Alternative Business

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Choice of Business Entity
A. Overview of Principal Forms of Business Organization and Relevant Statutes
1. What is a sole proprietorship?
a. A business wholly owned by an individual.
b. The business owner absorbs profits/losses on individual personal
income tax.
c. The owner of the business is personally liable on all business
obligations because there is no legal separation between the owner
and the business.
2. What is a General Partnership?
a. The General Partnership is the default form for businesses that are
owned by more than one person.
2 or more co-owners engaged in a business for profit.
b. Uniform Partnership Act (UPA)
UPA §6: Definition of General Partnership:
1) A partnership is an association of 2 or more
persons to carry on as co-owners a business for
2) But any association formed under any other
statute of this state, or any statute adopted by
authority, other than the authority of this state, is
not a partnership under this act, unless such
association would have been a partnership in this
state prior to the adoption of this act; but this act
shall apply to limited partnerships except in so far
as the statutes relating to such partnerships are
inconsistent herewith.
ii. UPA §9: Veto Power
1) Each partner is a general agent for the other
2) One may carry on the business of the partnership
for the other and legally bind the partnership.
3) One partner’s actions may legally bind the other
partner(s) in matters relating to the business.
iii. UPA §15: Nature of the Partnership
1) All partners are liable jointly and severally for the
debts and obligations of the partnership, including
the wrongful acts or breach of trust by other
c. Revised UPA (RUPA)
d. California
UPA §15001
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ii. RUPA §16100
e. Characteristics of General Partnerships
The definition of a partnership does NOT require a
formal writing.
1) Default standard so handshake = inadvertent
2) Default standard for handshake deals that do not
discuss the specific terms of the partnership.
3) The intent of the parties does not matter.
ii. If the partnership agreement is silent on a certain issue,
the UPA is the default standard.
1) Example: If A and B only talk about the split of
profits and not the split of losses, the UPA §18(a)
becomes the default standard and losses will be
allocated in the same proportion as profits.
iii. Under common law, partnerships were considered an
aggregation of the individual partners and the partnership
was NOT considered a separate entity from the
individual owners; however, RUPA amended this and
recognizes partnerships as a separate entity.
Partners have individual rights against their other partners
because each partner is jointly and severally liable for the
debts of the business.
f. Limited Liability Partnerships
General partnership in all respects except that the statute
provides that partners have no personal liability for firm
obligations that exceed the assets of the general partnership.
ii. Partners in an LLP have full personal liability for claims
arising from their own misconduct.
3. What is a Limited Partnership?
a. To form a limited partnership there must be 1 or more general
partners and 1 or more limited partners.
Uniform Limited Partnership Act (ULPA) §1
1) A limited partnership is a partnership formed by 2
or more persons under the provisions of §2,
having as members one or more general partners
and one or more limited partners. The limited
partners as such shall not be bound by the
obligations of the partnership.
ii. Revised ULPA §100
iii. California
1) ULPA §15501
2) RULPA §15611
b. To form a limited partnership, the partners must sign and
swear to the arrangement on a certified document.
Cannot have an inadvertent limited partnership.
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c. The limited partner cannot exercise control of the operation of
the partnership and retain the shield of limited liability.
Once the limited partner exercises control of the
partnership, he/she ceases to be a limited partner.
ii. ULPA §7
1) A limited partner shall not become liable as a
general partner unless, in addition to the exercise
of his rights and powers as a limited partner, he
takes part in the control of the business.
iii. RULPA §303
1) Changed the ULPA §7 rule by adding: “if the
limited partner participates in the control of the
business, he [or she] is liable only to persons
who transact business with the limited
partnership reasonably believing, based upon
the limited partner’s conduct, that the limited
partner is a general partner.”
CA RULPA §15632
1) “If a limited partner participates in the control of
the business without being named as a general
partner, that partner may be held liable as a
general partner only to persons who transact
business with the limited partnership with
actual knowledge of that partner’s
participation in control and with a reasonable
belief, based upon the limited partner’s
conduct, that the partner is a general partner
at the time of the transaction.”
4. What is a Limited Liability Company (LLC)?
a. Uniform Limited Liability Company Act (ULLCA)
b. California
LLC §17000
c. Hybrid of partnerships and corporations.
Newly created in the 1990s.
5. Corporations
a. Revised Model Business Corporation Act (RMBCA or MBCA)
b. California Corporations Code
c. There are formalities if you want to form a corporation
Must file Articles of Incorporation with the Secretary of
d. Hierarchy in Corporations
1) The shareholders elect the Board of Directors
ii. Board of Directors
1) The directors appoint the Officers
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2) The directors manage the “big picture” decisions
of the business, not the day-to-day functions.
iii. Officers
1) The officers manage the day-to-day business
affairs of the corporation.
6. Federal Securities Laws – Administered by the SEC
a. Securities Act of 1933
SEC Rules under the 1933 Act
b. Securities act of 1934
SEC Rules under the 1934 Act
7. State Securities Laws – Blue Sky Statutes
a. Uniform Securities Act
b. California – Corporate Securities Law of 1968 §25000
Administered by the Department of Corporations (DOC)
ii. Rules promulgated by the DOC
B. Overview of Basic Agency Principles
1. Klein and Coffee “Business Organization and Finance” (Handout)
a. Agency Relationship: Agent and Principal
Fiduciary Relationship that arises from the manifestation
of mutual consent between the principal and the agent
that the agent shall act on principal’s behalf and subject
to principal’s control.
ii. Fiduciary Relationship: default rule  If no agreement to
the contrary, there is a fiduciary relationship between
principal and agent. Principal owes Agent a duty to pay
and Agent owes Principal a duty of loyalty.
iii. Agency Relationship includes implied terms
1) Duty of care
2) Duty of loyalty
3) Fiduciary responsibility
2 elements to a principal agent relationship
1) Hierarchal: Principal has the right to control the
2) Consensual: Agent and Principal must both agree
to the relationship. Principal can only control the
Agent who consents to the control.
No writing is required, mere consent by conduct is
Example: AB Furniture Store (a partnership) hires C to
deliver furniture and drive truck.
1) AB Furniture Store = Employer = Principal
2) C = Employee = Agent
3) C is an employee of the furniture store and is
under the control of the business and under the
supervision of AB Furniture Store.
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Example: What happens if C is hired to be night manager?
C is hired o B can go home at nights. Is there a difference
between hiring C to drive a truck vs. hiring C to manage?
1) Still principal-agent relationship.
2) C now has more decisions more directly
impacting the profitability of the business.
3) C needs to be given enough incentives to act in A
and B’s best interest.
4) C has to be more trustworthy.
b. Scope of Agent’s Authority: Actual Authority and Apparent
General Rule: An agent can bind the Principal if the
Agent has Actual or Apparent Authority to Transact.
ii. Actual Authority: Defined boundaries in the scope of
the duty
1) Look to the writing
(a) Partnership agreements, or
(b) Executive Committees
(c) Board of Directors Resolution
(d) Bylaws
2) Implied Authority is authority inherent in the
iii. Apparent Authority: Exists if it is reasonable for the
third party to conclude that A has the authority to bind
the entity.
1) Factual Inquiry asking how Principal holds Agent
2) Cannot contract this away.
3) This is based on the perception of the 3rd party.
4) UPA §16 Partnership by Estoppel
Example: What if C, the night manager, who has been
explicitly told NOT to make any purchases on behalf of the
Furniture Store is working one night when a vendor of
Cuckoo Clocks comes to solicit business. Despite the lack
of actual authority, C enters into an agreement with the
vendor to purchase 10 cuckoo clocks. Is the store bound to
the agreement?
1) C has no actual authority
2) Does C have apparent authority?
(a) Factual Inquiry: did the vendor have
a reasonable belief that C could bind
the store?
(b) What was C wearing?
(c) Did C look like the manager?
(d) Did the vendor believe that C had the
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(e) Was the vendor on notice that C had
no such authority?
c. Doctrine of Respondeat Superior
Example: What happens if while C is driving a truck C hits
a pedestrian, V?
1) Respondeat Superior: AB Furniture Store may be
liable to V based on the principle that the accident
occurred while C was in the course and scope of
2) If V wants to sue, he can sue C, AB Furniture
Store, and A and B individually if the partnership
does not have enough assets.
3) If AB Furniture Store is incorporated, the
corporation is the only entity that can be sued as
long as the Corporate Veil of limited liability is in
d. Risks and Control: Incentives and Monitoring
The amount of discretion given to an agent can be lowered
by increasing the level of specificity.
1) However, there is a cost to increasing the level of
specificity.  Transaction Costs
(a) Can increase specificity by making
an employment manual.
(b) Apparent Authority can be
eliminated by putting 3rd parties on
notice of the agent’s actual authority.
ii. The Principal may seek to create an incentive to the Agent
to align their interests.
1) May create profit incentives for the Agent.
2) Ownership interest short of partnership.
3) The problem with this is that by giving the Agent
these interests in the store, A and B’s business
interests will be diluted.
iii. However, the Separation of Ownership from Control
gives rise to agency costs.
1) The principal must retain a right to information
to monitor investment from being squandered.
2) However, the principal must then also retain the
Right to intervene/Veto Power.
(a) What good is the right to information
if there is no right to intervene.
e. Importance of Fiduciary Duty Law
Fiduciary Duty arises in every agency relationship.
ii. The scope of the fiduciary duty depends on the legal
iii. Look at the expectations of the parties.
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1) If less than a breach of fiduciary duty, then
business ethics issue.
Klein and Coffee specialization of economic functions
maximize the organization of a company by separating
ownership and management although agency costs arise as
a result of unanticipated contingencies when ownership is
separated from control.
Trust is part of every agency relationship and fiduciary
duty law creates implicit duties and is used as a gap filler
for the responsibilities each person/entity in the relationship
owes to the other.
Choice of Business Entity
A. The General Partnership
1. Formation and the Need for a Written Agreement
a. The formation of a partnership does not require a written
b. However, an agreement in writing provides the parties with a
substantial number of benefits.
2. Sharing of Profits and Losses
a. A partnership agreement can provide for any method of sharing
profits and losses.
Where the agreement fails to provide for a particular
division of profits and losses, the UPA Controls.
1) UPA §18(a)
“A partner is to share in profits equally and
in losses according to his share in the
b. Partners are jointly and severally liable for the debts of the
3. Inadvertent Partnerships
a. A partnership may be implied from the conduct of the parties.
Martin v. Peyton (154): lenders investing in a nearbankrupt partnership were granted profit sharing and some
management rights until they were repaid. When the
partnership defaulted on debts, a creditor sued the lenders,
contending their rights made them partners and personally
liable for partnership debts.
1) Just receiving profits is prima facie evidence of a
partnership unless it is a loan [UPA §7(4)(d)].
(a) In this case the profits were to be
paid with a cap and floor and do not
continue indefinitely.
(b) There is a limited interest in the total
(c) No open-endedness
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(d) Length of the relationship is limited
to the date from which the loan must
be paid.
2) There is an option to purchase and interest in the
partnership suggesting that the creditors are not
(a) Preserves the intent of the agreement
which specifically states that this is
NOT a partnership.
(b) ***Suggests that intent is no
irrelevant, but the courts will look
beyond it***
b. Negative Rights of Control v. Affirmative Rights of Control
 ????Does one type make the partnership more likely????
Negative Rights
1) Protecting your interest?  Less likely that it will
be a partnership.
ii. Affirmative Rights
4. Management of Partnership Business – UPA §9, 15, 18
a. UPA §18 states that each partner has the right in management and
the conduct of the business and if the partners cannot agree with
each other, the business will do nothing because both parties have
the right to exercise control and exercise his/her veto power.
5. Duties of Partners to Each Other
a. Fiduciary Duty is an implied term of agency.
2 elements of Fiduciary Duty
1) Duty of Care: to promote the interest of the
2) Duty of Loyalty: to put the company’s interest
above the individual’s interest and not enrich
him/herself at the cost of the company.
b. Meinhard v. Salmon (80): Salmon and Meinhard are joint
venturers. They enter into a 20 year lease. 4 months before the
lease is over Salmon is offered a profitable lease which he accepts
under his wholly owned subsidiary, Salmon Corp.
Meinhard sues Salmon for breach of fiduciary duty.
