affirmative vote of majority of directors present (not just voting)
constitutes an action of the board
v. Directors must act together as board and not individuals to take actions
1. Reasons
a. Collective action is necessary, in order that the act may be deliberately
adopted after opportunity for discussion and an interchange of views.
b. The directors are the agents of the stockholders and given no power to
act otherwise than as a board.
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vi. Requirement of formal board action at duly assembled meeting recognized as
impractical for close (small) corporations where informal decisions are common
practice. Only requirement is that all directors are present.
vii. Cases hold where single shareholder owns substantially all stock he may bind the
corporation by his acts w/o a resolution of board of directors
E. Board Committees
i. State statutes allow board to divide into committees with the powers of the full board,
at least w.r.t. certain actions
1. Under MBCA committee cannot fill vacancies on board, or
adopt/amend/repeal by-laws
2. Under MBCA and DE board cannot appoint nondirectors to committees.
Board can appoint advisory committees with nondirectors
ii. Committees allow large corporations to operate more efficiently
iii. Most common committees:
1. Executive: Empowered to review and approve much of business. Will usually
bring most important decisions to entire board.
2. Compensation: Approving salaries and bonuses
3. Audit: Assuring books and records are accurate
4. Special litigation: Review issues pertaining to derivative suits and investigate
internal corporate misconduct.
5. Nominating: Used to select candidates for board
iv. Inside/Outside Directors
1. Inside Director: Director holding management position inside corporation.
a. Can function as agent of corporation when acting in management
capacity but cannot when acting as director
2. Outside Directors: Not employees, representatives of large shareholders, or
otherwise affiliated with the corporation
a. Thought to bring independence, broaden experience and perspective
to corporate decision making process
b. Delegation of authority to committees containing outside directors
avoids conflict of interest (i.e. audit committees)
3. A different type of director - representing interest of large stockholder but not
employed as officer
a. Primarily there for protecting purpose of stockholder
b. Often represented shareholder has enough shares elect director but not
enough to be appointed an officer of corporation
v. Directors Informational Right
1. Right to inspect books: Board must be able to inform themselves on the
corporation’s activities.
a. Inspection rights not absolute.
b. Some cases allow inspection rights even when director acting for
competitor
i. Rationale is that needed to prevent officers from saying
director’s reasoning is improper. Believed that sufficient
remedies are available if director’s reason is improper
2. DE: Director’s right to inspection must be reasonably related to his position
F. Officers and their source of Power
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i. Authority derives from agency law.
ii. Sources of authority: by-laws, resolution by board, board approved job description
iii. General rule is corporation’s business is managed through board. But boards meet
infrequently therefore act through officers/employees who operate with delegated
actual authority or apparent or implied authority.
iv. A corporation is bound by contracts entered into by its officers and agents acting on
behalf of the corporation and for its benefit, provided they act within the scope of
their express or implied powers.
G. Because of nature of corporations when dealing with officers/employees when a lot is at stake
it pays to double and triple check to make sure authority actually exist.
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VIII. THE DUTY OF CARE (CB Chapter 7)
A. The Standard of Care
i. Courts in determining liability, will distinguish between directors who are insiders (that
is, managers) and those who are outsiders
1. insiders will be held to a higher standard of care because they are more aware
of and are more involved in the business
2. if they are on board because of expertise (director who is an accountant may
be held to higher standard with regard to beliefs over financial statements;
lawyer over legal matters and duties of his profession)
a. however, accountants and lawyers can rely on officers, employees, and
professionals so long as it is reasonable to do so
3. outside directors held to a lower standard
a. want this so that companies can attract outside directors
ii. Generally,
1. director must act in good faith and in a manner the director reasonably
believes to be in the best interest of the corporation (some statutes merely
requires care in language of “ordinary prudent person”)
a. no strict liability because we want directors to feel not fear liability
when making decision, even risky, ones which could make the
company money
2. board must discharge its duty with the care a person in a like position would
reasonably believe appropriate in the circumstances
iii. Violations of the Duty of care generally occurs in two instances
1. malfeasance: decision was made in a negligent manner
2. nonfeasance: failure to monitor where a loss could have been prevented
iv. Bates v. Dresser: Supreme Court found President of a bank liable for failure to
discover theft by employee, although the fraud was somewhat elaborate. This is
because he had sufficient warnings of lost money and employee living beyond means.
Although, not even a bank examiner could
1. President (inside director)
a. Liable for the fraud “master of the situation”
b. Had all the red flags, plus the employee had been reported to be living
above means and the lost money
c. “In taking his position he should have contemplated being responsible
for losses of the bank”
2. Other directors
a. Free from liability b/c of novelty of the fraud and reasonable reliance
on President
b. Also couldn’t have seen it even had they examined the books
c. Plus, the govt examiner said it all was ok
v. Graham v. Allis-Chalmers:
1. the idea is that directors huge companies cannot be responsible for all
employees actions
2. they can rely on reports, summaries, etc. provided it is done in good faith
3. that is, cannot recklessly rely on untrustworthy employee or has ignored, either
willfully or through inattention obvious danger signs the he is liable
vi. Modern applicability
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1. an ordinarily prudent person serving as director should be concerned with
existence and effectiveness of procedures, programs, and other techniques
board uses to monitor
2. should be concerned with steps company takes to comply with state and
federal laws and regulations; also with the integrity of company employees
vii. Barnes v. Andrews
1. an outside director was found liable for his general failure to keep advised of
conduct of corporate affairs
a. can rely on counsel of advisors and officers, but still must stay
informed in some detail so as to give reasonable attention
b. must seek details and particularity
2. but, this is a tort cause and causation of the harm must be proven
a. cannot be proven that his negligence caused any losses so the claim
fails.
3. directors are merely advisors, they cannot be held liable to guarantee the
success of the company…if they were nobody would take the job
viii. Modern application of causation requirement:
1. Delaware said Barnes was a tort/negligence case and didn’t apply to breaches
of an officer’s or directors fiduciary duty
2. breach is enough to prove injury
3. directors must then prove the transaction was entirely fair
b. Business Judgment Rule
i. Generally
1. protects directors from personal liability and the courts from scrutinizing the
decision…protecting directors who are not negligent in the decision making
process
2. if director is found to have violated duty of care then those decision are
analyzed under BJR
3. However, courts will only review the process, not the substance, even if it is a
wrong or poor decision
4. the presumption is that in making a decision directors were informed, acted in
good faith and honestly believed that the decision was in the best interests of
the corporation
5. Procedurally: it is a rule of evidence placing the initial burden of proof on the
plaintiff
6. If BJR is rebutted by proving that the directors breached a duty (of good faith,
loyalty, or due care), then burden shifts to defendant to prove “entire fairness”
7. Policy:
a. Want directors to make decisions without fear of liability
b. Overly cautious directors reduce shareholder value
c. Courts don’t have the expertise
ii. Shlensky v. Wrigley:
1. plaintiff claimed negligence and mismanagment on part of corporation for
failing to install lights and operate baseball games at night
2. losses were alleged to be b/c of low attendance due to all day games, other
teams had night games, claims that Wrigley, owner of corporation which owns
team, refuses to install lights b/c of his personal opinion baseball is day game
despite all the good economic reasons to install the lights
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3. court says that the issue is properly before the boards of directors and they
motives show no fraud, illegality or conflict of interest in their making the
decision to stay
4. actions were sanctioned by the board duly chosen by the majority and will not
be struck down just because it seems there may be a wiser policy out there (not
even entirely clear in this case that there is) as long as they were done in good
faith and in the interest of the corporation
iii. Smith v. Van Gorkom
1. (super complex facts in this one. Took summary from commercial outline)
2. Van Gorkum, chairman and CEO, went to Pritzker who was known to be an
investor which he did without consulting the board of directors
3. at the time the shares of the company were at $38 and company had been
trying to figure out ways to raise price of shares
4. Pritzker agreed to buy for $55 which was suggested by Van Gorkum
a. This was 40% higher than the price and the 5-yr high was $39
5. Some opposition by officers, but Van Gorkum called board of directors
meeting
a. 5 inside directors
b. 5 outside directors
6. after two hour meeting, it was voted on and presented to shareholders for a
vote
7. The board received limited advice from CFO and no opinion from any
investment banker that the price was fair
8. Board thought they could pursue other options (using Pritzker’s offer as a
market test) and accept another offer from a higher bidder which could
compete with Pritzker which was not the case
9. Court decided they had breached their duty of care at the meeting of initial
approval and were not protected by the BJR
10. Court used standard of gross negligence (it us unclear if gross negligence is
only used for BJR analysis or it is used in all duty of care cases) “as the proper
standard for determining whether a business judgment reached by the board
was an informed one”
a. There were grossly negligent in not understandinghte intrinsic value,
Van Gorkum’s role in forcing the sale and establishing the price and in
approving the sale after 2 hours without prior notice or reason to act
so swiftly
11. Board claimed they were not grossly negligent for four reasons:
a. $55 was a high premium over $38
i. This failed because they had no other info about the value of
the company
ii. This was especially true when they knew the price to be
undervalued
iii. Also, reliance on stock price was inappropriate because that
deals with value of individual shares not of the company as a
whole (the value of the control premium)
b. Merger contract allowed market test offers
i. This failed b/c no evidence the original agreement actually
allowed for this
c. Board had extensive knowledge and experience in business
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i. The lack of valuation inquiry and the failure to secure a market
test option made this option fail
d. Board relied on counsel’s advice that failure to accept the offer would
result in shareholder litigation for failure to accept it
i. That advice was not the type of legal advice that allowed them
to make an uninformed decision on the sale of the corporation
12. Thus, there decision as not protected by the BJR
13. Board also claimed that subsequent events cured their breach of the duty of
care
a. After opposition by management, changes were made to the agreement
including wording requiring a market test option
b. However, in order to accept another offer there had to be either a
consummated sale or a definitive contract with greater consideration
than Pritzker’s offer, not merely a better offer
c. Time frame was narrowed for competing bid
d. It appeared board did not understand all of this so again they were
uninformed about the market test
e. Also, Van Gorkum was hostile to other bids (he was friends with
Pritzker)
14. Board also claimed that 70% of their shareholders approved the sale
a. Court required that a vote to ratify a transaction required full
disclosure
b. Burden to prove full disclosure is on directors, here the shareholders
didn’t know all that was going on behind scenes and at these meetings
15. Case was remanded to determine fair value of the shares based on intrinsic
value for remedy purposes
iv. Brehm v. Eisner
1. Ovitz received over $140M for only one year on the job; deal was put in place
by his friend Eisner, CEO of Disney
2. plaintiffs alleged facts that went beyond gross negligence and possible
protection of BJR
3. basically, that the directors failed to exercise any BJR in granting Ovitz a
contract that virtually guaranteed him an extraordinary severance package,
especially in the case of non-fault termination (where he could earn more
money by not fulfilling his contract than if he did)
a. it was known Eisner had difficulty working with other powerful
executives
b. consensus went from disapproval to vote of unanimous approval in
two months
c. board failed to properly inform itself of total costs of the
compensation package
d. statements by exec. Compensation expert who the board sought later
showed they didn’t actually look at it
4. Relationship breaks down and Ovitz negotiates a way to leave the company on
no-fault basis
5. Court looks at the case as a BJR case and the process of arriving at the
termination…says they contracted for the agreement and the settlement was
very similar
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6. Was this really, lack of due care in the decision-making process and waste of
corporate assets
7. whether court agrees with or approves of the board and its decision is not for
it to decide…shareholders elect the board and it is their place
8. Court says that the board was responsible for considering material facts that
are reasonably available, not those that are immaterial or out of the board’s
reach
a. Given the economic repercussion of the payouts here, the economic
exposure of the company was material and the info was reasonably
available
9. But, they could still avoid piercing the BJR and thus possibly incurring liability
because they relied on the compensation expert…it exercised proper business
judgment by relying on this expert which it as entitled to do in good faith
a. What the expert now believes, that it was a bad idea, is immaterial to
the analysis
b. Was the process good, not the decision
v. Emerald Partners v. Berlin
1. in this conflict of interest case (Chairman and CEO of one company also
owned 13 corporations which the company he was Chairman of tried to
acquire), the court required the defendant to show the fairness of the
challenged transaction
2. outside directors engaged Bear Sterns to investigate and render a fairness
opinion to the board and the stockholders
3. all three of the triad of duties must be discharged at all times
4. Following, Van Gorkum the Delaware legislature adopted statute which
permitted sharholders (who are entitled to rely on director fiduciary duties) to
adopt a provision in certificate of incorporation to exculpate directors from
any personal liability for the payment of monetary damages for breaches of
their duty of care, but for duty of loyalty violations, good faith violations, and
certain other conduct.
5. thus, monetary damages from directors on a pleading of violation of duty of
care is barred
6. When the standard of review is entire fairness, the board must show it
discharged all of its fiduciary duties with regard to each aspect of the nonbifurcated components of entire fairness: fair dealing and fair price
7. the court must first determine if there was unfairness before determining if
they are exculpated under § 102(b)(7)-Delaware statute
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IX. THE DUTY OF CARE (CB Chapter…)
II.
The Duty of Loyalty
a. Requires a fiduciary act in the best interests of the corporation
b. Self-Dealing Transactions
i. Globe Woolen Co v. Utica Gas & Electric Co.
1. plaintiff corporation sues to compel specific performance of a contract where
electric current was to be supplied to two mills by defendant’s electric
company
2. defense claims contracts were made under influence of a dominating, common
director, terms are unfair and consequences oppressive
3. Maynard was president, chief stockholder, and member of board of directors
for plaintiff (he has a large property interest in plaintiff)
4. Maynard also was director for defendant and chairman of its executive
committee (no real property interest in defendant)
5. Maynard sought new power source for mills paid Greenidge (employee of
defendant) to prepare a report. Change not approved at the time, but plaintiff
kept considering it.
6. Finally, Greenidge looks again at plaintiffs books and calculates max. rate for
service and guaranties saving of $300 a month. Contract executed b/t the two
via letters, installation (paid by plaintiffs) was begun.