1) Duty of loyalty case.
ii. Salmon had a duty of full and adequate disclosure of all the
facts to Meinhard.
1) Salmon can enter into an agreement with Gerry
but he must inform Meinhard of the opportunity.
iii. The breach of duty in this case came from the failure to
Cardozo’s point is that Salmon does not have to share the
opportunity Meinhard, but Salmon is obligated to notify
Meinhard of the opportunity.
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Meinhard gets the benefit of hindsight because if Salmon
had made a loss, Salmon would not be able to go after
Meinhard to share in the losses.
1) Cardozo is creating incentives for partners to
Dissenting Opinion
1) The dissent says that fiduciary duty law is a gap
filler when the agreement is silent, but the gap is
filled at the time of the agreement.
2) The contract is the end all and be all.
Cardozo does not ignore the agreement, but looks to the
duty of loyalty which he states was breached by Salmon
when he failed to disclose that he had entered into an
agreement with Gerry.
viii. Salmon could have terminated the partnership and entered
into the agreement, but Salmon did so when the partnership
was still in effect and when it was continuing.
6. Dissolution of General Partnership – UPA §29, 31
a. UPA §29 Dissolution Defined
The dissolution of a partnership is the change in the relation
of the partners caused by any partner ceasing to be
associated in the carrying on as distinguished from the
winding up of the business.
b. UPA §30 Partnership Not Terminated by Dissolution
On dissolution the partnership is not terminated, but
continues until the winding up of partnership affairs is
c. UPA §31 Causes of Dissolution
Dissolution is caused:
1) Without violation of the agreement between the
(a) By the termination of the definite
term or particular undertaking
specified in the agreement,
(b) By the express will of any partner
when no definite term or particular
undertaking is specified,
(c) By the express will of all the partners
who have not assigned their interests
or suffered them to be charged for
their separate debts, either before or
after the the termination of any
specified term or particular
(d) By the expulsion of any partner from
the business bona fide in accordance
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with such power conferred by the
agreement between the partners;
2) In contravention of the agreement between the
partners, where the circumstances do not permit a
dissolution under any other provision of this
section, by the express will of any partner at any
3) By any event which makes it unlawful for the
business of the partnership to be carried on or for
the members to carry it on in partnership
4) By the death of any partner
5) By the bankruptcy of any partner or the
6) By decree of the court under section 32.
7. Law Firm Partnerships
8. Limited Liability Partnerships (LLPs)
B. Fundamental Considerations in Choice of Entity Decisions
1. Limited Liability
a. One of 2 dominant considerations in choosing form of organization
b. Incorporation offers the corporate shield of liability.
c. There are other ways to protect individual investors from
individual liability aside from incorporation
An investor can contract to shift the loss
ii. An investor could be a limited partner in a limited
iii. An investor could buy insurance
2. Informality, Flexibility and Cost of Operation and Formation
a. Flexibility and Cost of Operation
When there are gaps in the agreement, for partnerships, the
statute is the gap filler.
ii. To become a member of a partnership, all the members
have to assent to the new member.
iii. To obtain a partnership interest, the partner does not need
to make a capital investment.
1) Can obtain an interest by contributing money or
labor, etc.
Partnership rules are completely open-ended, which is not
true of corporations.
1) Partnership agreements may alter the default rule
and allow for greater flexibility within the
partnership, especially if it is a large firm.
2) Example: Gibson, Dunn and Crutcher probably
does not require the unanimous consent of the
partners to make a business decision.
The partnership may be organized hierarchically allowing
for specialization by the partners.
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b. Formation
A corporation is harder to form than a general partnership
ii. Cannot inadvertently form a corporation while a general
partnership may be inadvertently created.
iii. The formalities of forming a corporation are expensive and
time consuming.
A partnership does not need to qualify if it wants to form
another partnership in another state.
3. Continuity of Life
a. 2 Issues in Continuity
Legal Continuity
ii. Business Continuity
b. Partnership
The death of a partner terminates and dissolves the
partnership unless the agreement provides otherwise.
ii. The business may continue, but the death of the partner has
terminated the partnership and the partnership may
liquidate the business, form a new partnership between the
dead partner’s heirs and the live partner, or the live partner
can buy out the dead partner’s heirs’ interest in the business.
iii. Survivorship Clause: the default rule for partnerships is that
they terminate/dissolve with the death of a partner. The
default may be contracted away with a survivorship clause
stating the entity survives the death of the partners.
c. Corporation
The death of a shareholder has no legal effect on the legal
continuity of the corporation.
1) The corporation is a legally separate entity and
survives the death of its shareholders.
2) The dead shareholder’s stock goes to his estate
because they are transferable and the corporation
continues to exist and there is no dissolution.
4. Centralization of Management
a. Partnership
Not all partners have equal rights of management
ii. People in the committees get appointed by the partners and
the partnership agreement may set up a hierarchy.
iii. The hierarchical structure is not the default rule in
partnerships; rather, it must be agreed upon.
The larger and more complex the economic enterprise the
more difficult it will be to establish.
b. Corporations
There is a basic corporate structure.
1) Shareholders
Elect the Board of Directors
2) Board of Directors
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Appoint the Officers
3) Officers
Engage in the day-to-day business affairs to
further the larger business objectives of the
Board of Directors.
ii. Each level of management is not mutually exclusive.
1) A shareholder may be a board member (and often
is), etc.
5. Free Transferability of Interests
a. Partnership
Partnerships require unanimity under the UPA to add a
partner to the entity or to substitute somebody into the
partnership as a new partner.
ii. One of the partners can choose to get out of the partnership
and dissolve the partnership or get another partner to buy
out his interest.
1) Interests are not freely transferable at the whim of
the partner.
b. Corporation
For a shareholder to leave the corporation, he has to be able
to find someone to buy his shares.
ii. When dealing with a large publicly held corporation, this is
not a problem and there is probably a free transferability of
interests; the problem is for closely held corporations.
C. The Corporation vs. The Partnerships: Reflecting on Certain Basic Federal
Income Tax Considerations
1. Income Tax vs. Capital Gains Tax
2. Entity Level Taxation vs. Conduit (or “flow through”) Taxation
a. Proprietorship
Not a separate taxable legal entity.
ii. Owners of sole proprietorships must pay the Self
Employment Contributions Act (SECA) of 1954 tax.
b. Unincorporated Business Forms (Partnerships)
An unincorporated business entity that has a single owner
generally will be disregarded as an entity separate from its
owner for federal income tax purposes unless the entity
elects to be classified for federal income tax purposes as a
corporation (i.e. “check the box”).  ????LLCs Only?????
ii. A partnership does not pay any tax.
1) The income or loss reported by a partnership is
“passed through” to the partners.
2) There is no entity level taxation.
3) However, individually, a general partner must pay
the SECA tax whereas the limited partner may not
unless the payments constitute “guaranteed”
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SECA tax is applicable to earnings of individual members
of the LLC to the extent attributable to a trade or business.
c. C Corporations
C corporations have their own special tax schedule.
ii. The corporate tax rate is in addition to the tax that the
shareholder must ultimately pay  Therefore, there is a
Double Taxation Burden.
d. S Corporations
Subchapter S of the Internal Revenue Code was to provide
relief from the double taxation treatment of C Corporations.
ii. Becoming an S corporation is an affirmative election by the
corporation and is not available to all closely held
iii. The election is a tax election and not a corporate law
election; the corporation possesses all of the normal
attributes of a corporation under state law, but is taxed in a
different way than C corporations.
1) No more than 75 individual shareholders
2) May not have a shareholder who is a nonresident
alien or a certain artificial entity; and
3) May not have issued more than one class of stock
(except for classes of common stock that differ
only in voting rights).
With a few exceptions, S Corporations have the basic flow
through treatment that partnerships and sole proprietorships
3. Strategies to Minimize Incidence of “Double-Taxation” Burden
a. Accumulation Bail Out Strategy  Pre-1986 Tax Strategy
Took advantage of the combined effect of the favorable
income tax rate on corporations plus the equally favorable
tax rate applicable to capital gains.
ii. The shareholder keeps the money in the business and pays
the lower tax on the income  Shifts the income from the
high tax payer to the person in the lower tax bracket.
iii. Example: A sells stock to C.
1) A = 100,000 basis (investment the seller of the
property has in the property).
2) A  C in stock for $1 million cash.
3) When A disposes his stocks he is going to gain $1
million (amount realized) - $100,000 (basis) =
$900,000 (Gain Realized).
The gain realized is NOT the same as
ordinary income.
The gain realized or the capital gain was
taxed at a lower rate than individual.
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4) Rather than receiving the distribution of $900,000
over the life of the investment period and pay high
individual taxes, A accumulated the amount in the
corporation, which paid less taxes, and then sold
the stock to receive the money as a capital gain.
The IRS and government applied an accumulation penalty
tax to deal with this strategy  Unreasonable
accumulations catch the eye of the government and subject
the corporation to this tax.
b. Zeroing Out Strategy
This strategy allows the corporation to avoid the corporate
ii. This strategy relies on the fact that while distributions in
the form of dividends are not deductible by corporations,
payments to shareholders in the form of salaries, rent and
interest are deductible by the corporation so long as they
are reasonable in amount.
iii. LIMITATION: may be subject to audit if zeroing out every
year.  Must show that the reason for the zeroing out is
D. Combination of Forms of Business Organization: Evolution of the Modern
Limited Partnerships with Corporate General Partner
1. Delaney v. Fidelity Lease Ltd. (Handout): Delaney is the landlord
plaintiff. Tenant is Fidelity (limited partnership). The general partner
is Interlease Corporation. There are 22 limited partners (19 doctors
and Crombie, Kahn, and Sanders). Crombie, Kahn and Sanders are
officers for Interlease Corp. Fidelity was going to operate a fast food
restaurant, but defaults. Delaney sues for breach of contract.
a. Delaney first sues Fidelity, but Fidelity is insolvent.
b. Delaney next sues Interlease, the general partnership, but Interlease
is also insolve.
c. Delaney sues the 3 officers of the corporation in their capacity as
limited partners.
d. Delaney points to evidence of control that makes the limited
partners liable.
The 3 officers exercised control by making management
1) The officers say that they were just acting as
officers of the corporation.  They were acting as
agents of the corporation and the lease was signed
with the explicit point that the officers were
signing in their capacity as officers.
There is no fraud.
2) The theory in this case was not to hold the officers
liable as shareholders by piercing the corporate
veil, but rather they are being sued as limited
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partners who violated ULPA §7 or RULPA §303
by exercising control.
The court finds that Delaney took a risk that the corporation would
not make a profit by leasing to a corporation with no assets.
Delaney is a stakeholder because he has bargained for a lower rent
in the beginning to escalate with the profitability of the business.
He is taking a risk that Fidelity may not make a profit.
Dissenting Opinion
The corporation cannot be a general partner.
ii. The statute says that a partnership can be dissolved by
retirement, death or insanity of a partner and so the partner
has to be a person.
iii. This is judicial activism because the statute does not
mention corporations. It is the job of the legislature to
change this law.
Breach of Fiduciary Duty Argument
1) The corporation cannot be the general partner
because Crombie, Kahn and Sanders are the sole
shareholders of Interlease (the general partner)
and they are also limited partners.
2) General partners have a duty to the Limited
Partner and the Officers of a Corporation owe a
duty to the corporation.
3) There is a conflict of interest because as officers
of a corporation and part of the limited
partnership, these 3 have divided loyalty.
Crombie, Kahn, and Sanders have a duty to
the corporation and to the limited
The dissent wants to establish a prophylactic
rule to eliminate the possibility of divided
4) However, the courts favor freedom of contract
and have allowed for situations that may give way
to potential conflicts of interest and have then
“filled in the gaps” with fiduciary duty law.
The court in this case looked at fundamental fairness and tried to
avoid giving Delaney a windfall because he bargained for this risk.
Under RULPA §303 the limited partner is only liable to
persons who transact business with the limited partnership
and reasonably believe that the limited partner is a general
In this case, Delaney knew for a fact that he was not
dealing with a corporation through Crombie, Kahn and
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RULPA §303(b) is a safe harbor provision that states that
you are not participating in the control of the business by
being a contractor for or an agent or employee f the limited
partnership or of a general partner or being an officer,
director or shareholder of a corporation that is a general
partner in a limited partnership.
j. When this case reached the Supreme Court, it agreed with the
dissent that a corporation could not serve as a general partner.