7. Maynard takes the proposal to defendants board, accompanied by Greenidge.
Greenidge testifies to board it would be profitable for company, Maynard says
nothing at meeting.
8. They then undertake to initiate same transition at the other mill.
a. This time the contract had it applied to any uses in additions to the mill
and that should there be a shortage of electric supply, Globe would be
the preferred client over everyone but the city of Utica
9. When it was taken to board, it was stated that is was a duplicate of the
previous agreement, but nothing was said of the new provisions. Again,
Maynard said nothing.
10. Changes to the calculations which Greenidge made rendered this extremely
disadvantageous and eventually defendant gave notice of recession
11. Plaintiff argues that since conflicted director withheld from voting that they
can stand by the bargain
12. refusal to vote merely gives the presumption of propriety, but duty of loyalty
demands constant and unqualified fidelity
13. “a beneficiary, about to plunge into a ruinous course of dealing, may be
betrayed by silence as well as by the spoken word”
14. he can’t rid himself of duty to warn and to denounce if there is improvidence,
either apparent or under surface to this practiced eye
15. Maynard dominant influence was asserted throughout
16. no difference in roles between plaintiff president and defendant’s director
a. no clean cut cleavage of between offices and agencies
b. At the time it went to board, ratification was all that was left, work had
begun and they had faith in his loyalty
17. He cannot keep the contract unless it is evident the terms are fair and just
18. Plaintiff especially knew that changes in business would occur and while he
may have relied on Greenidge to calculate savings with accuracy the
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comparative costs of the switch, he had to have known how one-sided the
contract was
19. Just because it was obvious to Maynard, doesn’t mean it would have been
obvious to the defendant’s board…and even Maynard didn’t know precisely
what would happen he knew it was unfair and thus it violated his duty of
loyalty
20. In sum, Maynard’s abstention gave the contract a presumption of propriety,
but did not excuse him of his duty to warn about its dangers. He had a duty to
warn, that is, to provide full disclosure of both his interest and the details of
the contract itself. Disclosure alone is not sufficient because the contract must
also be fair. There must be some reasonable proportion between the benefits
and the burdens. The process and the terms must be fair.
ii. Corporations: Cox, Hazen, O’Neal: statutory responses
1. under CA and MBCA:
a. in financially interested directors have to be counted up to make a
quorum or majority to authorize a transaction, such transaction are no
longer voidable at the option of the corporation merely by reason of
such participation, provided one of three conditions are met
i. ratification by an independent majority of directors
1. must take care to see if the statue permits disinterested
directors to ratify an already consummated agreement
or merely to approve a yet to be consummated
agreement
ii. approval or ratification by the shareholders
1. generally, shareholders can ratify and approve
consummated agreements
2. just as with the previous option, the ratification or
approval must be impartial, done in good faith and
following full disclosure of material information
iii. showing that the contract is just and reasonable as to the
corporation at the time of approval
1. Courts place this burden on the interested director or
officer to demonstrate the fairness of the entirety of the
transaction. Very important to this analysis is the
consideration paid compared with an independent
appraisal of the value. Very tough to demonstrate. can’t
act in conflict with the corporations interesting slightest
bit
iii. did we get into strong, semi-strong, current California, etc.????
c. Conflicts of Interest
i. Gilder v. PGA Tour, Inc
1. PGA board is composed of ten directors
a. Four players
b. Three officers of PGA
c. Three independent directors
2. ‘Board, after various investigations, surveys, and studies eventually prohibits
Karsten’s U-shaped groove club from play on grounds that it permitted greater
control of the ball
3. Breman, PGA commissioner and CEO, is the one who recommends their ban
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4. PGA by-laws required a majority of directors present and three of the players
to vote on any rule change
5. At the meeting, four players abstained from voting and the PGA officer
directors (ties to various golf club manufacturers) abstained from voting b/c
conflicts of interest
6. The three independent directors voted for the rule and Karsten challenges for
breach of fiduciary duties
7. Board later meets and all ten members of the board were present. They vote to
change the bylaws that disinterested directors can take binding action on
behalf of the PGA policy board when the majority of the directors could not
vote because of a conflict. Those three again voted to readopt the groove rule.
8. Plaintiff is player who fears harm to this game if forced to change clubs. (other
players feared losing endorsement money and exemption cards)
9. Plaintiffs allege directors breached the by-laws, directly and indirectly, and by
voting on an issue in which they had conflicting financial interests
10. Plaintiffs are members of the PGA and claim directors owe them fiduciary
duties and are prohibited from using their position for their private gain (here
their interest in competing golf club manufacturers clouds their decision to
ban a certain club)
11. Defendants claim that interested directors may vote after full disclosure to the
board
12. Court says that
a. Player directors are required to vote on a rule change, but none voted
because of ties to competing manufacturers (just like the officers have)
b. Each director later voted to change bylaws to allow non-interested
directors make a binding vote, possibly with the intention to then pass
the regulation on Karsten clubs
13. Remands for trial (case ended up settling)
ii. Marciano v. Nakash
1. court ruled that compliance with the Delaware conflict of interest statute
removed the taint of conflict of interest
2. failure to secure either disinterested director’s or shareholders approval did not
void contract as long as it was fair.
3. But, in dictum, the court said that compliance with the statute (in form of
shareholder approval or disinterested director vote) shifted the burden to the
plaintiff and afforded the BJR to the defendants
4. Plaintiff would then have to attack the process of approval, the lack of
independence by directors or the decision was wasteful
5. Gasoline has 6 directors and there is a deadlock on the board, two factions.
Nakash family made $2.5M loan of personal money to corporation and now
seek to have it paid in liquidation
a. When the two families joined up they also shared ownership and
control of Guess although each sort of ran their own show on
opposite coasts
6. Eventually the enterprise shutdown and a custodian recommended liquidation
and all valid debts were to be paid
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7. Marciano’s wouldn’t help secure loans from banks, Nakash floated a personal
loan to company, which they sought to be repaid for (the other corporation
Nakashes owned also had given Gasoline $30,000 in services)
8. In DE, the fiduciary relationship b/t directors and corporations impose
fundamental limitations on the extent to which a director may benefit from
dealings with the corporation and “the voting for and taking of” compensation
under common law can be seen as constructively fraudulent in the absence of
shareholder ratification, or statutory or bylaw authorization
9. Here, statutory protection did not appear to apply, but common law rule was
not determined by the relationship alone, the fairness of the transaction was
important
a. Court would look at its affect on the corporation and the disinterested
shareholders
10. Court appears to be using a two-tiered approach: application of section 144
(similar to statute response from above) coupled with an intrinsic fairness test
11. Since the loan was made with bona fide interest of helping Gasoline, it was
comparable in rate and term to other lenders, and were providing it a benefit
unavailable elsewhere it was adjudged as fair.
d. Corporate Opportunities
i. Generally
1. which corporate opportunities (investment opportunities) may a director or
officer take advantage of and which must he first offer to the corporation
which he serves
2. Major issues:
a. Is something a corporate opportunity
b. If corporation somewhere rejected or failed to take the opportunity
allowing the fiduciary to take it instead?
i. Could the corporation not afford to take it
ii. Did the third party not wish to deal with the corporation
3. Three types of tests:
a. Interest or expectancy test
b. Line of business test
c. Fairness test
4. Damages:
a. If the improper taking of a corporation oppty is found, damagers or a
constructive trust over the investment in favor of the corporation will
be awarded
ii. Guth v. Loft, Inc.
1. Court used a line of business test. The test applies if the oppty embraces “an
activity as to which the corporation has fundamental knowledge, practical
experience, and ability to pursue, which, logically and naturally is adaptable to
its business having regard for its financial position and is one that is consonant
with its reasonable needs and aspirations for expansion”
2. how closely related is the oppty to existing business
3. Guth was president of Loft and acquired formula to Pepsi, which was
challenged as a corporate oppty belonging to Loft
4. if oppty comes to director of officer in individual rather than official capacity
and the oppty is one which is not essential to the corporation, in which it has
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5.
6.
7.
8.
9.
10.
11.
12.
no interest or expectancy, and the didn’t use corporation money to pursue it,
then the director can keep it
duty and loyalty are inseparably connected
Guth, who basically chose and ran the board of directors like a dictator, was
looking to replace Coca-Cola in Loft’s stores
Loft sought a greater margin of profit on its sale of cola and searched the
limited cola syrup market to find something
Pepsi-Co went into bankruptcy I n1931
“Guth was Loft” and Lofts determination to replace the cola was simultaneous
with the oppty to purchase Pepsi-Co
Guth was informed of this by Megargel and claimed they had discussed his
buying Pepsi as early was 1928 (which court didn’t believe); and that the oppty
was offered to him personally and not as president of Loft
Court focuses on how exactly he received the proposition
Guth must prove that he always performed in good faith to Loft, that he had
received the offer as an individual
a. Court look at reasons for offering to Guth: the manner of the offer
and oppty
i. Megargel needed someone with the resources to offer his cola
and it is quite reasonable he approached Guth as the President
of Loft (stores in which to sell his product), to him it didn’t
matter if Guth personally or Loft, so long as his product sold
ii. In the circumstances existing at the time of the offer, was the
opportunity to secure a substantial holding in Pepsi so closely
associated with existing business activities of Loft, that the
purchasing of the Pepsi by Guth would throw him into direct
competition with the company
b. Guth argues that the scope of operations contemplated by Pepsi was
never contemplated by Loft (court agreed with this) which merely
made candy to sell in its stores
c. Guth argues Loft couldn’t have financed it (court disagrees)
d. Guth argues Loft is essential a retail store, not a producer of cola, “not
in line of business” it is a regional store (court disagrees…says Loft
was a large wholesaler as well and it manufactured its own syrups, just
not cola syrup)
e. Loft had practical knowledge, experience, personnel and ability to
pursue this expansion of operation (latitude should be allowed for
development and expansion)
f. Guth says no interest of expectancy, but Guth’s decision to
discontinue Coke, created the interest and expectancy of Loft to find
replacement
g. Guth as Pepsi basically could be as oppressive to Loft as Coke had
been
iii. Durfee v. Durfee, Inc.
1. applies the fairness test
2. looks to the fairness of the particular circumstances in which a director,
whose relationship to the corporation is fiduciary, in taking advantage of an
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opportunity for his personal profit when the interest of the corporation justly
call for protection.
iv. Miller v. Miller
1. applies a two step process:
2. First, is the line of business test satisfied
a.
3. Second, looking at the equitable consideration surrounding the defendant’s
acquisition of the oppty
a. Prior to, at time of, and following the officer’s acquisition
4. court will look at
a. nature of officer’s relationship to management and control
b. prior disclosure and board’s reaction
c. oppty presented as individual or as official of corp.
d. did officer use of exploit corporate facilities, assets or personnel in
acquiring the opportunity
e. did his acquisition harm or benefit corp.
v. Meiselman v. Meiselman
1. plaintiff must prove
a. he has standing as a shareholder in the corporate defendants to bring
suit against officer of corporate defendant
b. that the officer breached a fiduciary duty to corporate defendant to not
usurp a corp oppty of the corporate defendants
c. there are three types of oppties a fiduciary can attempt to take
advantage of
i. those entirely extraneous to the corporation’s business
ii. those in the same or a direct line with it
iii. those complementary to it
d. court acknowledges the three types of tests and says we have a statute
that speaks to this issue, so we don’t label our test
e. the defendant must show that the transaction he engaged in was just
and reasonable to the corporation
f. Court determines if the oppty has been usurped analyzing following
factors, among others:
i. Ability, financial or otherwise, of the corporation to take
advantage of the potty
ii. Whether the corp. engaged in prior negotiations for the oppty
iii. Whether the director or officer was made aware of the oppty
by virtue of his or her fiduciary position
iv. Whether the existence of the oppty was disclosed to the
corporation
v. Whether the corp. rejected the oppty
vi. Whether the corp. facilities were used to acquire the oppty
g. Court must ask: Is this functionally related, and is it one where there
was an interest of expectancy
vi. Johnston v. Greene
1. court held that oppty came to an officer as an individual not in his official
capacity
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2. even though at least one of the corporations which defendant worked for had
the financial resources, the individual could choose to keep it or offer it to one
of the corporations he worked for
3. there was no real tie in the investment oppty to the business of these
corporations
vii. ALI Principles of Corporate Governance
1. § 505 Taking of Corporate Opportunities by Directors or Senior Executives
(see page 249)
e. Competition and the Duty of Loyalty
i. Generally
1. employees may be able to do some preparation and the leave their
employment to compete if there is no contract which restricts competition
2. directors and officers are often held to a higher standard that limits their ability
to compete when employed by their corporation
ii. Lincoln Stores, Inc. v. Grant
1. plaintiff (Company) sought to enjoin defendants from operating store similar
to theirs and for damages plaintiff had received by their competition and
sought to force defendants shares and form a constructive trust
2. Grant was director in the Company (until June 1937), Martin was director
(until June 1937, Haley was a buyer (until May 1937
3. Company had a store in Norwich, that it felt was handicapped by lack of
space; possibility of getting more space was often discussed from 1927 onward
4. It had an option which expired in April of 1933 where it could acquire to other
spaces in the building
5. In 1932, the company decided to not acquire the space (Grant and Martin
participated in this decision) and the idea was tabled until 1938
6. real estate broker old Grant another store in town, on same street, had stock
for sale who told Martin, and Haley found out in a matter of days
7. They conspired to keep this secret, with only Haley going over to manage the
store. Grant started using confidential info to gauge how to run the store
8. They were asked to resign, would not, but did not continue to attend meetings
9. directors have duty of reasonably protecting and serving interest of the
corporation interests. A director cannot be allowed to profit personally by
acquiring property that he knows the corporation will need or intends to
acquire, and that this interest actual or in expectancy, must have existed while
the person involved was a director
10. Court feels that the Company had no interest or expectancy in acquiring the
store, nor was it essential to the Company
a. Company had declined an option to get more space, had not
considered to get more, and only after the defendants had acquired the
store did they consider the options again
b. Store had not expressed interest in this oppty, the business was neither
desired nor needed by the company
c. In the acquisition for the store the defendants violated not duty of
loyalty to the Company
11. However, if directors of officers enter into competition they must do so in
good faith
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a. This was wrong of them to do, but by payment of lost profits and the
compensation paid to the employees while they were competing, they
have been compensated
b. The wrong occurred not in the acquisition but in the new stores
operation
12. Question presented by Bullard in class: should it be required that the
info obtained (and used in competition) only be wrongful if it is from
outside someone’s typical duties? Like, supply person accessing supply
charts is ok b/c part of job, but CEO doing it is another and could be
wrongful.
iii. Duane Jones Co., Inc. v. Burke
1. plaintiff corporation sought damages when Burke and other account execs left
the advertising firm of Duane Jones and solicited former customers and some
key employees
2. employees and customers were leaving the firm
3. Duane Jones had been acting improperly and a large reason business and
employees were upset
4. a number of plaintiffs officers met secretly, one defendant said he had
proposed to current customers that they would either buy out Jones interest or
would form a new corporation
5. asked others to approach their clients with the same question
6. One of the defendants approached Jones and told him of their resolution and
said if he did not agree to sell they would resign in 48 hours and that the
clients had been pre-sold on the idea
7. Two days later, meeting was held with defendants and Jones, where Jones
accepted offer for company, but the sale was never consummated
8. Subsequently, they held a meeting of the board of directors and nine
defendants resigned as officers or directors but would stay on as employees
9. One defendant resigned but stayed on in nominal capacity to permit quorum
10. Others later, officially resigned or were fired
11. Even then, some of them continued to receive payment and do work for
plaintiff, some of whom were asked to do so out of courtesy by Jones
12. In August, some of the defendants formed a new corporation and within a
week it had 71 of the 132 person formerly employed at Jones
13. They also had clients of Jones, who they solicited prior to and during their
resignation/severance time
14. The rival agency was formed and clients solicited without disclosure to
plaintiffs
15. Bullards views on this:
a. If you are going to leave make it a clean break
b. Do not solicit while you are still working but call people the minute
you walk out the door
c. You can go rent office space, look at it, but not on company time
d. Don’t announce you are leaving face-to-face…give a letter at
beginning or end of day
e. You can buy things like stationary, but again do not spend company
money or company time
f. Don’t stay on in any position whatsoever
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g. Write a letter and say why you left (self-serving comments in your
defense in case you are sued)
h. Don’t contact current clients and tell them until you leave, probably
shouldn’t touch prospective clients if list was originated as part of
work
i. Don’t use their stationary to contact clients after you leave
j. Of course, firms can deal with this by doing non-competes
iv. Meehan v. Shaughnessy
1. non-compete
2. defendants violated fiduciary duties by denying they had plans to leave, and
solicited clients through a one-sided announcement they were leaving on firm’s
stationery
v. Johnson v. Brewer
1. associate referred clients to other law firms
2. not a breach, unless he received some type of compensation for doing so
III.
Romano Readings: Internal Governance Structures
a. The board of directors monitors managers to ensure that they maximize equity share prices.
But the board and outside shareholders are comparatively weak constraints on managers; thus,
we must look elsewhere for potent disciplining devices.
b. Fiduciary duty law serves to monitor the board or other monitoring bodies and the
shareholders must bring lawsuits to enact these constraints on board members.
c. Corporate Governance – Oliver E. Williamson
i. This article considers the board to be a governance structure whose purpose is to
safeguard those who face a diffuse but significant risk of expropriation because their
assets are numerous and ill-defined, and cannot be protected in a well focused,
transaction-specific ways
ii. Schema –
1. Node A consists of those individuals or other assets who are not
transaction/firm specific assets and have knowledge that is not specialized and
can be replaced.
a. Board representation is never warranted
2. Node B consists of those individuals or other assets who are valued b/c of
transaction specific knowledge and without corporate governance safeguards
to protect interests
a. Board representation may be warranted
3. Node C consists of those individuals or other assets who are valued due to
transaction specific knowledge, but have safeguards through other corporate
governance techniques
a. Board representation likely unnecessary due to effective bilateral
safeguards
iii. All of these characterizations assume free market contracting
1. Labor
a. If workers have general purpose knowledge or skills they are Node A
and can quit or be replaced without productive loss to either worker or
the firm
b. Ordinarily firms will recognize the benefits of creating specialized
structures of governance to safeguard firm-specific assets and move to
Node C. Failure to provide will cause demands for higher wages
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2.
3.
4.
5.
6.
i. Efficient when incentives are aligned and there is machinery
for grievances
ii. Another problem comes with asymmetric information and
more information might be achieved by labor membership on
board
Owners – suppliers of finance including stockholders and debtholders
a. Always Node B or C because Node A would require repossession
b. Stockholders – while individual stockholders can protect themselves by
selling shares this is not possible in the aggregate; stockholders are the
only voluntary constituency whose relation with the corporation does
not come up for renewal
c. Because stockholders are not associated with particular assets it is
difficult to construct the bilateral safeguards associated with node C;
thus, stockholders are unavoidably located at node B
d. As a protector of those with risk that cannot be covered by safeguards
the board of directors serves the stockholders
e. Corporate charter restrictions and disclosure requirements also serve to
protect stockholders
i. Individual managers commonly disclose info or distort data so
checks against this can be devised to give stockholders greater
confidence
Lenders – proof of financial soundness moves lenders to Node C and long
term lenders align incentives and provide safeguards to move to Node C
a. When there are high debt-equity ratios the creditors become more like
shareholders and greater consultation results: in this case bankers on
the board may be warranted
Suppliers
a. Suppliers who make substantial firm specific investments will demand
either a price premium or special governance safeguards
b. When suppliers such as labor are not given adequate safeguards to
categorize in C then there is a premium for the services because of the
hazard of expropriation
c. Can be regarded as penalty for not crafting safeguards
d. Considering variety of governance standards available there is little
need to supply extra protection through membership on the board –
should be restricted to informational
Customers
a. Main protection is ability to take trade elsewhere, but products with
delayed health risks cause further problems
b. With customers difficulty organizing makes bilateral governance
structures difficult to form and protection by third parties may be
warranted
c. Some consumer protection provided by brand name, warranties, and
arbitration panels
The Community
a. Externalities arise when parties do not bear contracting relation to each
other
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b. While public membership on board could conceivably reduce
misinformation this remedy bears the high cost of possible
politicization or missing the goal of a corporation
7. Managers
a. Managers who have firm specific human asset are located at B or C
b. If no protection is provided in governance structure then a higher
wage will be demanded
c. Both manager and firm should recognize the merits of compensation
packages that deter hasty dismissals and unwanted departures
i. Severance packages or sacrificing non-vested rights on quitting
d. Managers could enhance strategy of board because of their knowledge,
but this could steer the board toward managers interests rather than
firm interests
i. So long as the control of the board is not upset there are three
advantages to managers on the board
1. Permits board to evaluate decision making process and
outcomes
a. Effectiveness of the managers, competence
which helps board evaluate errors and correct
more quickly
2. Management participation may elicit better information
about investment proposals
3. May help safeguard employment relation between
management and the firm
d. Notes 1-10 (pgs. 179-83)
i. Not really sure any of this will be on there ask Andrew, Katherine, gabe.
IV.
Derivative Actions and Indemnification of Officers and Directors
a. Background:
i. Action is founded on a right existing in the corp. itself and in which the corp. is the
proper plaintiff but which the corp. for some reason (inattention, mismanagement,
conflict of interest) did not assert
ii. Shareholders are suing to vindicate the violation of a duty owed to the corporation,
either fiduciary duties owed by a corporate director or officer, or obligations of a third
party pursuant to a contract with the corporation then the action is derivative
1. With respect to third parties, Plaintiffs can allege mismanagement (duty of
care) by the board, in that members were indifferent or inattentive to a breach
by a third party of an important contract (like a supplier). They can also allege
self-dealing (duty of loyalty): that from some quid pro quo, the directors
favored the interest of a friend
iii. Stockholders basically ask the corporation to address a wrong and when the
corporation does not then the derivative suit is possible
iv. Any recovery goes to corporate treasury
v. Board of directors manages the business and affairs of a corporation which includes
litigation by the corporation, or by shareholders in the corporation
vi. Basically, the shareholder steps into the shoes of the corporation in order to vindicate
wrongdoing to the corporation
vii. In many cases that means suing directors, which is a problem because they won’t
decide to sue themselves
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viii. If plaintiffs win, it is viewed like the corporation has actually “won’ and benefited
1. as a result where the corporation greatly benefits then they pay the attorneys
fees of the plaintiffs atty who is viewed as “private attorney general” for the
corp
2. this is seen as a way to encourage suits, as individual shareholders may not be
able to maintain action themselves
b. Derivative vs. Personal Actions
i. Personal action need not be unique to one shareholder, they may affect others, if the
injury is not incidental to an injury to the corporation, an individual cause of action
exists
ii. See pages 775-76 for a list of those types of actions that are personal and those that
are derivative
c. Standing Requirements
i. Complaint shall allege
1. that the plaintiff was a shareholder or member at the time of the transaction of
which the plaintiff complains or that the plaintiffs share or membership
thereafter devolved on the plaintiff by operation of law (including inheritance);
and
a. “contemporaneous ownership” requirement
b. Usually required that plaintiff maintain ownership throughout
pendency of the pleadings an interruption or termination could result
in automatic ousting of plaintiff
2. that the action is not a collusive one to confer jurisdiction on a court of the
United States which it would not otherwise have.
3. It must also allege with particularity of the efforts, if any, made by the plaintiff
to obtain the action the plaintiff desires from the directors of officers (or if
necessary, the shareholders or members) and the reasons for the plaintiffs
failure to obtain the action or for not making the effort
4. a derivative action may not be maintained if it appears plaintiff does not fairly
and adequately represent the interests of the shareholders or members similarly
situated in enforcing the right of the corporation or association
a. an individual seeking to bring a derivative suit in order to pursue a
personal vendetta or private claim is not such an adequate
representative
i. plaintiff using derivate suit to seek enhancement of position in
claim in concurrent discrimination personal claim did not have
the judgment to enable him to stand for all stockholders
(Roberts)
ii. plaintiffs interest in increasing value of corporate stock
outweighed by interest in pursuing wrongful termination and
defamation claim (Zarowitz)
5. Dismissal or settlement must be approved by court and notice of proposed
dismissal or settlement shall be given tot shareholders or members as court
sees necessary
ii. Mergers: (Lewis)
1. shareholder bringing claim against corp in a merger lost standing, although the
acquiring corporation inherited the cause of action against he acquired
company. Two exceptions to the rule of contemporaneous ownership in a
merger: (1) where the merger itself is the subject of claim of fraud and (2)
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where the merger is in reality a reorganization which does not affect plaintiff’s
ownership
iii. Shareholder Inspection Rights (Saito)
1. shareholder’s inspection rights used for bringing a derivative suit would not be
subject to contemporaneous ownership requirement. This interpretation
allowed inspection of docs involving matters that occurred b/f shareholder
acquired shares in corporation, although the plaintiff was not allowed
unlimited discovery rights.
iv. Creditors have no standing to bring derivative actions (Harff)
d. Security for Expense Statutes
i. States adopt these in order to curb abuses of brining baseless derivative claims
ii. New York, require plaintiffs to put up security deposit against defendant’s expenses,
including attorneys fees, in the event suit is lost
1. Does not apply to plaintiffs holding five percent or more of a class of shares
of the corp
2. or, where plaintiffs holdings are valued at more than $50,000
a. case where court required shareholder with $4000 in holdings post a
50K bond
iii. CA, defendant can require bond if no reasonable possibility that the action will benefit
corporation or if the moving party (as in case of officer or director) did not participate
in the challenged action
iv. RMCBA, allows court at end of suit to require P to pay D’s reasonable expense,
including attys fees, if proceeding was commenced or maintained without reasonable
cause or improper purpose
e. Demand Requirement
i. Alford v. Shaw:
1. Is a special litigation committee’s decision to terminate plaintiff minority
shareholder’s derivative action against the defendant corporate directors
binding upon the courts?
2. Facts:
a. In response to charges by minority shareholders the board appoints a
special litigation committee composed of two new board members
appointed for the purpose of serving on the SLC whose purpose was
to determine if it would be in the best interest of the corp. to pursue
litigation if investigation uncovered wrongdoing
b. Complaint alleged defendants had violated fiduciary duties by fraud,
self-dealing, and negligent acquiesce in what was basically looting
c. SLC recommended one count be dismissed and two others be settled
d. Court of Appeals held corporate directors who are parties to a
derivative action may not confer upon a SLC the power to bind the
corporation as to the derivative litigation. Supreme Court affirmed
e. Supreme Court noted three approaches to the role of SLCs
i. Under Auerbach, judicial review of committee decisions is
limited to the issues of good faith, independence, and
sufficiency of the investigation. BJR applies (Auerbach)
ii. Directors charged with misconduct are prohibited from
participating in the selection of SLC (Miller)
iii. Two-step review. (1) an inquiry as to the independence , good
faith, and investigative techniques of the committee, expressly
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placing burden of proof as to these matters on corp.; (2) as a
safeguard against structural bias, an additional discretionary
level of scrutiny on the merits in which trial court exercises its
own independent business judgment. Report of SLC may be
considered (Zapata)
f. Court had applied modified-Auerbach rule (an inquiry on the merits of
the SLC report), but sees a trend away from this to mean courts don’t
trust SLCs which will be influenced to not bring suit against the corp.
g. Court feels that a modified Zapata rule: requiring judicial scrutiny of
the merits of the SLC recommendation
i. Court will look at reports by SLC in decision to dismiss a suit
1. even it appears that plaintiff could win if the recovery is
outweighed by burden to corp it may still be dismissed
h. Court notes that demand requirement is not necessary when you are
asking directors to sue themselves, it would be futile
i. When alleging self-dealing directors ought to be forced to prove
fairness (just and reasonable)
j. Plaintiffs could win if
i. Even if SLC was disinterested and unbiased it was unqualified
to review the alleged false tax and accounting info
ii. False or incomplete info was supplied to SLC b/c of the nonadversarial way it investigated
iii. That in light of other problems inherent in a board appointing
its own SLC (composed of board members) that the decision
“eviscerates plaintiffs opportunities to seek redress under the
law”
f. Claims Subject to Derivative Suits
i. Miller v. American Telephone and Telegraph Co.