2. Mt. Vernon Savings and Loan v. Partridge Assoc. (Handout): Partridge
Associates is a limited partnership. American Housing is the General
Partner and MIW is 50% limited partner. Partridge enters into a
contract from a loan with Mount Vernon Savings and Loan. FSLIC is
the federal agency that insured the deposits of Mount Vernon Savings
and Loan and became the successor in interest after the Savings and
Loan Scandal. Partridge defaults on its loan and the General Partner,
American Housing, is insolvent.
a. FSLIC sues MIW under the theory that MIW has exercised
sufficient control to be liable as a general partner.
b. MIW defense is that it did not exercise sufficient control to make
them a general partner.
ULPA §7: a limited partner shall not become liable as a
general partner unless, in addition to the exercise of his
rights and powers as a limited partner, he takes part in
the control of the business.
c. The court applies a 2 pronged test
Did Mount Vernon have actual knowledge when dealing
with Partridge that MIW was acting as more than a limited
1) MIW is going to point to the fact that prior to the
time when American Housing stopped making
loan payments, MIW’s president was not present
at the meetings.
2) Only after the default of payments did MIW’s
president go to the meetings.  At this point,
MIW has lost trust and confident in American
Housing Corp. as the general partner.
3) There is no evidence that MIW actually exercised
control at these meetings.
4) There is no evidence to suggest that Mount
Vernon relied on MIW as a general partner or was
in any way misled by MIW.
ii. Was MIW’s participation in the control of Partridge
Associations substantially the same as the exercise of the
powers of a general partner?
1) As a practical matter, MIW went to the meetings
as a gesture to American Housing Corp.
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2) MIW went to the meetings to exert influence and
pressure on the actual decision maker—American
Housing Corp.
d. The court in this case found that a limited partner will become
liable as a general partner if he transacts business with third parties
who have actual knowledge that the limited partner is exercising
There is no evidence of this in this case.
e. The limited partner could also be liable if the exercise of control by
the limited partner was substantially the same as that of the general
There is no evidence of this.
ii. The public policy behind this is to preserve the integrity of
the statute.
1) The shield of limited liability is granted by the
state and it requires that a limited partner cannot
take part in the control of the partnership.
2) Therefore, if a limited partner wants the limited
liability shield, he/she/it cannot usurp the state’s
authority by receiving the limited liability shield
even though acting as a general partner.
f. What would the majority in Delaney think of this case?
Majority would not have imposed liability because the
majority would only impose liability if Mount Vernon had
relied on MIW’s actions/control as a general partner.
ii. No liability without 3rd party reliance.
1) ULPA §7 had no 3rd party reliance
requirement, but Delaney required it to prevent
Delaney from getting a windfall.
2) Under RULPA §303 the law holds limited
partners liable when there is reliance by the 3rd
party that the limited partner is a general
As a matter of public policy the limited
partner is treated as a general partner only
when the 3rd party transacts business with
the limited partnership reasonably believing,
based upon the limited partner’s conduct,
that the limited partner is a general partner.
3) California §15632 is the equivalent of RULPA
California has additional language “based
upon the limited partner’s conduct” and
unsure as to whether that increases or
decreases the burden.
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The burden is now on the P to prove conduct
of limited partner and the P has to show that
the LP’s conduct was reasonably interpreted
as GP’s conduct.
iii. So long as the P is entering into the transaction with full
disclosure, the P is also assuming the risk.
1) The law is moving away from the notion that the
general partner is the “deep pocket”
2) And rather than the “integrity of the statute”
argument, the law has moved towards 3rd party
3. Limited Liability Partnerships
a. Part of the General Partnership Statutes.
California LLP provision begins at §16306.
ii. Allows for limited liability for the malpractice of your
partners, but not your own malpractice or your team’s
malpractice if you are the supervising attorney.
iii. Scope of LLP is unclear.
b. To be a LLP, must register with the Secretary of State and usually
put up some sort of bond.
4. Scope of Fiduciary Duty in Modern Limited Partnership
a. In Re USA Cafes, L. P. Litigation
5. The IRS “Check the Box” Regulations
History of the Corporation: Development of Corporation Law in the United States
A. Race of the Lax: Competition for State Incorporation Business
1. The corporation was originally created to allow for an entity that could
last forever separate and apart from the lives of the owners.
2. The industrial revolution created the need for limited liability.
a. This goal was established through special charters granted by the
Crown and State Legislatures.
3. The race of the lax refers to the competition between states to recruit
incorporation business.
4. States compete with one another in designing their laws.
B. Implications of the Separation of Ownership from Control
1. What is the cost of A leaving B in control of the furniture store and
traveling the world.
2. In a corporation, there is separation of ownership of the business from
managerial control.  What are the costs of monitoring and aligning
the incentives of the management with ownership?
C. Influence of Delaware Law
1. The Modern Corporation Code as Enabling vs. Regulatory
a. Enabling: facilitates incorporation.
b. Regulatory: regulates incorporation and requires knowledge of the
2. Goals of the RMBCA
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D. Internal Affairs Doctrine and California Corporations Code §2115
1. According to California Corporations Code §2115 there are 2 types of
a. Foreign
Corporations incorporated in another state/country.
ii. If a foreign corporation, must register/apply to do business
in CA.
iii. Quasi-Foreign Corporations
1) Internal Affairs Doctrine states that the
company’s internal affairs are governed by the
rules of the state in which the company is
2) In CA, this is true unless the corporation meets
the triple 50% test, then it is a quasi-foreign
corporation and the internal affairs of the
company are governed by CA statute.
- more than 50% of payroll
- more than 50% of property, AND
- more than 50% of sales
3) The reason for this rule in CA is to protect CA
corporations and CA believes that the listed
sections of the CA code are superior than other
states’ laws.
4) The theory is similar to minimum contacts.  So
much of the foreign corp.’s business is in CA so
that CA state slaw should be applied.
b. Domestic
Incorporated in CA.
E. Theories of Corporateness
1. Separate Entity Theory
a. Corporations are separate legal entities.
b. The separate entity status gives the entity all the rights of a natural
2. Realist Theory
a. The entity is really the identity of its individual investors
This may be true for AB Furniture Store and closely held
corporations, but is it true for Disney and other publicly
held corporations?
3. Contract Theory
a. The corporations code is an “off the rack” set of rules.
You opt into these set of rules by picking the state you
incorporate in and if you don’t like some things, you can
for the most part make alterations in your articles of
b. There is some manifestation of the idea that the corporations are
opting into the set of rules in the state.
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c. Economists have a nexus of contract theory that all employees
have an input in the company and the company is nothing more
than a nexus of all the inputs into the corporation.
The corporation comprises of contracts between different
groups, e.g. employees, shareholders, directors, officers, etc.
F. What is the Future?
Forming a New Corporation
The Incorporation Process and Its Pitfalls
A. Articles of Incorporation of Royal Plumbing Service, Inc. Hypothetical
1. Name
a. Choosing a Name
RMBCA §4.01(c)(2)
1) As long as the name of the company is not the
same as another company’s it will be accepted.
Gives less discretion to the Secretary of
More predictability.
Movement towards the Model Act to
encourage incorporation in the state over
other states.
ii. CA §201
1) The secretary of state may require the company to
change its name if it is too similar to another
company’s name because it may be deceptive or
Secretary of State has less discretion.
b. Reserving the Name  Reserve name to prevent another person
from incorporating under the same name, but it is valid for a
limited time to allow people from indefinitely reserving a name
and forming the business.
RMCBA §4.02
ii. CA §201(c)
c. Registering a Name  Required for foreign companies to register
their name in the state of business every year.
RMBCA §4.03
ii. CA §201
1) CA §110  Filing of Instruments, Date,
Endorsement, Requested Future Date, Return
for Failure to Conform to law, Resubmission,
Delayed Effective Date, Revocation
2. Duration
a. Unless the duration is limited by the Articles of Incorporation, the
life of the corporation continues indefinitely.
MBCA §3.02
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ii. CA §200(c)
b. If the corporation originally has a limited duration, the corporation
can amend the Articles under CA Chapter 9 if it wants to continue
the life of the corporation beyond that which it was limited to.
Can amend, but need the approval of the shareholders.
ii. Also, the Secretary of State must be notified of the
iii. Sometimes, if the corporation is limited and the corporation
continues without amendment, the law may recognize that
the corporation has continued, but someone could use the
life clause to argue that the corporation has been terminated.
a. General Purpose Clause unless you want to limit the purpose of the
b. If limited purposes, the ultra vires rules may apply.
a. In California, a corporation has all the powers of a natural person
unless the language in the Articles limits the powers of the
a. Mandatory Provision
RMBCA §2.02  There is no minimum capitalization
requirement because the RMBCA is an enabling statute.
ii. CA §202(d) and (e)
**Intentionally Omitted**
a. RMBCA §8.03
Need 1 or more directors to form a corporation
b. CA Code §212
Need just 1 director before the shares are issued to the
investors and need 3 directors after the shares are issued.
1) Blackstone: Need 3 directors to have a
2) CA EXCEPTION: if there is only 1 shareholder
or there are 2 shareholders, the code permits
having only 2 directors.
ii. CA §212 states if there are only 2 investors, need 3
directors to have a corporation. However, rather than
recruit a third body, the fight will be who gets to select the
3rd director.
1) Consequently, as a practical matter, when there
are 2 investors, there will be 4 directors.
c. Directors must be natural persons, but an incorporator may be
anybody, including a corporation, partnership or any entity.
Definition of a Person
1) RMBCA §1.40
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2) CA §200(a)
8. Limitation on Director Liability
9. Indemnification
10. Interested Officers and Directors
11. Signatures of the Parties
12. Verification and Acknowledgement
By-Laws are internal operating procedures for the company.
1. Not public record like the Articles of Incorporation.
Mandatory Provisions of the Articles of Incorporation
1. RMBCA §2.02(a)
2. CA §202
Option Provisions of the Articles of Incorporation
1. RMBCA §2.02(b)
2. CA §204
Incorporation Procedures: Formation of a Corporation
1. Where to Incorporate
a. Race of the Lax
b. For large publicly owned corporations, Delaware will probably be
the best choice, but for small, closely held corporations, should
incorporate in the principal state of business.
2. Preparation and Filing of the Articles of Incorporation
a. File with the Secretary of State’s Office
3. Post-Filing Procedures
Corporation’s Purposes and Powers: The Decline of the Ultra Vires Doctrine
1. The Articles of Incorporation must state the purpose of the business.
2. The Articles of Incorporation used to require narrow and specific
purposes that stated the specificity of the business.
a. When the purposes and powers of the Corporation were narrowly
construed, the Ultra Vires Doctrine was a doctrine through which
one could assert that the Corporation had gone beyond their
purpose or powers.
Ultra Vires Doctrine: “Beyond the Power.” An ultra
vires act or contract is one that is beyond the powers
expressly or impliedly conferred upon a corporation.
Applies to acts of a fully organized corporation.
3. 711 Kings Highway Corp. v. FIM’s Marine Repair Services, Inc. (277):
711 leased premises to FIM to operate a movie theater. FIM’s articles
state that their purpose is to conduct marine services. Landlord 711
sues FIM to prevent them from operating the movie theater and to
invalidate the lease.
a. The general rule today is that any business can do what they
want to today and engage in any lawful business activity.
b. To bring an ultra vires claim, must conform to RMBCA §3.04.
There is a proceeding by the Attorney General under
1) Rarely Happens
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There is a proceeding by a shareholder against the
corporation to enjoin the act
1) Ultra vires may be brought by a shareholder to
preserve the shareholder’s idea of what the
corporation should be engaged in.
2) Equitable Relief  RMBCA §3.04(c)
3) The landlord has constructive notice because the
Articles of Incorporation were publicly
filed/recorded.  If the shareholders want to
bring a motion to enjoin, the Landlord must be a
party to it as well because “all affected persons”
must be parties to the proceedings.
iii. There is a proceeding by the corporation, directly,
derivatively or through a receiver, trustee or other legal
representative, against an incumbent or former director,
officer, employee, or agent of the corporation.