1. plaintiffs bring suit against AT&T and all but one director to collect an
outstanding debt owed by DNC for services provided by DNC convention
when debt was owed for 4 yrs with no efforts at collection
2. Were the actions of the board protected by the BJR?
3. Court says had complaint only alleged failure to pursue a corporate claim it
would have failed under application of BJR, but where the decision not to
collect the debt is itself an illegal act (in this case, allegedly making a
contribution to the DNC in violation of federal statute) different rules apply
4. even though intended to benefit corporation, illegal acts (and those against
public policy) may amount to breach of fiduciary duties
5. Fed govt enacted statute in this area to destroy corp. influence of elections
through financial contributions and to check parties using corp. funds to
political parties without consent of the shareholders
6. in trial, plaintiffs must still prove the elements of violation of campaign finance
law
a. that corp. made gift to DNC
b. in connection with a federal election
c. for the purpose of influencing the outcome of that election
ii. Should shareholder derivative suits be allowed where corporate misconduct actually
benefited the company?
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1. court allowed a suit that exposed corp.’s unlawful operating of amusement
park on a Sunday which was brining in money (Roth)
2. Court allowed dismissal where SLC appointed by directors concluded it was
not in corp.’s best interest to pursue claim b/c at the time the action was not
unlawful (Gaines)
g. Indemnification of Officers and Directors
i. Merritt-Chapman & Scott v. Wolfson
1. directors claim for indemnification by corp. against expenses incurred in a
criminal action
2. claimants defended suit in which they were alleged to have participated in a
plan to cause the corp. to secretly purchase its own shares
3. claimants eventually plead to lesser charges of violating securities laws
4. DE statute has two subsection:
a. (a) which permits indemnification
i. Directors, officers, employee or agent, etc (of that empoyercorp or serving another corp at the request of the employer) in
pending or completed investigation (civil, criminal,
administrative) against expenses, judgments, fines and amounts
paid in settlement actually and reasonably incurred by him in
connection with such action if he in good faith and in a
manner he believed to be in best interest of corp.; and with
respect to criminal he did not believe his conduct was unlawful
ii. The termination of any action by judgment, order, settlement
conviction or plea of nolo contender shall not create
presumption person did not act in good faith
b. (c) which requires indemnification provided some conditions
i. To extend director or officer has been successful on merits or
otherwise in defense of action referred to in (a) or defense of
any claim issue, or matter therein he shall be indemnified
c. Policy: to encourage corporate officials to opposes what they consider
to be unjustified suits and claims secure in the knowledge that their
reasonable expenses will be borne by the corp. they serve in vindicated;
Also, to encourage qualified individuals to serve on boards
5. claimants were criminally charge, they were not convicted on all charges so
they must be found to have successfully defended the other charges thereby
placing them under subsection (c) for those
a. they are entitled to partial indemnification if even if unsuccessful on
the other counts
6. As for the other counts, the claimants are not entitled to indemnification
because the by-laws of the corp. limit the permissive indemnification to
instances where the person shall not be adjudged to be negligent or derelict in
their duties
7. “Reasonably Incurred” damages
a. Damages will be considered to be reasonably incurred if rates paid are
substantially higher that those charged by comparable firms
b. Charging a flat fee is not inherently unreasonable
c. Skill and vigorous defense necessary due to the position the plaintiff
was in when counsel was retained could be another factor for higher
costs
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V.
Bailey lecture (check with Andrew to see if he thinks there is any stuff from the lecture which will
be covered on exam…also check notes, I think I did an ok job of taking notes on this one)
a. D & O protection and insurance
b. Two forms of actions against directors and officers
i. Securities class actions suits: suit based on duty to inform the individuals who bought
stock
1. when some action surprises markets and causes significant drop in stock
market, securities plaintiff firms will file action alleging directors knew earlier
and should have warned the market. If the D&O would have warned the
market price would have gradually walked down and anyone who purchased in
the time in between bought at an inflated price
2. while none of these suits were over $100 million before, they are regularly over
this now
a. difficulty in proving intent to deceive, reliance on intent, deceit, etc. for
entire class
b. Supreme court mentioned in footnote that maybe recklessness was
sufficient rather than intent to deceive, then 10 yrs later created
concept of fraud on the market which made reliance easer to prove
because each Plaintiff did not have to actually read the report it was
expected to be priced into the market, then law changed in 1995
allowed major investment firms client to sue
3. these suits are almost never tried b/c D&O cannot afford to litigate
4. Problem is that defendants don’t have much leverage in settlement
negotiations
ii. Shareholders derivative suits: rather than suing for individual information rights, sue
for the company
1. Settlements far less than securities class action suits (2.8 billion vs. 54 million)
a. There is no multiplier of amount of inflated price by the number of
stock purchased which means less damages
b. Many more defenses in derivative suits (BJR, exculpation, pre-suit
demand) which help keep the settlement costs down
2. Still worry because in many states the company is not permitted to indemnify
the D&O
a. This would just hurt the company and go against the point of the suit
b. Only protection is insurance so the directors are very concerned with
this
3. most derivative suits are prosecuted in state courts (whereas securities class
actions are in federal courts) which brings more unpredictable results
a. Ellison wins on summary judgment through Delaware Supreme Court,
but not granted summary judgment in CA Supreme and settled for
$100 million
b. Settlement actually had company paying money and not getting
anything from directors
c. Personal Contributions
i. Decision in Enron and WorldCom forced outside directors to pay personally
1. first time significant amount was required from own pocket of outside
directors
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ii. Enron directors paid $1.3M out of their pockets but all this money was just an
agreement to pay back some of the money they made by insider trading before the
huge drop in stock prices
iii. However, in WorldCom the plaintiffs wanted to send a message that actually punished
directors for wrongdoing
1. directors ended up paying 20% of their net worth outside of their residences
2. Insurance did not make any difference because plaintiffs wanted to go beyond
whatever the insurance had in order to get some punishment for the D&O
3. The big question is will this happen again?
a. Bailey doesn’t think so, at least no regularly
d. Prior to 1995 New Law, co defendants were jointly and severally liable for securities class
actions suits, now there is proportionate liability for amount that each defendant contributed
to wrongdoing
i. Because of proportionate liability, Enron plaintiffs could not settle because they
amount they would settle with Enron would be limited to the insurance and recovery
with banks would be limited due proportionate liability which were possibly the best
recovery possibility
e. Arguments about whether or not directors should be paid more
i. Yes, because the risk they take is disproportionate with the reward and more pay is
required to keep the best people interested in these positions
ii. No, because this will just give plaintiffs lawyers more ammunition to say that you
misrepresented information in order to keep this lucrative position
f. Have the prices of D&O insurance changed? Initially after Enron and WorldCom prices went
up but then other insurance companies got into the market. This increase of players brought
he price back down due to competition even though the risk still remains high
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X.
CORPORATE DEMOCRACY – STATE LAW (CB Chapter 9)
A. Shareholder Suffrage – An Introduction
i. An essential part of state corporate statutes is the protection they extend to shareholders in
electing directors and voting on matters affecting the company, such as mergers and
acquisitions. As a practical matter, however, voting is not a right highly valued or used much by
most shareholders in publicly traded corporations, who often vote with their feet by selling
stocks. When they do vote, shareholders in publicly traded securities generally vote in favor of
management nominated directors and in accordance with management recommendations on
other issues. As a result, some have argued that it does not make economic sense to give voting
rights to shareholders b/c lot of time and expense wasted on meetings and proxies – market
through stock price will keep management in place.
ii. Today, shareholder populations of most large corporations are heavily weighted with so-called
institutional investors (e.g. pension funds, insurance cos. mutual funds), who are usually passive
investors that do not involve themselves in internal affairs of company and therefore, usually
vote in favor of management.
iii. The lack of shareholder participation in proxy contests has been concern for years. Professors
Berle and Means concluded that most large corporations where being run by management for
its own advantage rather than for the benefit of shareholders – the owners of the company.
They found varying degrees of control being exercised, which they divided in 3 categories:
1. Majority Control – 1 shareholder or group owns or controls 35% of more of stock.
2. Management Control – the largest block of stock owned in these companies does not
exceed 5-10% of outstanding shares. B/c management controls the proxy machinery &
most shareholders are passive, management will have almost complete control of the
company.
3. Minority Control – a single shareholder or group controls somewhere between 10 and
35% of the company’s shares. If the holder of this block is not participating in
management, then control is shared b/w that shareholder and management.
iv. Note:
1. Some sates have “control share” statutes designed as protection against unwanted
takeovers by disenfranchising shares owned by a new controlling shareholder, unless
that shareholder is given the vote by a majority of the disinterested shares.
B. Cumulative Voting (from LexisNexis guide)
i. Most corporations use so-called straight voting systems that limit a shareholder to one vote per
share for each director position that is open for election in a given year. This means that a
majority shareholder may elect all of the board members by voting that majority for each
director.
1. Example: In an election in which shareholders must elect 6 directors…If shareholder A
owns 60 shares and shareholder B owns 40, under straight voting A would elect all 6
directors.
ii. CV = A means by which shareholders w/less than a majority interest can have some
representation on the board. Permits a shareholder to combine (or accumulate) all of their
votes and cast them for one or more candidates.
1. Same example but using CV: B would be able to use all her votes (40 per director times
6 directors = 240 votes) in any way she decided.
2. In order to determine is she is able to use those votes and cumulate them to elect any
directors, she would calculate using the following formula:
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Number of shares
required to elect 1
director
number of shares voting
number of directors elected + 1
>
Here, the number of shares (100) divided by 7 (6 directors to be elected, plus 1) would
equal 14.28 or 15 shares needed to elect a director.
(14.28) 15 shares
>
100 shares voting
6+1
Thus, 15 shares, each with 6 votes to cumulate b/c there are 6 directors being elected,
means that 90 votes are needed for 1 candidate to win. Therefore, if B (1/total of 240
votes) voted at least 90 votes for each of 2 candidates, she would elect 2 directors. A
would elect the remaining 4 directors, so long as she cast at least 90 votes for each
candidate.
iii. CV is infrequently used in publicly traded corporations. CV must be set forth in the articles of
incorporation.
iv. Where CV rights are granted, there are certain statutory protections. For example, the Model
Bus. Corp. Act requires “reverse cumulative voting” to remove directors. This means the
shareholders cannot vote to remove a director elected by cumulative voting unless the number
of votes cast against removal are less than the amount that was sufficient to have elected him
originally.
C. Varying Shareholder Rights
i. Some statutes grant corporations wide latitude in varying the voting and other rights among
classes. The following is a description of some variations among classes of stock:
1. Weighted Voting: For example, 1 class of shares may be given a multiple number of
votes for each share held. That allows that class to cast a disproportionate number of
votes and allows acquisition of control with fewer shares than would otherwise be
required.
2. Class Voting (or voting by groups): The articles of incorporation may create different
classes of shares of subclasses w/varying voting rights. My be used in several ways
including to guarantee representation on the board and timing of vote casting.
3. Contingent Voting: Rights given to certain classes of shares or even to debt securities.
4. Disparate Voting: Today, most corporate laws permit nonvoting common stock.
Unless, the articles state, stock is voting stock. Even nonvoting shares are entitled to
vote on matters that affect them as a class. Example: 1 class has 10 votes for each share
held and another class has only 1 vote per share.
ii. Lacos Land Co. v. Arden Group, Inc. – dual stock structure
1. Facts: Plaintiff was a shareholder in defendant company, which, pursuant to a
recapitalization plan devised by defendant officer, proposed to issue a new class of
common stock that would create a dual common stock structure with one class
exercising control of company. The company’s shareholders approved the plan on a
vote based upon the company’s proxy statement. The proxy statement failed to
disclose whether the plan gave the officer the power to single-handedly effectuate
certain voting decisions. Further, at the shareholder vote approving the plan, the
officer threatened to block transactions that were beneficial to company if the plan was
not approved.
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2. Holding: On plaintiff’s motion, the court preliminarily enjoined the issuance of the new
stock, holding that (1) the vote was inappropriately affected by the officer’s explicit
threats, and (2) the proxy statement contained material misrepresentations or omissions
as to the officer’s post-plan voting power and, thus, rendered fatally defective the
shareholder approval based upon the proxy.
3. Bullard: Classic anti-takeover defense… Limited range of steps that shareholders can
take. Recapitalization = changing the corporate structure of a company.
D. Formalities for Shareholder Meetings
i. Corporate statutes generally require an annual meeting of shareholders and also provide that
failure to hold the annual meeting in accordance w/the bylaws does not affect the validity of
corporate action.
ii. There can also be a special meeting of shareholders called by the board or persons so
authorized in the articles of incorporation or the bylaws. A number of states also empower a
stated % of voting shares to mandate a special meeting.
iii. The annual meeting of shareholders is to be held at the time and place as fixed in the bylaws.
Under MBCA notice is required and must state the date, place and time. Special shareholder
meetings require more specific notice – must be at least 10 and no more than 60 days in
advance of the meeting date – and must contain a description of the purpose and matters to be
voted on. Notice requirements vary among the states.
iv. Notice of meetings is to be given to shareholders of record. To avoid issue of change of
ownership due to constant buying and selling of stocks, the corporation will set a “record date”
for those entitled to vote. Such a date under the MBCA may not be more than 70 days before
the meeting.
v. State statutes also address quorum requirements. MBCA permits a greater than majority
quorum and says nothing about a lower than majority quorum (seems to follow that they are
not permissible under this statute).
1. Can a quorum at a shareholder meeting be destroyed by a shareholder leaving the
meeting? The general rule is that it cannot since once there is a quorum, the meeting is
valid and a shareholder is deemed to be present for all purposes. Different rule for
directors meeting since a quorum consists of those present at the time a vote is taken.
2. MBCA also states that, unless otherwise provided in articles of incorporation, once
there is a quorum, action is taken at a shareholder meeting when a plurality of those
voting approve – more for than against vs. majority of shares entitled to vote as
required in Delaware.
vi. State statutes also contain provisions establishing quorum & voting requirements where a corp.
has classes of stock that vote in different groups. Essentially those statutes will require a
quorum composed of the group or groups of stockholders entitled to vote and will impose
voting requirements for each group in order to approve action.
vii. Traditionally, all shareholder action had to take place at meeting that was duly convened
according to the forgoing formalities. Many states adopted an exception for action by
unanimous written consent. An increasing number of states not allow such action if authorized
by articles of incorporation.
viii. Case:
1. Schnell v. Chris-Craft Industries Inc. (1971)
a. Facts: Plaintiff stockholders sued to enjoin defendant corporation from
advancing the date of the annual stockholders’ meeting from Jan. 11, as
previously set by the bylaws, to December 8. The corporation claimed it was
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allowed to do so by amendments to the Delaware business law. The trial court
found in favor of the defendants.
b. Holding & Rationale: In reversing the judgment, the court stated that the
conclusions of the trial court amounted to a finding that the defendant
attempted to utilize the corporate machinery and the Delaware Law for the
purpose of perpetuating itself in office, and to that end, for the purpose of
obstructing the legitimate efforts of dissident stockholders in the exercise of
their rights to undertake a proxy contest against management. Tactics
employed by management cited by court:
i. Management hired 2 established proxy solicitors;
ii. Management refused to produce a list of its stockholders to plaintiffs;
iii. Management turned a deaf ear to plaintiffs’ demands about a change in
management designed to lift defendant from present business slump;
and
iv. Management seized upon a relatively new section of DE Corporation
Law for the purpose of cutting down on the amount of time which
would otherwise have been available to plaintiffs and others for waging
a proxy battle.
The court held that these were inequitable purposes, contrary to established
principles of corporate democracy. In response to management’s argument
that they complied strictly w/the provisions of the new DE law in changing the
date, the court stated that inequitable action does not become permissible
simply b/c it is legally possible.
E. Shareholder Inspection Rights
i. Shareholders are owners of the corporation and should have the right to inspect its books and
records in order to determine the condition of their involvement. Such access should not,
however, be used to harm the company or expose its confidential information.
ii. State Ex Rel Pillsbury v. Honeywell, Inc. (1971)
1. Facts: Plaintiff appealed a trial court’s decision denying his writ of mandamus to
compel the defendant to produce its shareholder ledgers and all corporate records. The
plaintiff was opposed to defendant’s participation in Vietnam War effort (Honeywell
made munitions) and eventually bought one share of defendant’s stock for the purpose
of voicing his concerns to other shareholders. Petitioner sought shareholder ledgers in
order to find the identity of shareholders, so he could speak to/contact them about
Honeywell’s participation in the war.
2. Holding: Court affirmed the judgment of the trial court denying the plaintiff his writ,
stating that his purpose was improper to obtain an inspection of defendant’s records, as
the purpose was not germane to plaintiff’s or Honeywell’s interest but rather he plan
was designed to further plaintiff’s political and social beliefs.
3. Rationale: Under the applicable DE statute, the shareholder must prove a “proper
purpose” in seeking inspection of corporate records other than shareholder lists.
a. Plaintiff contended that a stockholder who disagrees with management has an
absolute right to inspect corporate records for purpose of soliciting proxies –
he wanted court to rule that solicitation is a “proper purpose” under the law.
b. Honeywell argued that a “proper purpose” contemplates concern with
investment return and court agreed. Mere desire to communicate with other
shareholders was not proper because it gave an almost absolute right to compel
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inspection, although some courts agree that communication w/other
shareholders is a proper purpose.
c. “Because the power to inspect may be the power to destroy, it is important that
only those with a bona fide interest in the corporation enjoy that power.”
d. Court stated that statutes in several jurisdictions agree that one must have
proper standing to demand inspection and often balk at compelling inspection
by a shareholder holding an insignificant amount of stock in the corporation.
In this case, court cited:
i. Plaintiff’s tenuous status as a stockholder – he had only one definitive
share, bought for the purpose of the law suit.
ii. Plaintiff had no interest in the affairs of Honeywell before he learned
of Honeywell’s production of bombs – he purchased stock for the sole
purpose of asserting ownership privileges in an effort to force
Honeywell to cease such production.
iii. Plaintiff was not interested in the long-term well-being of Honeywell or
the enhancement of the value of his shares.
B/c of the above factors, the court stated that such a motivation can hardly be
deemed a proper purpose germane to his economic interest as a shareholder.
In saying this, the court did not question plaintiff’s good faith incident to his
political and social philosophy, but did not feel that this is a proper forum for
the advancement of these political-social views – to hold otherwise would
expose companies to a multitude of these types of actions which are not bona
fide efforts to engage in a proxy fight for the purpose of taking over the
company or electing directors, which are legitimate and acceptable.
e. There are some recognized “improper purposes” such as:
i. Vexation of the corporation,
ii. Purely destructive plans,
iii. Nothing specific, just pure idle curiosity,
iv. Necessarily illegal ends, or
v. Nothing germane to stockholder’s interests.
iii. Notes:
1. DE statute places the burden on the corporation to show an improper purpose for a
shareholder seeking a list of shareholders. The burden is on the shareholder, however,
to show a proper purpose when seeking other records.
2. At common law, a shareholder, regardless of the amount of stock owned, had the right
to inspect the records of the corporation upon a showing of proper purpose. Statutes
may now affect that common law rights – most are thought to supplement the right of
inspection but some may limit by, for example, requiring the shareholder to own at
least a specified % of the corporations stock.
3. The MBCA sets forth the requirements that must be met to inspect corporate docs:
a. No showing of purpose required for semi-public docs such as articles of
incorporation and bylaws.
b. Access to other records require in “good faith and for a proper purpose.”
c. Further, records sought must be “directly connected” with the shareholder’s
stated purpose for the inspection.
i. Even then, access limited to minutes of board meetings, a list of
shareholders, and accounting records of the corporation.
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F. Proxy Contests
i. Basics
1. In publicly traded corporations, the voting actually occurs prior to the shareholder
meeting b/c the shareholders generally do not want to incur the cost of attending the
meetings. To facilitate voting in this situation, the statutes permit the use of proxies.
Proxies allow shareholders to vote on certain matters prior to a meeting or assign the
voting right to another person who will be present at the meeting.
2. DE law and other state laws permit shareholders to act without a meeting through the
use of written consents or consent solicitation. The consent solicitation seeks the
requisite vote and once obtained, the action is approved. However, may not be used to
replace the annual meeting.
3. Managers send out proxies to shareholders requesting their votes. If there exists a
group which opposes management, that group may send out its own proxy material
which results in a “proxy fight.” Proxy fights can occur in 3 situations. They can
involve:
a. A challenge to current directors by replacing them w/new directors (change
management);
b. Changing the directors with new directors who will support an acquisition of
the corporation (change directors to facilitate an acquisition); and
c. Not challenging directors but seeking shareholder votes on a policy issue or
corporate governance rules that the directors oppose (change policy).
ii. Campbell v. Loew’s Incorporated
1. Facts: Plaintiffs, corporate directors, sought to enjoin defendants (corporation and rival
directors) from holding a stockholders’ meeting at which stockholders would be called
upon to remove them.
2. Holding: The Delaware chancery court declined to enjoin the stockholders’ meeting but
did preclude the corporation from counting proxy votes and from using corporate
personnel and facilities to solicit proxy votes. In so ruling, the court reasoned that (a)
the president of the board of directors was authorized by the bylaws to call a
stockholders’ meeting for any reason; (b) stockholders were not restricted in when they
could vote on directorships, and thus they could replace a director at any time; (c)
directors could be removed for good cause, and allegations made by defendants
supported the proposed removal of plaintiffs; but (d) plaintiffs had not been afforded
sufficient opportunity to respond to the allegations in the proxy solicitations, and thus
the votes tendered by the proxies could not be counted unless and until plaintiffs were
given such an opportunity.
iii. Rosenfeld v. Fairchild Engine & Airplane Corp
1. Facts: Appellant brought a stockholder's derivative action where he sought to compel
the return of funds paid out of the corporate treasury to reimburse both sides in a
proxy contest for their expenses. The lower courts affirmed the judgment of the official
referee that dismissed appellant's complaint. The court affirmed the dismissal. The
court noted that appellant did not argue that the funds were fraudulently extracted from
the corporation, but instead admitted that the charges were fair and reasonable. The
court held that since appellees acted in good faith in a contest over policy, they had the
right to incur reasonable and proper expenses for the solicitation of proxies and in
defense of their corporate policies, and were not obliged to sit idly by. The court also
noted that stockholders had the right to reimburse successful contestants for reasonable
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and bona fide expenses incurred by them in any such policy contest, subject to court
scrutiny. Thus, the dismissal of appellant's complaint was proper.
iv. Hewlett v. Hewlett-Packard Company
1.
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XI. CLOSELY HELD CORPORATIONS (CB Chapter 10)
A. The Characteristics of a Close Corporation (primarily from the Donahue case)
i. Definition: There is no single, generally accepted definition of a close corporation. Some
commentators emphasize an integration of ownership and management, in which the
stockholders occupy most management positions. Others focus on the number of stockholders
and the nature of the market for the stock. In this view, close corporations have few
stockholders; there is little market for corporate stock. A close corporation is one in which the
stock is held in a few hands, or in a few families, and wherein it is not at all, or only rarely, dealt
in by buying or selling. In general a close corporation is typified by:
1. a small number of stockholders;
2. no ready market for the corporate stock; and
3. substantial majority stockholder participation in the management, direction and
operations of the corporation.
ii. The close corporation closely resembles a partnership.
1. A close corporation is often little more than an “incorporated” or “chartered”
partnership.
2. Many close corporations are really partnerships between two or three people who
contribute their capital, skills, experience and labor.
3. The stockholders “clothe” their partnership with the benefits peculiar to a corporation,
limited liability, perpetuity and the like.
4. Just as in a partnership, the relationship among the stockholders must be one of trust,
confidence and absolute loyalty if the enterprise is to succeed. All participants rely on
the fidelity and abilities of those stockholders who hold office.
iii. Opportunity for the majority stockholders to oppress or disadvantage minority stockholders.
1. The minority is vulnerable to a variety of oppressive devices, termed “freeze-outs,”
which the majority may employ. In particular, the power of the board of directors,
controlled by the majority, to:
a. declare or withhold dividends and
b. to deny the minority employment.
2. To cut losses, the minority stockholder may be compelled to deal with the majority,
which is the capstone of the majority plan.
a. Majority “freeze-out” schemes are designed to compel the majority to
relinquish stock at inadequate prices. The majority wins when the minority sells
out at less than fair value.
iv. Rights of and difficulties facing minority shareholders.
1. The minority shareholder of a corporation can initiate suit against the majority and their
directors.
2. However, in practice, the plaintiff will find difficulty in challenging dividend or
employment policies. According to Prof. O’Neal, the 2 principal barriers to the courts
granting relief to aggrieved shareholders are:
a. The business judgment rule – such policies are considered to be within the
judgment of the directors, and
b. The principle of majority rule in corporate management. Courts prefer not to
interfere with the sound financial management of the corporation by its
directors, but declare as a general rule that the declaration of dividends rests
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within the sound discretion of the directors, refusing to interfere with their
determination unless a plain abuse of discretion is made to appear.
v. How do you dissolve a close corporation? Different rules in every state.
1. Most states, including the Model Business Corporation Act, provide that “oppression”
by the majority (i.e., when the acts of the directors or those in control of the
corporation are “oppressive” to the shareholders) may be grounds for dissolution.
2. In Massachusetts (Donahue jurisdiction), the stockholder, in the absence of corporate
deadlock, must own at least 50 percent of the shares or have the advantage of a
favorable provision in the articles of organization. Therefore, the minority stockholder,
by definition lacking 50 percent of the corporate shares, can never “authorize” the
corporation to file a petition for dissolution under by his own vote.
B. Heightened Fiduciary Duties in Closely Held Corporations
i. How the duties differ in a closely held corporation context? (Bullard’s question in class)
1. Due to the fundamental resemblance of a close corporation to a partnership, the trust
and confidence which are essential to this scale and manner of enterprise, and the
inherent danger to minority interests in the close corporation, stockholders in the close
corporation owe one another substantially the same fiduciary duty in the operation of
the enterprise that partners owe to one another.
a. The standard of duty owed by partners to one another is the “utmost good
faith and loyalty.”
b. Stockholders in close corporations must discharge their management and
stockholder responsibilities in conformity with this strict good faith standard.
c. They may not act out of avarice, expediency or self-interest in derogation of
their duty of loyalty to the other stockholders and to the corporation.
-VERSUS2. There is a less stringent standard of fiduciary duty to which directors and stockholders
of all corporations must adhere in the discharge of their corporate responsibilities.
a. Corporate directors are held to a good faith and inherent fairness standard of
conduct and are not permitted to serve two masters whose interests are
antagonistic.
ii. Cases:
1. Donahue v. Rodd Electrotype Company of New England, Inc. (1975)
a. Facts: Harry Rodd was the controlling stockholder in Rodd Electrotype, which
was run in large part by him and his sons. As he approached retirement, he
began gifting and selling his stock to his two sons and his daughter, also
defendants.
Date/Action
Son 1
Son 2
Daughter
1959-1967 HR distributed his shares
equally among his kids
July 1970 HR negotiated w/sons to have
company purchase 45 of his shares for
$36,000, and HR sold shares to each child.
1971 HR gave his remaining shares to his
children.