4. Theodora Holding Corporation v. Henderson (280): Corporation Alex
Dawson, Inc. made a charitable donation to Charity Alex Dawson
Foundation. Minority Shareholder Theodora Holding Corp. sues
derivatively as well as on its own behalf for losses allegedly sustained by
the corporate Defendant as a result of the charitable gift.
a. The court found that a corporation may make reasonable charitable
Reasonableness is defined by the IRS codes/deductions.
G. Premature Commencement of Business: Liability on Pre-Incorporation
1. Promoter’s Liability on Pre-Incorporation Contracts
a. Stanley J. How & Associates, Inc. v. Boss (288): Boss (Promoter)
entered into an agreement with How on behalf of a yet to be
formed corporation. Boss is going to start a corporation to form a
chain of hotels and How is going to design them as the architect.
When the contract is entered into by How and Boss, Boss signs as
“Edwin A. Boss, agent for a Minnesota corporation to be formed
who will be the obligor.” Boss does not sign as Boss Hotel, Inc.
because the corporation has not yet been formed.
There is a breach of contract and Boss argues that the
corporation is liable, not him.
ii. The corporation is insolvent and How cannot collect
against the corporation.
iii. The manner in which Boss signed the contract is
ambiguous and the intent is unclear.
The court states that there are 4 different interpretations of
this ambiguity.
1) One party is making a revocable offer to the
nonexistent corporation which will result in a
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contract if the corporation is formed and
accepts the offer prior to the withdrawal.
The offer comes from the architect and the
architect started performance on the contract
and so the court does not accept the
revocable offer theory.
2) A party is making an irrevocable offer for a
limited time.
Consideration to support the promise to keep
the offer open can be found in an express or
limited promise by the promoter to organize
the corporation and use his best efforts to
cause it to accept the offer.
The contract will be formed only upon the
formation of the corporation and the
corporation’s acceptance of How’s offer.
Architect started performance on the
contract almost immediately and did not
wait for the formation of the corporation
suggesting the contract was between How
and Boss (not the corporation).
3) The parties agree to a present contract by
which the promoter is bound, but with an
agreement that his liability terminates if the
corporation is formed and manifests its
willingness to become a party. There can be no
ratification by the newly formed corporation
since it was not in existence when the
agreement was made.
When the corporation is formed and agrees
to enter into the contract, the promoter is
released from liability.
4) They agree to a present contract on which,
even though the corporation becomes a party,
the promoter remains liable either primarily or
as surety for the performance of the
corporation’s obligations.
Boss is not released from liability.
If the company does not pay, the corporation
and Boss can be sued.  Boss can sue the
corporation for equitable indemnification.
The court favors interpretations 3 and 4 in this case because
How had already begun performance on the contract.
Rule of Personal Liability: The promoter is personally
liable unless the parties manifestly contract that Boss
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will NOT be liable and that the corporation yet to be
formed will be liable.
1) The default rule is personal liability for the
b. Quaker Hill, Inc. v. Parr (293 and Handout): Parr is the promoter
of a yet to be formed corporation, Denver Memorial Inc. Parr
signs an agreement with Quaker Hill, Inc. on behalf of the
Quaker Hill sued Denver Memorial, but since it never came
into existence, sued the promoter, Parr.
ii. Default Rule: Rule of Personal Liability
1) Parr hast eh burden of proving that he is not
personally liable.
2) For Parr to not be liable, he has to show that there
was an agreement that Quaker Hill would only
look to the corporation for payment.
iii. The court in this case found that there was no promoter
liability because the Quaker Hill knew that the corporation
was not formed and Quaker Hill’s salesman, Barker,
nonetheless, urged signing the agreement.
c. In the above 2 cases, the court seems to be saying “He who could
have prevented the harm must be liable for it.”
In Boss, the promoter could have avoided the liability by
waiting to sign the contract until the corporation was
formed. So, between How and Boss, Boss was the one who
could have prevented the harm and must bear the
responsibility for the resulting injury.
ii. In Quaker Hill, the vendor could have avoided the harm by
waiting for the corporation to form before signing the
d. Releasing Promoters from Liability
Goldman v. Darden (294, Note 6)
1) “We do not believe the agreement to release a
promoter from liability must say in so many
words, ‘I agree to release.’ Where the promoter
cannot show an express agreement, existence of
the agreement to release him from liability may be
shown by circumstances. Of course, where
circumstantial evidence is relied on, the
circumstances must be such as to make it
reasonably certain that the parties intended to and
did enter into the agreement.”
2. Corporation’s Liability on Pre-Incorporation Contracts
a. MacArthur v. Times Printing Co. (Handout): Nimocks is the
promoter for Times Printing and enters into an employment
contract with MacArthur. MacArthur is to be the Advertising
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solicitor for the newspaperfor one year, but is fired and sues for
breach of contract.
The corporation argues that the agreement was entered into
before the corporation was formed and so the promoter is
personally liable.
ii. When the newspaper is formed, it does not become
automatically liable unless the corporation adopts the
agreement (most often expressly).
1) However, the promoters liability is not
automatically released by the corporation’s
2) The promoter should get a release by the
corporation and by the other party in the contract
to assure that he/she has been released from
iii. Although the contract is signed by Nimocks, there is
evidence that all of the stockholders, directors and officers
of the corporation knew of the contract at the time of its
organization or were informed of it soon afterwards and
none of them objected or repudiated it, but retained P in the
employment of the company without any other or new
1) Therefore, the court finds that although the
contract between Nimocks and MacArthur did not
bind the corporation, the corporation acquiesced
to the contract through their subsequent actions. It
adopted the contract and accepted liability.
MacArthur could have probably sued the promoter but
wanted to sue the corporation because the corporation has
H. Defective Incorporation
1. De Jure Corporations
a. Official Corporation recognized by the State and Certificate of
b. That which exists by reason of full compliance by
incorporators with requirements of an existing law permitting
organization of such corporation.
c. Properly formed corporations.
d. Can be a de jure corporation without by-laws because by-laws are
NOT required to form a corporation.
2. De Facto Corporations
a. An association claiming to be a legally incorporated company,
and exercising the power and functions of a corporation, but
without actual lawful authority to do so.
b. De Facto Corporation Requirements
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A valid law under which such a corporation can be lawfully
ii. An attempt to organize thereunder
iii. Actual use of the corporate franchise
Good faith in claiming to be and in doing business as a
corporation is often added as a further condition.
3. Corporations by Estoppel
a. A corporation which comes about when parties, by their
agreements or conduct, estop themselves from denying the
existence of the corporation.
4. Robertson v. Levy (297): Robertson and Levy entered into an
agreement. Levy was to form corporation Penn Ave. Record Shack, Inc.,
which was going to purchase Robertson’s business. Levy submitted the
Articles of Incorporation to the Secretary of State, but a Certificate was
not issued and the Articles were rejected on Jan. 2, 1962. On Jan. 8,
Robertson executed a bill of sale to Penn Ave. Record Shack, Inc. the
Certificate of Incorporation was issued on Jan. 17, 1962. In July, the
corporation stopped paying lease.
a. It was up to Levy to form the corporation and the corporation was
going to use a note providing for installments payments to pay for
the purchase of Penn Ave. Record Shack, Inc.
b. Robertson did not know that the corporation was not in existence
when he entered into the contract with Levy.
c. The court found that Levy was liable for the breach of contract to
Robertson because he had no authority to act but did so.
d. Model Act §50: De Facto Corporations
RMBCA §2.03 Eliminates de facto corporations.
e. Model Act §139: Corporation by Estoppel
RMBCA §2.04 “All person purporting to act as or on
behalf of a corporation, knowing there was no
incorporation under this Act, are jointly and severally liable
for all liabilities created while so acting.
f. The trial court had found that Levy had no liability under the
estoppel theory.
Robertson bargained on the risk.
ii. Robertson was looking to the corporation for payment on
the note.
iii. Robertson, by not obtaining a personal guarantee from
Levy assumed the risk.
5. Cantor v. Sunshine Greenery, Inc. (handout): Cantor (P) sued Brunetti,
officer/promoter of Sunshine Greenery, Inc. for a lease agreement.
Brunetti had signed a certificate of incorporation on Dec. 3 and mailed
it to the Secretary of State on the same date with a check for the filing
fee, but for some reason the filing was not immediate and there was no
de jure corporation until Dec. 18, 2 days after the execution of the lease.
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a. The court found that there is no personal liability under the De
Facto Corporation Doctrine.
b. The P cannot attack the promoter because there was a good faith
delay, and D honestly believed there was a corporation in place.
The shield is placed to protect D from P.
ii. If de facto corporation, the state can sue the corporation,
but nobody else can.
1) The state can sue because it is the one who grants
the right of a business entity to be a corporation.
c. Many states are trying to eliminate the de facto doctrine.
6. Cranson v. International Business Machines Corp. (handout): Cranson
goes to the attorney to form a corporation, signs the articles of
incorporation and then enter into a contract to buy computers from IBM.
The lawyer does not file the articles of incorporation.
a. There was no effort made to organize the entity as a corporation.
b. The court allocates the consequences of the mistake.
c. Cranson argues that there is a shield of limited liability because of
the corporation, but IBM responds that there is no shield because
there is no de jure corporation.
d. Cranson, then argues that his corporation is a de facto corporation.
Cranson has difficulty arguing that he has the shield of
limited liability as a de facto corporation
1) There is no good faith effort to incorporate under
the existing law.
e. Cranson will then argue Corporation by Estoppel.
Equitable Doctrine.
ii. Cranson was holding himself out as a de jure corporation,
IBM was relying on the representation and now IBM is
estopped from denying the corporation’s existence.
1) The party making the representation is not the one
that is estopped from talking about the truth of the
iii. Cranson did not have knowledge that the Articles of
Incorporation were defective or not issued, whereas Levy
knew of the defective incorporation.
f. In CA, where there is no de facto corporation doctrine, the state
still holds onto an estoppel doctrine because there may be equitable
If a corporation by estoppel, the shield is not against
everyone, but just the person who reasonably relied.
ii. If a de facto corporation, the state can take action against
the corporation whereas the rest of the community cannot.
iii. If a de jure corporation, then P would have to pierce the
corporate veil.
1) However, if like Cranson, since he was in the best
position to make sure that there was correct
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incorporation, against a 3rd party, the corporate
veil would probably be pierced and Cranson
would probably be liable.
7. Frontier Refining Company v. Kunkel’s, Inc. (310): Kunkel wants to
start a gas station and is financed by Fairfield and Beach. Kunkel
enters into a contract with Frontier Refining Co. The contract is signed
by “Clifford D. Kunkel dba Kunkel’s, Inc.” Frontier Refining Co.
contemplated getting paid on a COD (Cash on Delivery) basis but the
delivery man did not collect the money. Kunkel, Inc. started doing
poorly and Frontier sues Kunkel, Beach and Fairfield.
a. There was no actual incorporation and so Frontier claims that
Kunkel, Fairfield and Beach were general partners.
b. The court found that Beach and Fairfield were not liable.
The court found that Beach and Fairfield were inactive
investors and because they did not know that they were not
incorporated, there is no intent and they did not hold
themselves as a corporation.  They did not purport to
act, Kunkel did.
c. A decisive element in this case is the intent of Frontier and
Kunkel, Inc. because Frontier would have gotten a windfall.
Frontier did not get paid because they made a mistake and
did not collect upon delivery.
ii. Frontier’s mistake and failure to internally control the
payments led to the error.
iii. Frontier only became aware of Beach and Fairfield
sometime after they had cut off credit to Kunkel and
wanted money.
d. Beach and Fairfield are not liable as promoters because Frontier
never relied on them and to hold Beach and Fairfield liable,
Frontier would have the burden of showing that they relied on
Beach and Fairfield for payment should the corporation default.
e. Estoppel does not apply because Kunkel, Inc. was involved in the
dealings and Fairfield and Beach were not involved.
f. There is an argument that Beach and Fairfield should have
followed up if they really had wanted the shield of limited liability
and should have checked to make sure that Kunkel incorporated.