Total Shares
39
39
39
Corporate
Treasury
2
2
2
2
45
10
10
10
51
51
51
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Harry’s allocation of his shares precluded any 1 sibling from joining with the
plaintiff to take over control of the company (according to Bullard, Harry’s real
worry was likely his daughter b/c she didn’t sit on the board or hold a
management position in the company; she worked in the company but didn’t
make a big salary like her brothers – jealousy). When the plaintiff, a minority
shareholder in the closely held corporation, learned of the sale, she wanted her
shares to be purchased by the corporation as well. However, the defendants
refused to purchase plaintiff’s stock, claiming the company was not in a
financial position to do so. The plaintiff brought suit against the directors and
controlling stockholders of the company. The trial court dismissed plaintiff’s
suit, ruling that the transaction had been carried out in good faith.
b. Holding: On appeal, the court reversed and held that either the initial sale had
to be rescinded or defendants had to offer to purchase plaintiff’s stock at the
same price agreed upon in the initial sale.
c. Rationale: The court stated that in a close corporation, all shareholders owed
one another a strict duty of utmost good faith and loyalty. As such, the court
held that a controlling shareholder could not utilize its position to create an
exclusive market for its shares. In this case, defendants had created a market
for the controlling shareholder but refused to extend that market to plaintiff,
thereby excluding her. A close corporation may purchase shares from one
stockholder without offering the others an equal opportunity if all other
stockholders give advance consent to the stock purchase arrangements through
acceptance of an appropriate provision in the articles of organization, the
corporate by-laws, or a stockholder’ s agreement.
2. According to Bullard, much of this comes back to this issue of marketability. The
stockholders in a close corporation, especially the minority holders, are trapped by the
inability to sell b/c there’s no marketability. Liquidity (the ability to convert into cash)
in and of itself has value. Thus, the illiquidity of a minority shareholder’s interest makes
him vulnerable to exploitation by the majority. When courts apply the higher standard,
it often leads back to this issue.
3. Meiselman v. Meiselman (1983)
a. Facts: The plaintiff, Michael, and one of the defendants, Ira, are brothers and
shareholders in a group of family-owned close corporations. After their father
dies, Ira becomes the majority shareholder (70%). He is married with children
and has more reason to plan for the long-term future. Michael, the minority
shareholder (30%) is not married and has more interest in immediate financial
rewards. According to Bullard, these characteristics are driving the differences
between these brothers and how they are going to want to realize the economic
benefits of the corporation. Ira wants to take the earnings and reinvest – likely
tax-related. Michael begins feeling disenfranchised by Ira; he feels he’s being
cut out of management. He filed a suit seeking to dissolve the corporations
under the provisions of state law or, in the alternative, any other such relief as a
court could deem appropriate. After Michael files suit, Ira fires him. The trial
court denied Michael’s request for relief. The appellate court reversed. Ira and
the corporation appealed. Michael contends that he is entitled to relief under a
state statute that grants judges the power to liquidate the assets and business of
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a corporation in an action by a shareholder when it established that “liquidation
is reasonably necessary for the protection of the rights or interests of the
complaining shareholder.” Question presented: Have Michael’s rights as a
shareholder been violated?
b. Holding: The North Carolina Supreme Court agreed with the trial court and
remanded the case to the trial court, stating that the court is:
i. To determine Michael’s rights or interests in the corporation, and
ii. then to determine if liquidation, or some form of relief, is reasonably
necessary for the protection of those rights or interests.
c. Rationale: The court stated that, first, Michael’s “rights or interests” must be
articulated. The court determined that in a close corporation, a complaining
shareholder’s rights or interests include the “reasonable expectations” the
complaining shareholder has in the corporation. These reasonable expectations
are to be ascertained by examining the entire history of the participants’
relationship. The history will include:
i. the reasonable expectations created at the inception of the participants’
relationship;
ii. those reasonable expectations as altered over time; and
iii. the reasonable expectations which develop as the participants engage in
a course of dealing in conducting the affairs of the corporation.
In order for plaintiff’s expectations to be reasonable, they must be known to or
assumed by the other shareholders and concurred in by them. Privately held
expectations which are not made known to the other participants are not
reasonable. Therefore, in order for the plaintiff to obtain relief under the
expectations analysis, he must prove that:
i. he had one or more substantial reasonable expectations known or
assumed by the other participants;
ii. the expectation has been frustrated;
iii. the frustration was without fault of the plaintiff and was in large part
beyond his control; and
iv. under all of the circumstances of the case plaintiff is entitled to some
form of equitable relief.
d. Analysis of factors: Michael contends his “rights or interests” include secure
employment, fringe benefits which flow from has association with the
corporation, and meaningful participation in the management of the family
business, all of which have been frustrated by his firing.
e. Note: Bullard mentioned this as a possible exam question under both Fiduciary
Duty and Corporate Opportunity, asking whether this represents a “taking” of
something from Michael. Also, he stated that in a case like this the trial court
might ask each of the parties to come up with a plan. Courts have a much
stronger role to play in defining how expectations should be enforced in closely
held corporations.
f. This case demonstrates the desirability of confronting these issues at the outset
when organizing the enterprise and assuring that the reasonable expectations of
the parties are contained in well drawn agreements and/or bylaws.
C. Voting Agreements
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i. These agreements provide that all signing shareholders shall votes as they agree or, failing
agreement, as a designated individual (i.e., the family lawyer, a trusted aunt) directs.
Alternatively, the agreement may provide that all signatories agree to vote as a majority of the
group decides. They can be used to enhance voting power, b/c it allows you to pool your votes
together enabling you to elect more directors than you could separately.
ii. Stock pooling agreements are distinct from voting trusts, and are not controlled by the same
principles. A voting trust as commonly understood is a device whereby two or more persons
owning stock with voting powers, divorce the voting rights from the ownership, retaining to all
intents and purposes the latter in themselves and transferring the former to trustees in whom
the voting rights of all the depositors in the trust are pooled.
iii. Generally, agreements and combinations to vote stock or control corporate action and policy
are valid, if they seek without fraud to accomplish only what the parties might do as
stockholders and do not attempt it by illegal proxies, trusts, or other means in contravention of
statutes or law.
iv. Cumulative Voting – A system for electing corporate directors whereby a shareholder may
multiply his or her number of shares by the number of open directorships and cast the total for
a single candidate or a select few candidates. Cumulative voting enhances the ability of
minority shareholders to elect at least one director.
v. Ringling v. Ringling Bros.-Barnum & Bailey Combined Shows, Inc. (1946)
1. Facts: The widows of 2 Ringling brothers each held 315 shares of the famous circus
corporation. The third shareholder, John Ringling North, owned 370 shares. The
corporation had cumulative voting which assured each owner of having representation
on the board, which had 7 directors. By voting together, the 2 Ringling widows were
able to control 5 seats, instead of 4 if voting individually. Using a voting agreement, the
widows combined their voting power. In the event of their failure to agree on who the
5th director should be, or on any other question, their agreement appointed their lawyer
as arbitrator. He could then determine how the shares would be voted. At the annual
meeting, however, Haley, through her 2nd husband, declined to follow that arbitrator’s
command as to the 5th director. Instead, Mr. Haley voted for himself and his wife,
while the other widow voted as the arbitrator directed. The result was that the 5th
director did not receive enough votes to win. Pursuant to cumulative voting, John
Ringling North then would be able to elect 3 rather than 2 directors.
Directors
Haley
(315 shares – 2205)
Ringling
(315 – 2205)
North
(370 – 2590)
1 (N)
864
2 (N)
863
3 (N)
4 (H)
5 (H)
882
882
6 (R)
7 (R)
8
(H&R)
441
882
882
441
863
Turmoil ensued. The other Ringling widow sued to enforce the terms of the
agreement. The defendant widow argued that the agreement was unenforceable under
Delaware law b/c it is only an “agreement to agree,” or b/c it involves an attempted
delegation of irrevocable control over voting rights in a manner which is against the
public policy of the state.
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2. Holding: As to the defendant widow’s first argument, the court concluded that the
agreement was sufficiently definite in terms of the duties and obligations imposed on
the parties to be legally enforceable. The court found that the agreement was not
illusory, since a stated consequence followed a failure to agree, namely, empowerment
of the arbitrator. As to defendant widow’s second argument, the court determined that
the agreement was not a voting trust within the meaning of that term in the Delaware
General Corporation Law § 18 and as such was not invalid for failure to comply with
the provisions thereof. In sum, the agreement did not contravene public policy, and
the stock held under the agreement should have been voted pursuant to the direction
of the arbitrator to the parties or their representatives.
3. Relief: The court stated that the nature of the agreement did not preclude the granting
of specific performance. To deny specific performance would be tantamount to
declaring the agreement invalid. As the shareholder’s rights were properly preserved at
the stockholders’ meeting, the meeting was a nullity to the extent that it failed to give
effect to the provisions of the agreement. It was preferable to hold a new election
rather than attempt to reconstruct the contested meeting. Thus, while the court upheld
the agreement in its substantive aspects, the court would not specifically enforce the
agreement by ordering the shares voted as the arbitrator had decided. Rather, the
court, as stated, threw out the Haley votes and ordered a new election.
vi. Ringling Bros.-Barnum & Bailey Combined Shows, Inc. v. Ringling (1947)
1. Facts: The widow, Haley, appealed the above decision, arguing, again, that the voting
provisions are illegal and revocable.
2. Holding: The court again found the agreement valid and to be a well recognized means
by which a shareholder may effectively confer his voting rights upon others while
retaining various other rights. The court also stated that, generally speaking, a
shareholder may exercise wide liberality of judgment in the matter of voting, and a
group of shareholders may, without impropriety, vote their respective shares so as to
obtain advantages of concerted action.
vii. As a result of the decision in Ringling,
1. many statutes now expressly provide that shareholder voting agreements shall be
specifically enforceable and,
2. knowledgeable attorneys are careful to spell out in detail the consequences should one
or the other party breach a shareholder voting agreement.
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XII. DUTIES OF CONTROLLING SHAREHOLDERS (CB Chapter 11)
A. Who are Controlling Shareholders?
i. Controlling shareholder has enough voting shares to determine the outcome of shareholder
voting. Therefore, any shareholder who can assemble a voting majority wields effective
control.
1. In a large public corporation with widely dispersed shareholders, it may be enough to
own as little as 20% and if it has the support of incumbent managers.
B. Fiduciary Duties of Controlling Shareholders
i. In parent-subsidiary dealings…
1. Basic Problem – Dealings between a controlling shareholder (parent) and corporation
(subsidiary) also raise many conflicts of interest.
a. Dealings with Partially Owned Subsidiaries – Risks of control abuse:
i. Dividend policy – Example: Subsidiary adopts a no-dividend policy to
force the minority shareholders to sell to the parent.
ii. Share transactions – Subsidiary issues shares to the parent at less than
fair value, thus diluting the minority’s interests.
iii. Parent-subsidiary transactions – Subsidiary enters into contracts
with the parent or related affiliates on terms unfavorable to the
subsidiary, effectively withdrawing assets of that subsidiary at the
expense of the minority.
iv. Usurpation of opportunities – Parent (or other affiliate) takes
business opportunities away from the subsidiary.
b. Scrutiny applicable to parent-subsidiary dealings
i. Parent-subsidiary dealings in the ordinary course of business are subject
to fairness review only if the minority shows the parent has preferred itself
at their expense.
1. If so, the courts presume the parent dominates the subsidiary’s
board and places the burden on the parent to prove the
transaction was “entirely fair” to the subsidiary.
2. If there no preference, the transaction is subject to business
judgment review, and the minority must prove the dealings
lacked any business purpose or that their approval was grossly
uninformed.
ii. Sinclair Oil Corp. v. Levien (1971)
1. Parties:
a. Sinclair Oil Corp. – original defendant and plaintiff on appeal.
b. Sinven – subsidiary of Sinclair, organized for the purpose of operating in
Venezuela. Sinclair owned about 97% of Sinven’s stock.
c. Levien – original plaintiff and minority stockholder in Sinven.
2. Facts: Levien brought a derivative action against the parent corporation, Sinclair, for
a. an accounting of excessive dividends – plaintiff argues that Sinclair caused
Sinven to pay out such excessive dividends that the industrial development of
Sinven was effectively prevented, and
b. a breach of contract between two of its subsidiaries.
The court ruled for the plaintiff on both issues. Sinclair appealed.
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3. Holding: The Supreme Court of Delaware reversed the order as to dividends because
the dividends were paid fairly to all stockholders, and it affirmed the order as to breach
of contract because the intrinsic fairness standard applies to dealings between
subsidiaries.
4. Rationale for Issue 1 – the dividends:
a. With regard to issue 1 (the dividends) the court stated that the trial court
incorrectly applied the standard of intrinsic fairness rather than the business
judgment rule. A dividend declaration by a dominated board will not inevitably
demand the application of the intrinsic fairness standard. A parent does indeed
owe a fiduciary duty to its subsidiary when there are parent-subsidiary dealings.
However, the higher intrinsic fairness standard will only be applied when the
fiduciary duty is accompanied by self-dealing – the situation that occurs when
the parent is on both sides of a transaction with its subsidiary and, by virtue of
its domination, causes the subsidiary to act in such a way that the parent
receives a benefit to the exclusion and at the expense of the subsidiary. In this
case, the payment of dividends by Sinven was not self-dealing by Sinclair, b/c a
proportionate share of the money was received by the minority shareholders of
Sinven. Sinclair received nothing from Sinven to the exclusion of its minority
shareholders. Thus, the business judgment standard should have been applied.
Rule: Where a proportionate share of dividend money is received by the
minority shareholders of the subsidiary, these dividends are not selfdealing and the business judgment standard should be applied.
5. Rationale for Issue 2 – the breach of contract:
a. The contract between Sinven and International, another of Sinclair’s
subsidiaries through which Sinclair purchased all its crude oil, called for
minimum and maximum quantities and prices of crude oil and payment upon
receipt. International did not follow either of the terms of the contract, making
late payments and disrespecting the pricing agreement. The court stated that
Sinclair’s act of contracting with its dominated subsidiary constituted selfdealing. When the situation involves a parent and a subsidiary, with the parent
controlling the transaction and fixing the terms, the test of intrinsic fairness,
with its shifting of the burden of proof, is applied. The court held that, under
this standard, Sinclair must prove that its causing Sinven not to enforce the
contract was intrinsically fair to the minority shareholders of Sinven, and that
Sinclair failed to meet its burden. Rule: Burden is on the defendants to
prove the fairness of a self-dealing transaction.
6. Summary of the 2 standards (from Sinclair court)
a. Intrinsic Fairness Standard – Involves both a high degree of fairness and a
shift in the burden of proof. Under this standard, the burden is on the parent
company to prove, subject to careful judicial scrutiny, that its transactions with
the subsidiary were objectively fair. The rule applies when the parent has
received a benefit to the exclusion and at the expense of the subsidiary. A
parent owes a fiduciary duty to its subsidiary when there are parent-subsidiary
dealings, but this alone will not evoke the intrinsic fairness standard. This
standard will be applied only when the fiduciary duty is accompanied by selfdealing, when a parent is on both sides of a transaction with its subsidiary. Selfdealing occurs when the parent, by virtue of its domination of the subsidiary,
causes the subsidiary to act in such a way that the parent receives something
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from the subsidiary to the exclusion of, and detriment to, the minority
stockholders of the subsidiary.
-VERSUSb. Business Judgment Rule – Under the business judgment rule, a court will not
interfere with the judgment of a board of directors unless there is a showing of
gross and palpable overreaching. A board of directors enjoys a presumption of
sound business judgment, and its decisions will not be disturbed if they can be
attributed to any rational business purpose. A court under such circumstances
will not substitute its own notions of what is or is not sound business
judgment.
iii. Exclusion of Minority
1. Courts hold controlling shareholders to a higher standard when they use control in
stock transactions to benefit themselves, to the exclusion of minority shareholders.
iv. Zahn v. Transamerica Corp. (1947)
1. Facts: The case involved Axton-Fisher Tobacco Company and 2 classes of shares. The
Class A were similar to preferred shares, and the Class B functioned as common shares.
The class A shares, which were entitled to twice as much liquidation as class B shares,
could be redeemed by the corporation at any time for $60. Plaintiff held Class A stock
in Axton-Fisher. Defendant owned virtually all of Axton-Fisher’s Class B stock and
dominated the management, business, and affairs of the company (i.e., the class B
shares held voting control). The controlling shareholder (defendant) had the
corporation redeem all of the minority’s Class A shares and then liquidate the
corporation’s assets, which had recently tripled in value. The result was that the
controlling shareholder received the lion’s share of the company’s liquidation value.
Plaintiff filed a class action suit, claiming a breach of duty of loyalty (with the burden
on the defendant to prove fairness to them). Defendant moved to dismiss the
complaint, and the trial court granted the motion. Plaintiff appealed.
2. Holding: The appeals court reversed because defendant, as the board of directors of the
company and as controlling stockholder, had a fiduciary duty to minority Class A
stockholders that was violated if the allegations of plaintiff were true. The act of
redeeming the Class Act stock was consummated at the direction of defendant, for its
own profit, not for the protection of the minority stockholders’ interests. Although the
majority (Class B) shareholders had every right to do what they did, the directors had an
obligation to let the A shareholders exercise their conversion possibility on the basis of
full information (company’s increased value). Rule: Controlling shareholders may
not use their control to self deal unfairly with the assets of the corporation.
3. Rationale:
a. The majority has the right to control; but when it does so, it occupies a
fiduciary relation toward the minority, as much so as the corporation itself or
its officers and directors.
b. A director is a fiduciary. So is a dominant or controlling stockholder or group
of stockholders. Their powers are powers in trust. Their dealings with the
corporation are subjected to rigorous scrutiny, and where any of their contracts
or engagements with the corporation is challenged, the burden is on the
director or stockholder not only to prove the good faith of the transaction but
also to show its inherent fairness from the viewpoint of the corporation and
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those interested therein. Every act in its own interest to the detriment of the
holders of minority stock becomes a breach of duty and of trust, and entitles to
plenary relief from a court of equity.
v. Jones v. H.F. Ahmanson & Company (1969) – Bullard loved this case!
1. Facts: Defendants were majority shareholders of the corporation, United Savings and
Loan Association (Association) in which the plaintiff was a minority shareholder.
Defendants created a second corporation, United Financial (UF), and transferred their
shares (85% of Association) to UF. After the exchanges, UF owned 85 percent of
Association’s outstanding shares. Thus, defendants became the majority shareholders
of the new corporation and continued to control the original corporation’s stock (UF
essentially became the parent corporation of Association). The control group then had
2 public offerings of UF stock based primarily on book value attributed to the first
corporation. Most of the proceeds of the sale went to the control group, allowing them
to cash in on their investment in Association through the sale of UF stocks. However,
the minority shareholders of Association were not given the same opportunity to also
transfer their shares to UF and share in the increased value from the sale.
Before the transaction:
Association
Control Group
(85%)
Minority
(15%)
Step 1: the control group transfers its Association shares to UF, which then becomes a
holding company of Association.
United Financial
(UF shares)
(Association shares – 85%)
Control Group
Association
Minority (15%)
Step 3: UF then sells shares to the public and the proceeds from the sale go to the
control group.
Control group
$$
shares
United Financial (85%)
Association
Public
$$
Minority (15%)
The minority shareholders of Association brought a direct suit against the controlling
shareholders for breach of fiduciary duty. Defendants argued that there was no breach
b/c the sale of their shares to UF and going public was a legitimate transfer of their
controlling shares for a premium.
2. Holding: The CA Supreme Court held that plaintiff sufficiently stated a claim for injury
against defendants.
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3. Rationale: A corporation’s director is a fiduciary, and so is a dominant or controlling
stockholder or group of stockholders. Majority shareholders, either singly or acting in
concert to accomplish a joint purpose, have a fiduciary responsibility to the minority
shareholders and to the corporation to use their ability to control the corporation in a
fair, just, and equitable manner. Majority shareholders may not use their power to
control corporate activities to benefit themselves alone or in a manner detrimental to
the minority. Any use to which they put the corporation or their power to control the
corporation must benefit all shareholders proportionately and must not conflict with
the proper conduct of the corporation’s business. The court stated that there was a
“comprehensive rule of good faith and inherent fairness to the minority shareholders in
any transaction where control of the corporation is material.” Because, in this case, the
controlling shareholders took actions using their control to obtain an advantage
unavailable to the minority without any business purpose, they violated their fiduciary
duty to the shareholders.
C. Sale of Control Transactions
i. Generally when the control group sells its shares, they are selling their personal property,
which does not automatically implicate any breach of fiduciary duty. Controlling
shareholders who sell their controlling shares may receive a premium from the purchaser, that
is, they receive more for their shares than the current market price. In sale of control cases,
an issue arises as to whether it is fair to other shareholders that the control group receives this
premium.
ii. There are 3 important exceptions to the rule that a majority shareholder may retain a
premium received in the sale of control shares, which involve:
1. Sales to a looter,
2. Sales of a corporate office, and
3. Sales of corporate assets.
iii. Thomas L. Hazen, Transfers of Corporate Control and Duties of Controlling Shareholders – Common
Law, Tender Offers, Investment Companies – And a Proposal for Reform.
1. No legal theory prohibiting the receipt of control premiums has received more that
partial and sporadic judicial acceptance.
a. Professor Berle developed the “corporate asset” theory of control. He argues
that the premium above the per share market price that the seller realizes in
return for a controlling block of stock is a corporate asset because it “arises out
of the ability which the holder has to dominate property which in equity
belongs to others.” In other words, the control premium doesn’t belong to the
shareholders but belongs to the company.
b. The consequence of this theory is that the entire premium “if it goes anywhere,
must go into the corporate treasury.”
2. However, the courts generally agree that, absent special circumstances, a shareholder is
not precluded from receiving a premium above the market price for selling a
controlling block of stock.
iv. Zetlin v. Hanson Holdings, Inc. (1979)
1. Facts: The defendants, controlling shareholders in a corporation, sold their interests to
another company at a premium price. Zetlin, a minority shareholder, filed suit against
the defendants contending that minority stockholders were entitled to an opportunity
to share equally in any premium paid for a controlling interest in the corporation. The
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trial court ruled for the defendant, and the appellate court affirmed. Zetlin again
appealed.
2. Holding: Absent looting of corporate assets, conversion of a corporate opportunity,
fraud or other acts of bad faith, a controlling stockholder is free to sell, and a purchaser
is free to buy, that controlling interest at a premium price. Minority interests are entitled
to protection from abuse, but cannot inhibit the legitimate interests of other
stockholders.
v. Gerdes v. Reynolds (1941) – looting & sale of corporate offices
1. Facts: Defendants were the officers and directors of an investment trust company.
They were also stockholders and owned a majority of its common stock. Ownership of
the majority of the common stock was sold for a premium, and defendants resigned
their offices and directorships and elected as their successors four persons designated
by the purchaser. The purchaser used the acquired control to loot the company of its
primary assets and then proceeded to liquidate the corporation to the detriment of the
remaining shareholders, who brought suit to hold accountable those who sold, bought,
and aided in the transaction. The defendants claim they had no knowledge of the
purchaser’s intentions toward the company.
2. Holding: The court ruled that defendants violated their fiduciary duties and had to
account to the corporation or its duly appointed trustees for all damages naturally
resulting from their official misconduct. What was to be accounted for was not
proceeds of the sale of stock, but proceeds of an illegal sale of corporate offices. The
court stated that the price paid was so grossly in excess of the value of the stock that it
carried upon its face a plain indication that it was not for the stock alone but partly for
the en masse resignations and immediate election of the purchaser’s nominees as
successors.
3. Rationale: Officers and directors cannot terminate their agency or accept the
resignation of others if the immediate consequence would be to leave the interests of
the company without proper care and protection. Neither can they accept payment in
any form or guise for their own resignation or for the election of others in their place.
The court stated that the questions determinative of the liability of corporate officers
and directors in such a situation are as follows:
a. Are the circumstances such that, despite actual ignorance of the unlawful plans
and designs on the part of the purchasers, they are chargeable with notice of
such plans or designs, or perhaps more accurately, with notice that unlawful
plans and designs are a risk reasonably to be perceived?
b. Is the price paid in reality a price paid for the stock, or is it, in part at least, a
price paid for the resignations of the existing officers and directors and the
election of the buyer’s nominees?
The court stated that the principal factors needed to answer these questions are:
a. The nature of the assets which are to pass into the possession and control of
the purchasers by reason of the transaction,
i. For example, land and buildings versus securities. With securities, the
risk of dissipation or speedy misapplication is greater.
b. The method by which the transaction is to be consummated, and
c. The relation of the price paid to the value of the stock.
i. Gross excessiveness or inadequacy or price may be sufficient to charge
a seller with notice of fraudulent intent on the part of a buyer.
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vi. Essex Universal Corporation v. Yates (1962) – transfer of control immediately after the sale
1. Facts: The plaintiff corporation purchased controlling shares in stock of a company
from the defendant, the company’s president and chairman, pursuant to contract
allowing defendant to retain certificates as security and that gave plaintiff right to
demand resignation and replacement of majority of purchased company’s board of
directors. Before the deal was complete, Yates challenged the contract on a number of
grounds. The lower court found agreement invalid on the theory that the provision in
the contract for the immediate transfer of control of the board of directors was illegal
per se and tainted the entire contract.
2. Holding: The appellate court disagreed because though an agreement to sell control of
the management of corporation by itself would be invalid, the plaintiff was actually
buying substantial percentage of company’s stock.
3. Rationale: It is legal to give and receive payment for the immediate transfer of
management control to one who has achieved majority share control but would not
otherwise be able to convert that share control into operating control for some time. If
a company is contracting to acquire what in reality is equivalent to ownership of a
majority of stock, i.e., if it would as a practical certainty have been guaranteed of the
stock voting power to choose a majority of the directors of a company in due course,
there is no reason why a contract transferring control of board immediately with the
exchange of stocks should not similarly be legal. In addition, the court stated that there
was no suggestion that the immediate transfer of control carried any threat to interests
of the company or its shareholders. Because contract was for ownership of majority of
stock and because it was permissible for seller to choose to facilitate immediate transfer
of majority control, contract was permissible. Rule: A sale of a controlling interest in
a corporation may include immediate transfer of control. Control of a
corporation may not be sold absent the sale of sufficient shares to transfer such
control.
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XIII. PUBLICLY TRADED STOCKS – SEC REGULATION (CB Chapter 12)
A. Overview of the Federal Securities Laws
i. Securities Act of 1933
ii. Securities Exchange Act of 1934
iii. Public Utility Holding Company Act of 1935
iv. Trust Indenture Act of 1939
v. Investment Company Act of 1940
vi. Investment Advisors Act of 1940
vii. The Securities and Exchange Commission (SEC)
Bullard said this material
would not be tested (426-34).
B. Financial Reporting by Public Companies
C. SEC Proxy Regulations
i. Thomas L. Hazen, Treatise on the Law of Securities Regulation
1. With the passage of the Securities Exchange Act of 1934, Congress took note that a
number of the great corporate frauds had been perpetrated through management
solicitation of proxies without indicating to the shareholders the nature of any matters
to be voted on. Accordingly, section 14 of the Act was included to regulate shareholder
voting to avoid proxy abuse.
2. The federal rules do not address substantive voting rights, which remain a matter of
state law, but rather they supplement the requirements of state law. State law
determines the basic corporate governance rules while federal securities law imposes
disclosure requirements over and above the state law requirements.
3. There are 4 primary aspects of SEC proxy regulation:
a. There must be full and fair disclosure of all material facts with regard to any
management submitted proposals that will be subject to a shareholder vote –
14(a).
b. Material misstatements, omissions, and fraud in connection with the solicitation
of proxies are prohibited.
c. The federal proxy regulation facilitates shareholder solicitation of proxies as
management is not only required to submit relevant shareholders proposals in
its own proxy statements, but also to allow the proponents to explain their
position in the face of any management opposition.
d. The proxy rules mandate full disclosure in non-management proxy materials
and thus are significant in corporate control struggles and contested take-over
attempts.