I. Promoter’s Fiduciary Duties
1. Frick v. Howard (Handout): Preston bought land with the intent of
opening a hotel on the land. He enters into a contract to purchase for
$240,000. On April 1, 1958, he formed a corporation, Pan American
Motel, Inc. After he formed the corporation, he took title to the property
and Pan American bought the property from Preston for $350,000 with
a $110,000 note. The directors who approved this transaction were
Preston, his wife and his attorney. Later on, no payments were made on
the note and the company took back the $110,000 note and substituted a
$145,000 note which is sold to Frick. Preston collects $72,500 from
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Frick in December and in January Pan American goes bankrupt. Frick
sues Pan American, Inc. because Frick is a secured creditor. Howard is
the Receiver and is suing to stop the foreclosure of the property because
he doesn’t want Frick to take over the property.
a. Howard tried to prevent the sale of the property by invalidating the
transaction between Preston and the Corporation.
b. The court says that if Preston wants to engage in this transaction,
he must disclose all the material facts to creditors and future
Like Meinhard v. Salmon.
ii. Full and adequate disclosure is required.
Piercing the Corporate Veil: Risks of Corporateness Being Disregarded
A. These cases begin on the premise that the corporation is a de jure corporation.
B. The Common Law Doctrine
1. Contract Creditor Cases
a. Bartle v. Home Owners Corp. (315): Westerlea, Inc. was
established by Home Owners Corp. to build homes for war
veterans. Westerlea, Inc. went bankrupt and P (bankruptcy
trustee) seeks to pierce the corporate veil and hold Home Owners
Corp. liable for Westerlea’s debts because the homes built by
Westerlea were to be sold to Home’s shareholders for a fixed
amount so that Westerlea would never make a profit.
Basic Standard for Piercing: Must show fraud and
fundamental unfairness to pierce the corporate veil.
ii. The court found that there was no fraud because WEsterlea
never misled, confused, etc. the contractors
iii. The court found that there was no illegality.
1) When doing business with a company, there is an
assumption that the company is established to
make profits and so there is fraud.
2) The corporate veil should be pierced.
b. Dewitt Truck Brothers v. W. Ray Flemming Fruit Co. (317):
Flemming is an agent between the fruit growers and the markets.
Flemming hires truckers to transport the fruit. One of the truckers
hired is Dewitt. Ray contemplates paying Dewitt through a
corporation, Flemming Truck Co. and by paying Dewitt from part
of his profits from picking up the fruit. Flemming takes
commission. Money from vendors is to be distributed to Dewitt,
Flemming for commissions, and the fruit growers. Ray Flemmings
Co. becomes insolvent and goes bankrupt.
Ray Flemmings Co. is a one man operation.
1) The company is not retaining profits because its
revenues are being zeroed out by paying a salary
to Flemming.
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Dewitt did not get paid and Flemming gave a personal
assurance that he would pay Dewitt if the corporation did
iii. Dewitt sues Flemming personally to recover the balance
due from Flemming’s corporation.
The court finds Flemming to be personally liable because
of fundamental unfairness.  The corporation was an
artificial shield for Flemming’s actions.
1) Alter-Ego
2) Commingling of Funds
3) Instrumentality Theory
4) Failure to observe corporate formalities
Dewitt was harmed as a result of Flemming
failing to observe corporate formalities.
5) A marginally capitalized corporation can be used
to allocate risk and so by itself is not fraudulent.
The fact that there is no money in the
corporation is irrelevant.
Marginally financed corporations are used to
allocate the risk which generates the revenue
As long as Flemming is honest and discloses
the business model, the corporate veil will
not be pierced for inadequate capitalization.
Flemming becomes fraudulent by taking out money from
his proceeds and cheating his creditors.
1) He takes out money and distributes it to himself
instead of paying his creditors.
2) Flemming gave Dewitt a personal guarantee.
When the corporate veil is pierced,
Flemming is being held liable through the
corporation’s actions.
The corporation acted as an alter-ego of
2. Tort Creditor Cases
a. Baatz v. Arrow Bar (326): a married couple is in a car accident.
The person who hit the couple had been at Arrow Bar and was
intoxicated. The bar and its owners, Ed and Lavella, are being
sued along with the tortfeasor. The theory is that the employee of
the bar was negligent in serving alcohol to an already intoxicated
customer and the employer is personally liable through respondeat
The tortfeasor has no money and no/not enough insurance
and the corporation does not have enough and so Ed and
Lavella are sued to pierce the corporate veil.
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Ed and Lavella personally guaranteed a $145,000 loan from
the bank and contributed $5000 into the corporation.
iii. Factors for Piercing the Corporate Veil (328)
1) Fraudulent representation by corporation
2) Undercapitalization
Alone  Insufficient to pierce the corporate
3) Failure to observe corporate formalities
4) Absence of corporate records
5) Payment by the corporation of individual
6) Use of the corporation to promote fraud,
injustice or illegalities.
The court rules against eh P and incentivizes the honest
business entrepreneur.
1) But to know if Ed and Lavella are honest business
entrepreneurs, don’t we need to know the price of
dram shop insurance and whether or not they
made a reasonable business decision.
Fraud and Fundamental Unfairness are required to
pierce the corporate veil.
1) The factors that tend to show fraud and
fundamental unfairness are the same in contract
and tort creditor cases.
Role of the Lawyer
1) Inform the clients of not getting dram shop
2) As the business gets more profitable, encourage
the clients to buy insurance at that point
3) Inadequate capitalization
When do you measure it?
What do you measure it on?
Where does the law come from?
b. Radaszewski v. Telecom Corp. (334): Contrux is engaged in
interstate commerce and a driver of Contrux gets into an accident.
Contrux is liable under the theory of respondeat superior.
ii. The problem in going against Contrux is that Contrux’s
insurance carrier went insolvent.
iii. Contrux went beyond what was required to protect their
business, but because the insurance company was bankrupt,
they did not have enough to cover the accident and the P
wants to sue Telecom by piercing the corporate veil.
The court found that the P could not pierce the corporate
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P argues that there is fundamental unfairness because
Contrux was undercapitalized.
1) The court found that this did not matter and
Contrux was not inadequately capitalized because
the company purchased insurance to take care of
situations such as this.
The court protects the reasonable expectations of the parent
c. Walkovsky v. Carlton (338, Note 4): Carlton owns cab companies.
Required insurance with $10,000 coverage. A person injured by
one of the cabs sues.
P’s medical costs exceed the $10,000 insurance coverage.
ii. P tried to show that all the cab companies were one
business and that Carlton was the parent company.
iii. In order for the P to pierce the corporate veil, he has to
show that there was fundamental unfairness.
1) There was commingling of funds
2) Failure to observe corporate formalities
3) Etc.
The court found that the complaint failed to state any
sufficiently particularized statements that the D, Carlton,
and his associates were actual doing business in their
individual capacities shutting their personal funds in and
out of the corporations without regard to the formality and
to suit their immediate convenience.
3. Parent-Subsidiary Cases
a. Fletcher v. Atex, Inc. (341): Ps sued Atex and parent company,
Kodak, for injuries caused by use of their keyboards. Atex was the
wholly owned subsidiary of Kodak. P sought to hold Kodak liable
for Atex under the alter ego theory.
P alleged that Kodak and Atex operated as a single
economic entity.
ii. P could not prove that Kodak and Atex operated as a single
economic unit, and even if they were a single economic
entity, there is no evidence that shows fundamental
1) Fundamental unfairness is the confusion in the
creditor’s mind as a result of the failure to
disclose that these entities are separate.
iii. Delaware Law requires
1) Parent and Subsidiary “operated as a single
economic entity” AND
2) An overall element of “injustice or unfairness”
Cash Management System
1) Every night the subsidiary corporation hands over
their revenues to the parent corporation and the
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parent is able to invest more money and make
more money.
2) By collectivizing their investments the consumer
is hoping that the company will have lower costs
and pass the lower costs to consumer.
3) Tool by parent company to get a better return on
C. Cases that Masquerade as Piercing the Corporate Veil Cases
1. Stark v. Fleming (366): appellant placed her assets into a newly
organized corporation and began to draw $400 per month as salary and
built up her social security account.
a. The government, via Secretary of Health, Education, and Welfare
is suing the widow because she used this newly organized
corporation to build up her social security.
b. The court found that a widow is an intended beneficiary of Social
Security Statute.
c. The court did find that the secretary could make an objective
reappraisal of the widow’s salary to determine if it was reasonable
for the services she performed.
2. Reccograndi v. Unemployment Compensation Board (366): appellants
are all members of a family who are involved in the wrecking business
together. Each member is an officer of the corporation. During periods
of insufficient work, the board meets and lays off 2 of the 3 family
members who then in turn claim unemployment compensation.
a. The court found that unemployment is for employees, not
employers and the owners of capital.
The unemployment statutes were not intended to benefit the
owners of capital, but rather laborers and employees.
D. Equitable Subordination Doctrine
1. Pepper v. Litton (372): Dixie Split Coal Co. is fully owned by Litton
who also acts as the President of the company. The company is
successful, at first, but starts to decline. Litton stops paying himself and
his salary accrues. Litton has a royalty contract with Pepper and
Pepper sues Dixie Co. for Breach of Contract. When Litton finds out
that Pepper filed a law suit, he files one against Dixie Co. for his back
a. In the claim by Litton against Dixie Co., the company confesses
judgment to the back salary.
b. Once executed and judgment is enforced, Dixie Co. files for
bankruptcy and the trustee sues on behalf of the creditors.
c. Pepper sues Litton under the “Deep Rock” Doctrine.
“Deep Rock” Doctrine: bankruptcy court has the
power to subordinate inequitable claims of dominant
and controlling shareholders.
d. This is not a piercing case, but looks like it because equitable
subordination requires a showing of fundamental unfairness.
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e. The court does not allow Pepper to pierce and go after Litton
because then Pepper will get a windfall because he did not bargain
for a personal guarantee from Litton.
f. Pepper wants to undo the execution of the judgment from Litton v.
Dixie Splint and restore the assets to the company and make it
available for him and the other creditors.
g. The court does not find that it was inherently fraudulent for Litton
to do what he did.
h. This is like Frick v. Howard wherein there is no independent
person agreeing on the note.
In this case there is no independent person to judge the
unpaid wages and confess judgment of back salary.
Planning the Capital Structure of the Closely Held Corporation
The Financial Structure of the Closely Held Corporation
A. Planning the Capital Structure for the Closely Held Corporation
B. Types of Securities: The Fundamental Distinction between Debt and Equity and
the Concept of Hybrid Securities
1. Debt
a. Debt is a contract and it alludes to the rights of the creditors.
b. Generally speaking the money is borrowed and the transaction
establishes a maturity date (when the loan is due) and this
transaction is not free (interest) and the interest is tax deductible to
the business.
2. Equity
a. Money invested as shares gives a return in form of dividend and is
taxable and gives rise to double taxation.
There are ways to avoid double taxation.
b. Every corporation has an Articles of Incorporation that define the
types of stocks that they have.
There are 2 types of stocks
1) Preferred
2) Common
C. Different Types of Equity Securities
1. Attributes of Common Stock
a. Rights are established in Articles of Incorporation.
b. Stock generally has 2 basic attributes
Financial Rights
1) Right to receive payments and distributions from
the company
2) Distributions are payments to the shareholders.
ii. Control Rights
1) What kind of voting rights
c. Must have common stock for their to be preferred stock.
2. Shareholder Distributions (including Dividends)
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a. There are 2 types of Distributions
1) Distributions from current/retained earnings
ii. Liquidation
1) Distributions from the liquidation fo the business
2) When the stocks are sold to get out fo the
3) Liquidity is the ability to get in and out of the
4) Includes redemptions and repurchases
b. Nobody has the right to a dividend until the board declares a right
to a dividend.
The board has to declare a dividend before somebody has a
legally enforceable right to a dividend.
3. Preferred Stock: Use of Multiple Classes of Stock
a. Preferred stock is senior to the common, but gets paid its
preference AFTER the creditors.
Only senior to the common stock, but not senior to the
b. There are 3 types of shares
Authorized = Maximum number of shares a company can
ii. Issued = Shares that are actually sold
iii. Outstanding = shares that are sold, but not reacquired.
c. The statement of authorized capital must be set forth in the Articles
of Incorporation
RMBCA §2.02 and §6.01-6.03
ii. CA §202(d)-(e)
d. If there is no distinction of stocks set forth in the articles, all the
stocks are treated as common stocks.
CA §203
4. Different Types of Preferences
a. Cumulative Dividend
Dividend Overhang
ii. Give the holder a priority to receive any prior unpaid
dividends from a previous year before any dividends
are paid on common stock.
b. Non-Cumulative Dividend
Rights of Preferred shareholder do not accumulate and
carry over unpaid dividends from previous years.
ii. If the company does not pay dividends one year, it
disappears for that year.
c. Partially Cumulative Dividend
If the company could have paid the dividends, but chose
not to pay, the unpaid dividends will accumulate.
d. Participating Preferred Stocks
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The shareholder receives their preference before
distribution to the common shareholder, but also gets
distributions that common shareholders are entitled to.
ii. Participating preferred stocks get paid twice – once for the
preference and again with the common shareholders.
e. Dividend preferences can be changed
CA §902-903 allows changes in rights, preferences and
privileges of a class of outstanding preferred stock
ii. The company’s Articles of Incorporation must show the
capital structure of the corporation, so there must be an
amendment which is approved by the shareholders if a
change is to be made.
iii. A corporation can change the articles by board action and
approval by the shareholders.
1) But the amendment has to be approved by the
outstanding shareholders entitled to vote and the
preferred stock holders if the proposed
amendment would affect their rights.
CA §903(a)(4)
Classes and Series of Stock
1) Preferred stock is a class and that class carried a
dividend preference, but the market changes and
the dividend preference in the market changes.
To change the dividend preference, must
take a vote and amend, but that is
cumbersome and so rather than do that, the
corporations have moved to “series” and
Blank Check preferred stock (leaves the
preferences blank and the blanks are filled in
by the board of directors.
(a) RMBCA §6.02
(b) CA §202(e) and §401
f. Voting or Non-Voting Preferred Stock
Usually preferred stock has no voting rights in general.
ii. However, can be triggered by consecutive defaults on
dividend rights of preferred stock.
iii. Voting rights must be specified in articles of incorporation,
which represents preferred shareholder’s contract with
Gives shareholders some right to monitor/control.
g. Liquidation (or dissolution) Preference
When a corporation is dissolved and all creditors claims
have been paid—both secured and unsecured, then
preferred shareholders have priority over common shares to
extent of their preference in any further distribution of any
remaining assets.
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After payment of any liquidation preference, distribute any
remaining funds to common stock (residual claimants).
h. Use Participating or Non-Participating Preferred Stock
Participating preferred stock is a hybrid security – having
some features of common stock (i.e. the right to participate
in further dividend distributions made by the company) as
well as having some preference over common stock (which
makes it look more like a senior security).
i. Making Changes to Terms of Outstanding Preferred Stock
Changes to rights, preferences and privileges of a class of
outstanding preferred stock are governed by the codes.
1) RMBCA §10.03-10.04
2) CA §902-903
ii. The board cannot unilaterally amend terms of its
outstanding preferred stock.
iii. The terms of an outstanding class of preferred stock cannot
be amended without first obtaining the preferred
stockholders’ consent to such changes (usually by a
majority vote of such class) – even if such shares are
otherwise non-voting.
j. Authorize Different Classes (or series) of Preferred Stock
To avoid the cumbersome process of changing the
preferred stock preferences, corporations have moved to
“series” of preferred stock.
1) i.e. $2 dividend series, $4 dividend series, etc.
k. Authorize Blank Shares?
Blank Check Preferred Stock
1) Allows the Board flexibility to establish financial
terms of a particular class or series of shares at
time of issuance.
2) The market and the fiduciary duty of the Board
will dictate how the Board fills in the blank.
3) The board issues a Certificate of Determination
once it decides to issue preferred stock.
ii. Allows board to take into account current economic
conditions in specifying the terms of the preferred stock it
plans to sell.
5. Redeemable Preferred Stock
a. Preferred Stock “Redeemable” at Option of Corporation –
“Callable” Preferred Stock
Stock that is callable at the option of the Board.
ii. Usually callable at a fixed price in the Articles (redemption
price) and subject to any other terms or restrictions on the
Board’s right to redeem out these preferred shares.
1) Any discretion that the shareholder is going to
have is going to be in the Articles of Incorporation.
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iii. CA §402
b. Preferred Stock “Redeemable” at Option of Shareholder – a form
of demand indebtedness?
Preferred stock may be made redeemable at the option of
holder – akin to a “demand note.”
ii. The preferred shareholder can demand that the company
pay him/her.
iii. The difference between a demand note and preferred stock
is the tax treatment.
1) Dividends on preferred stock are taxed twice.
2) Demand note is a debt and the company has to
pay interest, which is a fixed obligation.
Preferred stock does not result in a fixed
debt until the board declares a dividend.
Security interest
For the preferred shareholder that is worried about not
being paid, insist on a “sinking fund” which is established
to set aside money to pay preferred shareholders.
6. Convertible Preferred Stock
a. Convertible at Option of Holder
Generally convertible into some other class of stock.
1) Example: convertible preferred stock that is
convertible into company’s common stock.
ii. Usually subject to limitations
1) How many shares if the shareholder converts?
2) What is the price of conversion?
3) Are there black out periods for exercising
iii. Preferred shareholders will want to convert if the
company is making a lot of money because the
preferred shareholder is limited in equity sharing.
CA §403
b. Forced Conversion
Preferred stock redeemable at the board’s call.
ii. When the call for redemption is made, the preferred
stockholder gets the redemption price set out in the articles.
iii. Once the call is made, no longer preferred shareholders;
only entitled to the amount of the money set forth in
The preferred shares are no longer considered outstanding
 The company has reacquired them.
1) Preferred shares may be converted to common
stock and there is an exchange ration of 1 on 1.
In a forced conversion, the corporation eliminates the
preferences and the class of preferred stock from the
capital structure.
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The board assumes that preferred stockholder will convert
if trading price of common stock exceeds redemption price
of preferred stock at time Board makes the call for
redemption of preferred stock.
7. Redeemable Common Stock
a. In CA, redeemable common stock is absolutely prohibited (as was
the law under common law).
Danger to the corporation because of cash flow problems
and fraud on the creditors. ???Why a fraud to
1) ???Depleting your account by buying back
common stock???
2) Purchasing stock with capital that was
assumed to be for the creditors.
3) Made assumption that the call would be when the
company is doing poorly.
ii. CA §402(c)
b. Model Act allows for redeemable common stock.
Broad Freedom of Contract.
1) Creditors take the risk when they decide to loan
money to the corporation.
2) It is up to the creditors to take the necessary
ii. RMBCA §6.01
c. At the Option of the Holder
d. At the Option of Corporation (Callable Common Stock)
8. Convertible Common Stock
a. Convertible into another class of stock
Downstream Conversion
1) Allows conversion from preferred to common
2) Allows bondholders/debt holders to convert into
stock if the company performs well.
- Convertible Debenture.
ii. Upstream Conversion
1) Upstream Conversion is the right to convert
common shares into preferred shares, or to
convert either common or preferred shares
into debt securities or interest.
2) Although preferred stock may be convertible into
common stock, most state statutes prohibit shares
with an “upstream conversion” right.
3) Both the Model Act and CA permit conversion
from common shares into preferred stock.
4) What about converting from being a shareholder
to a bondholder?
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- Problem because the creditors have relied
on the common shareholders.
- CA views upstream conversion as
inherently fraudulent and prohibits it.
- Model Act allows upstream conversion
and can bargain for the protections you want.
Everybody is on notice.  Default Rule.
b. Convertible into debt
9. The RMBCA’s “Freedom of Contract” Approach
D. Issuance of Shares
1. Problem 1, Page 415-416
2. Subscription Agreements
a. Post-Incorporation Subscription Agreement
Contract usually made after the company is in place that
obligates the investor to buy shares and obligates the
company to issue the shares on the terms set out in the
subscription agreement.
b. Pre-Incorporation Subscription Agreement
Contract between A and B wherein B will insist on a
subscription agreement because B has no cash and A has all
the cash and B wants to insure that A will invest his cash.
3. Number of Authorized Shares: Herein of “Dilution”
a. Disparate contributions of founding shareholders
A is contributing all the money into AB furniture store and
so if the corporation issues its shares equally to A and B,
should something happen to the corporation and its assets
be liquidated, A and B will receive half of the corporation’s
1) A will be mad because he financed the capital.
2) B argues that he is putting in consideration as well
 Non-cash consideration. Labor Capital.
b. Valuation of non-cash consideration
Must value B’s contribution to the corporation, but is hard
to do.
ii. In CA, a promise to render future services is NOT
considered consideration because it is uncertain as to
whether or not the services will be rendered.
1) The CA rule protects creditors who are
contributing tangible assets to the corporation.
iii. Under the Model Act, future services may be consideration.
1) As long as there is some benefit to the company,
anything may be consideration.
c. Concept of “Earn-Outs”
A is putting in the money and since B is not going to
contribute capital, he is going to sign an employment
agreement at which he is going to receive his shares on a
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“sliding scale” according to the services rendered to the
ii. Example: A is going to contribute $100,000 in cash and
buys 100 shares and B contributes $100 in cash and buys
100 shares. What happens if there is an electrical storm
and the company has $100,100 and the company is
1) If the company decides to liquidate then the
dividends will be distributed 50-50. A will argue
that B hadn’t vested and didn’t earn the full
- Problem of Equity Dilution on Premature
2) When there is premature liquidation, B gets a
windfall and A suffers.
3) B has a tax problem, if he gets his shares today, B
gets a bargain purchase because he got something
for $100 what someone else paid $100,000 for.
The government will impute the income and tax B
for the full $100,000.
4) CA §409
5) RMBCA §6.21
- Old Model Act §19
4. Concept of “Par Value”
a. Par value is largely obsolete, but Delaware still retains this concept.
Created in a period when the government wanted to
encourage industry.
ii. Par value is an arbitrary dollar value assigned to shares
of stock which represents the minimum amount for
which each share may be sold.
iii. When somebody pays for stock greater than the stated par
value, the par value amount goes into the stated capital
account under Shareholder’s equity. The addition amount
goes into the Capital (or Paid-In) Surplus account under
Shareholder’s equity.
b. Balance Sheet Accounts
Stated Capital
ii. Capital Surplus
iii. Retained Earnings
c. Watered Stock Liability
Watered stock liability arises when the stock is sold for less
than the par value.
ii. Hospes v. Northwestern Manufacturing and Car Company
(393): the Board issued common stock for less than the par
value of the stock when it was issued.
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Hanewald v. Bryan’s Inc. (397): de jure corporation.
Hanewald sold Bryan’s Inc. his dry goods store. Bryan’s
has another dry goods store in another state. Hanewald
has agreed to sell the store to the corporation that Keith
and Joan are going to form. They pay $60,000 ($55,000 in
cash and $5000 in promissory note). Keith and Joan also
agreed to a 5 year lease for $600 per month. After 4
months Bryan’s Inc. shuts down. Hanewald sues Keith and
Joan because he didn’t get paid his note or his rent for the
5 years. The company had 100 shares total, which were
issued and divided 50-50 between Keith and Joan. Keith
and Joan contributed $10,000 for which they got stock and
a $10,000 note. The company owes Keith and Joan
$10,000. Keith and Joan also guaranteed a loan from the
bank for the corporation. Keith and Joan enter into the
transaction completely transparent. The par value of the
shares was $1000.
1) The articles stated a very high par value and so
look at the Legal Capital Rules §18.
2) Keith and Joan had paid off themselves, the bank
and other trade creditors by collecting on the par
value of their shares, but didn’t pay Hanewald.
3) Hanewald had entered into the contract with the
corporation, but because the corporation is
insolvent Hanewald is attempting to pierce the
corporate veil.
4) There are 3 theories regarding watered stock
based on par value.
- Trust Fund: the par value is treated like a
reserve/fund for the creditors. This theory
has been rejected because this theory implies
a separation of legal and equitable interest
which is not true and because the company
is supposed to spend money in the best
interest of the company (not the trustees – or
creditors in this case)
- Implied Contract: based on the theory that
there was an implied contract between
Hanewald and investors. Implied contract
that one will pay at least par value for the
stock. In this case, Keith and Joan did not
pay the full value for the stock or any value.
- Fraud/Holding Out: no fraud because
Hanewald did not rely on a fraudulent
balance sheet.
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5) The trial court found that because Keith and Joan
did not act in bad faith, the corporate veil would
not be pierced.