4. SEC Rule 14a-8 – shareholders may submit proposals to the corporation for inclusion
in their proxy statement, unless
a. 14a-8(c)(1) – it is not a proper subject for action by the shareholders
i. determined by state law shareholder’s rights:
1. sale of substantially all assets
2. election of directors
3. amendment of the bylaws
4. mergers
5. amendments to the articles
6. dissolution
7. “recommendations”
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b. 14a-8(c)(3) – it includes false or misleading statement under SEC Rule 14a-9.
i. This can be avoided if the proxy uses words like “in my opinion...” to
preface bad things.
c. 14a-8(c)(4) – it relates to a personal claim, grievance, or interest not shared by
the shareholders at large.
d. 14a-8(c)(5) – it relates to an operation which:
i. accounts for less than 5% of total assets; AND
ii. accounts for less than 5% of the net earnings and gross sales; AND
iii. is not otherwise “significantly related” to the registrant’s business.
1. Ex: this is not a purely economic rule. The proposal will be
allowed even if it deals with less than 5% of the operations, if it
raises a substantial policy concern (such as animal abuse –
Lovenheim).
iv. This section deals with whether the subject of the proposal is even
related to the business.
e. 14a-8(c)(7) – it relates to ordinary business operations.
i. This does not include matters which involve a “substantial policy
matter” such as equal opportunity.
5. Rule 14a-8 applies to any solicitation which is “reasonably calculated” to influence the
shareholder’s votes.
a. Ex: a newspaper advertisement condemning the action of the corporation falls
under the proxy rules, and is an invalid proxy solicitation attempt, if it deals
with issues which are the subject of an upcoming shareholder’s vote – Long
Island Lighting.
6. Rule 14a-8(b)(1) the proposal and all supporting statements must not exceed 500
words.
7. Rule 14a-8(a)(1) - must own at least 1% or $2,000 of stock.
ii. Sadler v. NCR Corp. (1991)
1. Facts: Plaintiffs, New York residents, sued under New York law to compel defendant
foreign corporation, which did business in New York, to provide a list of record
stockholders and to compile and produce a list of non-objecting beneficial owners
(NOBO). They want a “CEDE” list, which identified the brokerage firms and other
record owners who bought shares in a street name for their customers who have placed
those shares in the custody of depository firms and a “NOBO” list, a list of nonobjecting beneficial owners, people who don’ t object to their name being known.
Defendant’s state of incorporation, Maryland, did not allow plaintiffs to obtain the lists.
2. Holding: The court held that N.Y. Bus. Corp. Law § 1315 authorized production of the
shareholder and NOBO lists.
3. Rationale: The court stated that the plaintiffs were qualified persons under the statute
to obtain the lists, even though they named another as their agent for purposes of
inspecting the records (the plaintiffs were working with AT&T). N.Y. Bus. Corp. Law
§ 1315 also compelled defendant to compile and produce a NOBO list when one was
requested by plaintiffs. N.Y. Bus. Corp. Law § 1315 did not violate the Commerce
Clause, U.S. Const. art. I, § 8, cl. 3. The court also stated that denying an opportunity
to contact the NOBO’s is inconsistent with the statutes objective of seeking “to the
extent possible, to place shareholders on equal footing with management in obtaining
access to shareholders.”
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iii. Thomas L. Hazen, Treatise on the Law of Securities Regulation
1. The SEC takes a broad view of the terms “solicit” and “solicitation” so as to include
“any request for a proxy whether or not accompanied by or included in a form of any
request to execute or not to execute, or to revoke, a proxy; and the furnishing of any
communication to security holders under circumstances reasonably calculated to result
in the procurement, withholding or revocation of a proxy.” The definition has been
liberally interpreted by courts to include materials such as:
a. Open letters to regulatory bodies, and
b. Newsletters urging shareholders to reject a proposal.
2. SEC Rule 14a-3 sets forth the types of information that must be included in materials
used for proxy solicitations (if specifics needed, see page 443 of CB) and apply both to
management’s proxy statement and proxy solicitations by others.
iv. Long Island Lighting Co. v. Barbash (1985)
1. Facts: The power company had been embroiled in a public controversy over its
construction of a nuclear power plant and believed that several groups had begun to
solicit proxies in anticipation of an upcoming stockholders meeting. After an expedited
hearing that allowed for very limited discovery, the district court granted summary
judgment to the defendants. The power company sought review of the order
dismissing their complaint against defendants and efforts to enjoin defendants’ alleged
violations of Securities Exchange Act of 1934 § 14(a) and Securities Exchange
Commission (SEC) Rules 14a-9, 14a(11) promulgated under that Act. The complaint
alleged that the defendants committed such violations by publishing false and
misleading advertisements in connection with a special meeting of LILCO shareholders
for the purpose of electing a new board of directors.
2. Holding: The court reversed and remanded, holding that it was an abuse of discretion
limiting the power company’s discovery by restricting opportunity to examine
defendant under oath, preventing review of recently produced documents,
circumscribing the scope of questioning, and denying the opportunity to question other
defendants. Discovery limitations denied plaintiff a meaningful opportunity to
establish defendants’ advertisements were solicitations under SEC Rule 14(a). The
court also held it was error to hold that proxy rules did not include defendants’
newspaper and radio advertisements. The Act regulated not only direct requests to
furnish proxies but also those communications which indirectly accomplished the same
result. The court stated that the question in every case is whether the challenged
communication seen in the totality of the circumstances is “reasonably calculated” to
influence the shareholders’ votes.
3. Securities Exchange Act of 1934 Rule 14(a) governs the solicitation of proxies with
respect to the securities of publicly held companies, with enumerated exceptions set
forth in the rules. Proxy rules promulgated by the Securities Exchange Commission
regulate as proxy solicitations
a. any request for a proxy whether or not accompanied by or included in a form
of proxy;
b. any request to execute or not to execute, or to revoke, a proxy; or
c. the furnishing of a form of proxy or other communications to security holders
under circumstances reasonably calculated to result in the procurement,
withholding or revocation of a proxy.
v. Notes:
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1. The SEC amended its proxy rules after the decision in LILCO to narrow the definition
of what constitutes a proxy solicitation that would be subject to the proxy rules.
a. A statement by a person who does not otherwise engage in a proxy solicitation
stating how that individual will vote is exempted if the statement “is made by
means of speeches in public forums, press releases, publications or broadcast
opinions, statements, or advertisements appearing in broadcast media, or
newspaper, magazine, or other bona fide publication disseminated on a regular
basis…”
b. Also exempted are certain solicitations by persons who do not seek to act as a
proxy for a security holder.
2. There are 2 immediate consequences of a communication falling within the definition
of solicitation.
a. First, there are filing requirements either before or after the solicitation is made.
b. Second, the solicitation is subject to Rule 14a-9’s prohibitions against materially
misleading statements.
3. In order to encourage communication among institutional investors, Rule 14a-2(b)(2)
excludes from the federal proxy regulation solicitations not made on behalf of the
company where the number of persons solicited is not more than 10.
D. Shareholder Proxy Proposals
i. Section 14(a) of the Act gives the SEC virtually a blank check (very wide leeway) to write
rules governing the solicitation of proxies for shareholder meetings.
ii. Under 14a-8, if a shareholder of a registered company gives timely notice to the management
of his intention to present a proposal for action at a forthcoming meeting, management must
include the proposal, with a supporting statement of not more than 500 words, in its proxy
statement and afford security holders an opportunity to vote for or against it in the
management’s proxy.
iii. To be eligible to have such a proposal included, the investor’s holdings must be worth at least
$2,000 or constitute 1% of the securities entitled to be voted at the meeting.
iv. Rule 14a-8 has been extensively utilized by proponents of “shareholder democracy.”
v. Notes from class:
1. Schedule 14(a) lays out everything you need to know for a proxy.
2. When you have an upcoming shareholder mtg. you have a timeline you’re following.
3. Before you mail the proxy, you have to file it with the SEC. SEC reads it, and will call
you, make comments, get to the point that you’re comfortable that the SEC won’t stop
you in sending out the proxy.
4. Technical requirements…
a. Person making proposal must hold at least $2000 in shares or constitute 1% of
the securities entitled to be voted at the meeting.
b. Also have to submit with enough notice to get into proxy statement, has to be
within enough time to give the corporation time to review it, etc. and decide
whether it should be submitted.
c. Submission in proxy statement cannot exceed 500 words.
vi. Lovenheim v. Iroquois Brands, LTD. (1985)
1. Facts: The plaintiff owned 200 shares in defendant company. He wanted to offer a
resolution at an upcoming shareholders meeting regarding the procedure used to forcefeed geese for the production of pate de foie gras in France, a type of pate imported by
the defendant. Specifically, his resolution called upon the company’s directors to form
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a committee to study these production methods and possibly discontinue importing
this product until it could be produced in a more humane manner. The defendant
refused to allow the plaintiff’s proposal to be included in the proxy materials, and to do
so, relied on an exception to the general requirement of Rule 14a-8, Rule 14a-8(c)(5).
14a-8(c)(5) states that an issuer of securities may omit a proposal from its proxy
statement if the proposal relates to an operation which:
a. accounts for less than 5% of issuer’s total assets at the end of its most recent
fiscal year; AND
b. accounts for less than 5% of the net earnings and gross sales for its most recent
fiscal year; AND
c. is not otherwise “significantly related” to the issuer’s business.
The defendant submitted information regarding its pate sales, which fell below the 5%
level required. Plaintiff did not contest that his proposed resolution related to a matter
of little economic significance to the defendant, but he claimed it had “ethical or social
significance,” which exempted it from 14a-8(c)(5) exclusion. Plaintiff brought suit to
enjoin defendant from excluding the materials he requested from the proxy materials to
be sent out to shareholders.
2. Holding: Finding the proposal to have a “significant relationship to the issuer’s
business” and also to have “ethical and social significance,” the court granted plaintiff’s
motion for injunctive relief.
3. Rationale: The court reviewed the history of Rule 14a-8(c)(5) and noted an SEC
statements on the issue – “…it [SEC] did not believe that subparagraph (c)(5) should
be hinged solely on the economic relativity of a proposal.” The court stated that the
Commission required inclusion “in many situations in which the related business
comprised less than 1 percent” of the company’s revenue, profits or assets “where the
proposal has raised policy questions important enough to be considered ‘significantly
related’ to the issuer’s business.” The court determined that in light of the ethical and
social significance of plaintiff’s proposal and the fact that it implicates significant levels
of sales, plaintiff has shown a likelihood of prevailing on the merits.
4. Bullard – Currently, the trend has been for the SEC to allow more of these proposals
in. What’s the significance as a social issue?
vii. SEC v. Transamerica Corp. (1947-48)
1. Question (Bullard): when is something a proper subject for a shareholder proposal?
2. Facts: A shareholder submitted four proposals which he desired to present for action
by shareholders at the next annual stockholder’s meeting. The 3 relevant proposals
requested
a. the attendance of an independent auditor at the annual meetings (a by-law
amendment),
b. an amendment to the corporate bylaws (by-law amendment), and
c. an accounting of the proceedings of the annual meeting to be sent to all
stockholders (a straight resolution).
The corporation refused to include shareholder’s proposals. As a result, SEC brought
an action against defendant to enjoin defendant from making use of any proxy solicited
by it for use at the annual meeting, from making use of the mails to solicit proxies or
from making use of any solicited material without complying with the SEC’s demands.
The lower court enjoined defendant from holding its annual meeting until it complied
with the proxy rules by giving notice in the proxy of the shareholder’ s proposal.
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3. Holding: The appellate court modified the lower court’ s decision to compel resolicitation on the shareholder’s proposals regarding the amendment of the bylaw and
the accounting of the proceedings of the annual meeting because they were proper
subjects for stockholder action under the purview of the proxy rules.
4. Rationale: The court stated that the case turned in some part on the interpretation of
Proxy Rule X-14A-7 which provides that:
a. If a qualified security holder has given the management reasonable notice that
he intends to present for action at a meeting of security holders “a proposal
which is a proper subject for action by security holders” the management shall
set forth the proposal and provide means by which security holders can vote on
the proposal.
The court stated that the auditing of the books of a corporation is a proper subject for
shareholder consideration and action, as “stockholders are entitled to employ the
watchmen to eye the guardians of their enterprise.” The court also stated that proposal
4 – sending stockholders a report as to what transpired at the annual meeting of their
company – is certainly proper.
viii. Since management usually resists the inclusion of shareholder proposals, the provisions of
14a-8 that specify the kinds of proposals that can be omitted have been the subject of
constant controversy and frequent change. Currently, Rule 14a-8(i) permits management to
exclude a proposal for any one of 13 reasons:
1. Impropriety under corporate law (governing state law).
a. SEC points out that the wording of the proposal may determine whether it
concerns a proper matter for consideration. For example, a proposal that
mandates corporate action, and thereby seeking to circumvent the board of
directors, may be excludable, while a proposal merely recommending that the
directors consider a certain action will be appropriate.
2. Violation of law generally.
a. May exclude if it would require the company to violate state or federal law, such
as breach of existing contract.
3. Contrary to SEC proxy rules.
a. E.g. the proposal is vague or misleading in violation of 14a-9.
4. Redress of personal claim or grievance.
5. Relevance.
a. E.g. the Lovenheim case (remember: the relevance standard contains both an
objective and subjective test).
6. Beyond the company’s powers to effectuate.
a. E.g. a proposal that relates to social concerns that management by itself cannot
remedy.
7. Ordinary business operations.
a. Management may exclude a shareholder proposal if it relates to day-to-day
management decisions rather than the more general policy issues that may arise
to the level of shareholder concern.
8. Relating to election to office.
a. Shareholders wishing to propose their own slate of directors or oppose
management’s slate must do so through their own solicitation.
b. On the other hand, proposals relating to election procedures generally rather
than specific candidates may have to be included. Management can thus
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9.
10.
11.
12.
13.
exclude a shareholder proposal calling for the removal of a corporate officer or
director.
Contradicting management proposal.
Mootness.
Duplication.
Resubmissions.
a. If more details are needed, see CB page 462.
Dividends.
a. Management may exclude a shareholder proposal that relates to a specific
amount of dividends, b/c as a matter of corporate law, dividend declarations
fall within the discretion of the board of directors.
b. However, proposals relating to more general questions of dividend policy such
as whether to declare dividends “is extremely important to most security
holders, and involves significant economic and policy considerations.”
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