- Although Bryan’s Inc. is liable on the note
and lease, Keith and Joan are not.
6) The appellate court reversed the decision of the
trial court.
- The court found that the risk had been
allocated to Keith and Joan to inform their
creditors.  The judge ignored the clear
language of Model Act §18.
7) The trial court had found for Keith and Joan
because Hanewald was not looking to Keith and
Joan to get paid, but the corporation.
8) The maximum liability exposure based on
watered stock liability was $38,000.
9) When the corporate veil is pierced the Ds are
liable for the total debt but under the Watered
Stock liability there is a cap on par value and how
much Ds received.
5. What type of Consideration can be used to Acquire Stock?
a. Traditional Distinction between Permitted (Eligible) Forms of
Consideration and Prohibited (Ineligible) Forms
c. CA
6. Par Value in Modern Practice
a. Modern Use of “No Par” shares
Today to avoid watered stock liability corporations will
issue no par value shares.
b. Legally available source of funds for shareholder “distributions”
Retained earnings
1) Can pay out of this account as long as it does not
result in insolvency.
- Prior to GAAP, Insolvency = cannot pay
debts when due
- Balance Sheet Test
ii. Capital surplus
1) If you distribute from capital surplus, must
disclose to the shareholders that you are
distributing from this account.
iii. CANNOT distribute from stated capital.
7. Legal Restrictions on Dividends and Other Shareholder Distributions
Use of Debt Financing
A. Different Types of Debt Securities
1. Bond
2. Debenture
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3. Revisiting the Concept of “Hybrid Securities”
Concept of Leverage
1. Loans made by 3rd Parties (“Outside” Debt)
2. Loans made by Shareholders (“Inside” Debt)
Tax Advantages of Debt
1. Debt-Equity Ratio
a. The courts have found that the proper debt-equity ratio is 3:1.
2. “Thin” Capitalization
a. When there is a high debt-equity ratio.
Debt as a Planning Device: Obre v. Alban Tractor Co. (413): Obre and Nelson
form a new corporation to engage in moving dirt and building roads. Obre
agreed to contribute to the corporation equipment and cash worth $65,548.10
while Nelson agreed to contribute $10,000 in cash and equipment. The value of
the equipment is negotiated by Obre and Nelson.
1. The Board values the consideration and once it does the value is binding.
a. CA §409
2. The company in this case became insolvent.
3. The company had been financed as follows
a. Obre
Non-Voting Preferred Shares
ii. Voting common stocks
iii. Note (5 years/5% interest)
b. Nelson
Voting common stocks
ii. Total
c. This is within the zone of acceptability because there is a 1:1 debtequity ratio.
4. The creditors sue when the company becomes insolvent
a. The creditors argue that Obre’s 35,500 note was really equity and
not a loan.
Equitable Subordination: Deep Rock Doctrine (Pepper v.
5. The court found that there was no showing of undercapitalization, fraud,
misrepresentation or estoppel.
6. Not a piercing claim because the creditors were not trying to hold Obre
personally liable.
7. There was no fraud in this case  Obre and Nelson were disclosing to
their creditors the $35,500 note to Obre and so the creditors assumed a
Use of Debt in Planning Capital Structure of AB Furniture Store, Inc.
Use of Limited Liability Company as an Alternative to Incorporation
A. What is a Limited Liability Company?
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1. LLCs are relatively new entities that were first created in Wyoming to
address the problem in Delaney in which the general partner in the
limited partnership was a corporation.
a. In the Delaney case the limited partnership was established
because it wanted flow-through tax treatment.
2. LLCs provide for complete freedom of contract
3. Benefits
a. The entity lasts forever
b. Taxed like a corporation
c. Limited liability
4. Drawbacks
a. Relatively new
b. Uncertainty in a lot of areas
Will the courts pierce the shield of limited liability?
ii. Can the parties contract to eliminate fiduciary duty?
c. Expensive to create the Operating Agreement because of complete
freedom of contract.
d. LLC statutes vary widely in their terms
Question as whether other states will recognize other state’s
LLC statutes if the LLC becomes interstate.
5. To form an LLC must file with the Secretary of State
6. CA LLC Statute §17000, et. al. seq.
B. Taxation of LLCs
1. Check the Box Tax Treatment
C. AB Furniture Store and Choice of Entity Decision
1. Page 421 Chart
Professional Responsibility
A. If you have a client who wants to help you form a LLC or corporation or LLP, as
a threshold issue the lawyer must clarify who the client is.
B. There is a potential for conflict of interest.
Public Offerings
A. Securities Act of 1933
B. Blue Sky Laws
1. California Corporations Codes §25000
C. IPO’s – Initial Public Offerings
D. Additional Rounds of Debt or Equity Financing by Publicly Traded Companies
Doctrine of Preemptive Rights
A. Traditional Common Law Approach
1. Stokes v. Continental Trust, Co. (443): bank had outstanding shares of
221 to the Ps. Blair and Company was offering to buy 5000 shares at
$450 per share. The par value was $100. P is complaining that his
proportionate interest has been cut in half and although his equity
interest has not been diluted, his voting rights have.
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a. P wanted to exercise his pre-emptive rights and purchase the 221
shares at par value of $100.
b. The majority found that the pre-emptive right was not waived but
rather he should have been able to exercise them.
Property rights form the basis for pre-emptive rights.
c. The dissent states that P waived his pre-emptive rights when he
refused to pay the $450.
2. Model Act §6.30: Pre-Emptive Rights exist on an opt-in approach.
a. A shareholder has pre-emptive rights when the Articles of
incorporation provide for them.
b. The right is only provided when it is in the articles.
3. CA §406: Pre-Emptive Rights are Opt-In.
4. In an opt-out provision, the statute would state that the pre-emptive
rights are the default rule unless the Articles eliminate them.
a. Articles of publicly traded companies show that I many states the
statutes are opt-out provisions and that most companies eliminate
the pre-emptive rights because they are cumbersome.
B. Modern Doctrine of Quasi-Preemptive Rights
1. Katzowitz v. Sidler (448): closely held corporation in which 3 people
each hold 5 shares. The 3 shareholders had a falling out and entered
into a stipulation rather than go to trial. The stipulation provided that
the P, Katzowitz, would withdraw from the active participation of the
day to day operations of the business but would be remain on the board
and Katzowitz is to receive the same benefits and compensation that the
other 2 board members receive.
a. There are 1000 authorized shares, but only 15 are outstanding.
b. The corporation ends up owing $2500 to each of the 3 shareholders
and the company is going to be $7500 poorer and so rather than
pay the money to the directors, the corporation wants to issue more
The board of directors decides when the shares will be
issued and the price of the shares.
ii. Sidler and Lasker decide to issue 75 more shares at $100
per share and offers 25 shares to each of the 3 board
members with the consider being $2500 that the company
owed each director.
1) Adequate Compensation?
- Legal Capital Rules §18 and §19
- CA §409
(a) Elaborates on §19 of the Legal
Capital Rules
(b) States this is permissible
(c) Debt-cancellation.
iii. Sidler and Lasker buy the shares, but Katzowitz wants his
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c. After this, there is an accident and the company decides to dissolve
and liquidate.
d. The corporation is liquidating and it pays its creditors and then the
Katzowitz only has 5 shares whereas Sidler and Lasker
have 30.
ii. Katzowitz receives $3147.59 upon liquidation and Sidler
and Lasker each receives $18,885.52 upon liquidation.
e. Katzowitz got his pre-emptive rights, but chose to waive them and
is not in the same situation that Stokes was in.
f. Katzowitz’s harm is that Sidler and Lasker bought the extra 25
shares at a “bargain price” and Katzowitz suffered equity dilution.
The shares were sold above par value because there was no
par value so Katzowitz claims that they were sold below
book value.
g. Book value is the worth of the stocks  [(Assets –
Liabilities)/number of shares]\
May or may not be the true value.
h. Sidler and Lasker have a duty to act in the best interest of the
corporation.  Sidler and Lasker violated their fiduciary duty.
The quasi-pre-emptive rights duty is one grounded in
fiduciary duty and not property rights.
ii. Katzowitz has standing to complain of fiduciary duty.
i. The board of directors owes a fiduciary duty to the corporation.
The duty is not to the controlling shareholders
C. Introduce the Concept of “Freeze-Out” Transaction (452-453)
Management and Control of Closely Held Corporations
The Respective Roles of Shareholders and Directors
A. Shareholder Agreements and the Rule of McQuade
1. McQuade v. Stoneham (499): D was the majority shareholder of the
corporation and P was a minority shareholder. As part of the
transaction, P paid D money for the stock he purchased and they entered
into an agreement wherein P would become the treasure. P was fired
and sues for breach of contract. The board argues that firing McQuade
was best for the corporation.
a. The court found that the contract between McQuade and Stoneham
was unenforceable because it violated the public policy by
requiring directors to vote in a certain way.
b. The directors have a duty to the corporation and the contract is
limiting their discretion by violating the strong public policy that
the Board makes decisions in the best interest of the corporation.
c. The “Corporate Norm” Rule
RMBCA §8.01(a)
ii. CA §300(a)
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d. The agreement between the shareholders cannot be enforced
because it impinges on the discretion of the board members.
e. Stoneham got a financial windfall by getting paid more by
McQuade for not only the stocks but the agreement for guaranteed
employment as an officer.
f. Shareholder agreements that impinge on the director’s discretion
and business affairs violate public policy.  Job of the Board of
2. The board manages the business affairs of the corporation.
a. The job of the shareholders is to vote for the Board.
b. An agreement that voids the “corporate norm” is generally
B. Exceptions to the Rule of McQuade
1. Clark v. Dodge (503): Agreements that run afoul of the corporate
norm are unenforceable unless
a. ????All the shareholders sign the agreement????
b. The impingement on the Board’s discretion is slight.
C. The Modern Judicial View of Shareholder Agreements in the Context of Closely
Held Corporations
1. Galler v. Galler (505): Brothers Isadore and Benjamin form a
corporation and split the stock 50-50. They enter into an agreement so
that if one of the brothers dies the shares of the company will be
transferred to their wives.
a. Statutes
RMBCA §10.20 and §2.06(b)
ii. CA §211 and §212(b)
b. The brothers want to amend the by-laws to require a minimum of 3
for quorum.
This does not violate McQuade because this is something
that should be properly decided by shareholders.
c. There is an agreement to pool their votes together and elect
themselves to the Board.
Does not violate McQuade because the shareholders are
binding themselves and not directors.
ii. RMBCA §8.10
iii. CA §305
d. The agreement provided for a balance of power on the board.
They also have a provision to pay a certain amount of annual
dividends so long as a certain amount of capital surplus is retained
by the corporation.
The court found that this was a slight impingement and did
not violate public policy.
e. The brothers also agree to a restrictive legend on the stock
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So long as the restriction is “reasonable” under RMBCA
§6.27 or CA §418 and CA §204(b) this does not violate
f. The brothers also agree to continue salary contributions to the
The board decides the salary of the employees so doesn’t
this violate the rule in McQuade?
ii. The court found that this does not impinge.
g. The court usually will not uphold agreements that continue
Worried about the “Dead Hand” Problem of somebody
trying to run the corporation from the grave.
ii. The court got around this by saying that the duration of the
agreement was until the death of the wife.
h. The reason the court probably upheld this agreement was because
this is a closely held corporation without a lot of liquidity.
i. This case is like Katzowitz because the wife is being squeezed out.
j. Today, to eliminate the uncertainty, the corporation can elect to be
a closed corporation
If a closed corporation, the company will be governed
under CA §158.
ii. CA §158 requires that there be no more than 35
shareholders and the articles must make the election to
be a closed corporation.
iii. CA §300(b) states that if the corporation makes the
election to be a closed corporation, although the board
still manages the business affairs, shareholder
agreements that relate to any phase of the business
affairs are permissible and they will not be invalidated
based on the premise that it is impinging on the
functions of the board.
D. The Modern Legislative Approach to Shareholder Agreements
1. Zion v. Kurtz (516): Zion and Kurtz form Group, Inc. with the sole
purpose of financing Lombard-Wall, Inc. as stated in the agreement.
Kurtz assured Zion that the Articles of Incorporation would be amended
to make the corporation closed, but did not.
a. The court in this case enforced the agreement and found for Zion
even though the articles did not have the language stating that this
was a closed corporation.
Kurtz started the business and told Zion that he would
change/reform the articles and did not.
ii. Kurtz is estopped to deny that the corporation is closed and
the court balances the rights between Zion and Kurtz.
iii. Between Kurtz and Zion, Zion is the innocent party.
b. Dissenting Opinion
Public policy of giving notice to the public/creditors.
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The state gives this status and so the corporation’s articles
must be amended.
c. This court was a NY court applying DE law under the internal
affairs doctrine.
In Nixon v. Blackwell (522) the DE Supreme Court
followed the dissent and stated that unless the Articles
conformed with the state’s requirements, no closed
corporation existed.
2. The Close Corporation Election
a. Once the corporation elects to be closed, it does not need to rely on
the ambiguity of “slight impingement” because the courts are more
likely to enforce shareholder agreements.
b. In CA, not only does the election to be a closed corporation have to
be in the Articles of Incorporation, but the corporation must
disclose this information to the creditors.
Adequate Capitalization: make sure that the client is not
undercapitalized for involuntary creditors.
c. RMBCA §7.32
d. CA §158, §186, §300
E. Shareholder Monitoring of Directors and Business Affairs of the Corporation
1. Auer v. Dressel (522): This is not a squeeze out case. The Class A
stockholders want Auer, but Auer has been ousted by the Board who
have a statutory responsibility to fire him for the benefit of the company.
a. The Board is the one who decides who the officers of the company
will be.
b. In this case, the shareholders want to call a special meeting to
reinstate the president.
c. Special Meeting v. Annual Meeting
RMBCA §7.01 and 7.02
ii. CA §600(d)
1) Special meetings may be called by the board, the
chairman of the board or over 10% of the
d. Proper Practice Clause
When management is faced with a demand, the
management will argue that the purpose for the special
meeting is not proper.
e. The question in this case is whether the shareholders can call a
special meeting to remove the current president.
The court finds that the shareholders cannot because that is
the job of the Board.
ii. However, the majority finds that the shareholders can call a
special meeting to make a recommendation to the Board
1) This allows the shareholders a voice
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2) This may be a useful signal to the directors that
the shareholders are opposed to the Board’s
f. The shareholders can call a special meeting to remove Board
Members because their job is to elect the board.
Under Modern statutes the shareholders can remove a
director with or without cause.
ii. The old statutes required good cause.
1) Cause = fraud, misrepresentation, breach of
fiduciary duty, egregious misconduct.  Need
Due Process before removing for cause.
g. Under the modern view, if the director is removed by shareholders,
the shareholders may fill the vacancy; however, if there is a natural
occurrence or a director resigns, the Board can fill the vacancy.
Shareholder Voting and Shareholder Pooling Agreements
A. Election Inspectors and Other Mechanics of Shareholder Election of Directors
1. Mechanics of Shareholder Meetings
a. Notice
RMBCA §7.05-7.06
ii. CA §601
iii. Must provide notice of shareholders meetings
1) Time
2) Place of meeting
Must provide notice of annual and special meetings
1) When
2) Where
For special meetings must provide notice of the purpose of
the meeting
1) A proper purpose of a meeting is something that
does not impinge on the role of the directors
2) Cannot go beyond the purpose stated in the notice
of the special meeting.
Waiver of Notice
1) Expressly: must be in writing and can be made
either before or after the meeting
2) Implied: if the shareholder attends the meeting
and there is no objection of notice, there is an
implied waiver.
b. Quorum
RMBCA §7.25
ii. CA §602(a)
iii. Unless otherwise stated, a majority of the voting shares
constitutes a quorum
c. Voting
RMBCA §7.07
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CA §701
Record Owner v. Beneficial Owner
1) Record Owner = the person who owns the shares
in name/certificate.
2) Beneficial Owner = the person with the interest in
the company.
3) In the Ling case (575), the court found that stocks
may be transferred by signing a certificate but the
endorsed stock certificate does not make the
person with the endorsed stock certificate the
record owner, but rather the person has to go to
the corporation and get the corporation to reissue
new stocks in that person’s name and cancel the
old stocks in the seller’s name to make the buyer
the record owner.
Record Date: The date set by the Board on which the
people with shares on that date will be able to vote at the
1) Must be set within 60 days of the meeting.
2) Hypothetical: C corp. sets the annual meeting
date for July 7 and sets June 6 as the record date.
On June 25, S sells her C Corp. shares to B. Who
votes the shares at the annual meeting?  S gets
to vote because S owned the shares on the record
Proxy Voting
1) RMBCA §7.22
2) CA §705
3) Can vote by proxy.
4) Hypothetical: same as above.  What should
the B do? The buyer should bargain with the
seller to obtain the proxy from the seller and hold
the proxy. Proxy voter = S. Proxy Holder = B. a
proxy is revocable unless it is coupled with an
interest by the proxy holder.
Monitoring Elections
1) CA §707 and §709
2) The election inspector monitors the annual and
special meetings.
2. Salgo v. Matthews (529): annual meeting of General Electrodynamics.
There are 2 factions, one headed by Salgo and the other by Matthews.
Matthews got the proxy from Pioneer, inc. a company that is in
receivership because it has filed for bankruptcy. The election inspector
refused to accept the proxy.
a. The authority to act for Pioneer is obtained by going to the
bankruptcy court.
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b. For Matthews to validly assert the proxy, he has to show up at the
annual meeting with
Certificates showing that Pioneer owns the stock
ii. Proxy document giving him the right to vote from Pioneer
signed by the Receiver
1) Court paper giving the receiver the power to act
on behalf of Pioneer.
c. The court found that the election inspector has the discretion to
decide who gets to vote and who doesn’t and only after the election
is over and the votes are tabulated and the results announced can
the other side sue for injunction and/or preliminary injunction for
the uncounted votes and question the discretion of the election
d. The election inspector’s decisions are reviewable but only after the
final results of the vote are announced.
e. RMBCA §7.24(b)(3): The election inspector has the discretion to
determine if the “…evidence is acceptable to the corporation…”
The statute limits the discretion of the corporation and it
does not have unfettered discretion, but the discretion is
reviewed only after the final count of the vote.
f. This case is before Street Ownership.
B. Cumulative Voting vs. Straight Voting
1. Shareholder Voting Rules
a. Who gets to vote?
Rule of Record Date Ownership.
b. There are 3 different standards for when an action has been
passed by shareholders
Old Model Act
1) Majority of the shares present at the meeting
ii. RMBCA §7.25
1) Majority of the shares actually voting
iii. CA §602(a)  Public policy behind the 2nd prong is to
prevent situations in which a small number of shareholders
are deciding the actions of the company (extreme example:
1 yes, 0 no, 599 abstaining which would pass under the
1) Majority of the shares present and voting AND
2) Majority of the required quorum.
c. For the election of directors, the rules require a plurality to elect a
d. There are 2 types of voting for the Election of Directors
Straight Voting
ii. Cumulative Voting
1) This gives the minority shareholder(s) a chance to
get an opportunity to get somebody on the board
because under straight voting there is no chance
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for the minority shareholder(s) any say in the
election of the board.
Cumulative Voting Hypothetical
a. Facts
A = 74 shares
ii. B = 26 shares
iii. [s/(d+1)] + 1
1) [shares/(number of directors + 1)] + 1 = the
number of shares a shareholder needs to have in
order to win 1 director’s seat.
2) S = total number of shares voting, NOT
b. A is the controlling majority.
c. This is a 3 person board.
d. If Straight Voting:
A1, A2, A3  Nominated by A
ii. B1, B2, B3  Nominated by B
iii. All of A’s nominees are going to be appointed because
each is going to get 74 votes vs. B’s 26 votes.
e. If Cumulative Voting:
A gets 74 x 3 votes = 222 total votes
ii. B gets 26 x 3 votes = 78 total votes
iii. In this company, in order for the minority shareholder to
elect a director, the minority shareholder needs 26 shares
1) [100/(3+1)] + 1 = 25 + 1 = 26
If you want to vote cumulatively, need to give notice
(usually 24 or 48 hours before the meeting).
1) The purpose of the notice requirement is to allow
for the voter to “vote smart.”
RMBCA §7.28
a. Cumulative Voting is present when the company opts-in and the
articles provide for cumulative voting.
CA §708(b) and §301.5
a. Cumulative voting is mandatory unless you have opted out.
b. The only corporations that may opt out are those that are publicly
traded on the NYSE.
The CA code also allows for staggered voting for publicly
traded corporations.
c. Under CA §301, cumulative voting is mandatory unless publicly
If not publicly traded, must have cumulative voting and
cannot have staggered voting (must elect directors at the
same time and for the same terms).
Removal Rules
a. CA §303(a)(1): “(a) Any or all of the directors may be removed
without cause if the removal is approved by the outstanding shares
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(§152), subject to the following: (1) Except for a corporation to
which paragraph (3) is applicable, no director may be removed
(unless the entire board is removed) when the votes cast against
removal, or not consenting in writing to the removal, would be
sufficient to elect the director if voted cumulatively at an election
at which the same total number of votes were cast (or, if the action
is taken by written consent, all shares entitled to vote were voted)
and the entire number of directors authorized at the time of the
director’s most recent election were then being elected).”
6. Humphreys v. Winous Co. (526): 3 person board and each stands for
election every year allowing the minority shareholder to get in at least
one board member. The majority shareholder gets mad and classifies
one of the directors, staggering the election of directors. Each director
is given a 3 year term.
a. The P (minority shareholder) argues that the statute grants
cumulative voting to guarantee a seat on the board, but by
staggering the terms, the D (majority shareholder) has nullified
cumulative voting and rendered it straight voting.
b. The court rules in favor of D and finds that the statute guarantees
cumulative voting, but not a seat on the Board.
c. In CA, this problem will never come up for a small closely held
corporation. This rule only applies to large publicly traded
CA §301.5  Implemented as a result of the race of the lax.
C. Shareholder Pooling Agreements and the Use of Irrevocable Proxies
1. Ringling Bros.-Barnum and Bailey v. Ringling (543): Cumulative
voting case. This is a small closely held firm with 3 shareholders. Edith
and Aubrey each have 315 shares and North has 370 shares. Edith and
Aubrey decide to get together and pool their votes to become the
controlling shareholders.
a. This pooling agreement does not violate public policy because the
shareholders are agreeing to fulfill their shareholder function and
are not taking away discretion from the board.
b. Edith and Aubrey have a falling out and there is a provision in the
agreement that stated if the 2 reached an impasse, Loos (an
attorney) would be the “tie-breaker” and each would vote as
directed by Loos.
c. Aubrey does not vote the way that Loos instructs.
d. If the point of the agreement between Aubrey and Edith was to
control the board, there is still a majority, but Edith is made
because the people that Aubrey vote for are now going to vote with
Edith wants to bind the directors to vote with her.
1) This violates McQuade because it impinges on the
discretion of the directors.
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Edith alternatively wants the vote as the arbitrator (Loos)
1) She wants specific performance.
2) The courts are reluctant to award specific
3) The trial court said that to get around the problem
of specific performance Edith would get to vote
Aubrey’s shares as an implied agent possessing
the irrevocable proxy.
4) The problem with the trial courts decision was
that the proxy was “implied” and continued
litigation would ensue.
e. This court does not invalidate the election, but invalidates
Aubrey’s votes.
As a practical matter this means Aubrey’s votes will only
count if she honors the agreement.
ii. However, under this remedy, the control of the circus will
be under North so that intent of the pooling agreement is no
longer effectuated by this agreement.
iii. Ultimately, Edith does not get what she wants.
1) Edith wanted an irrevocable proxy, but the
general rule is that a proxy is freely revocable
unless it is coupled with an interest by the person
given the proxy (i.e. seller is the record date
owner but subsequently sold shares to buyer).
Use of Committees of the Board
1. RMBCA §8.25
2. CA §311
Action by Written Consent
1. RMBCA §7.04
a. Unanimous approval is required.
b. All the share entitled to vote must approve an action without a
2. CA §603
a. Absolute majority vote rule
51% of the outstanding shares required to give written
consent to get shareholder action without a meeting.
Use of Voting Trusts
1. When legal title is surrendered to a 3rd party (the voting trustee) who
votes for the parties.
2. Brown v. McLanahan
Use of Classified Stock to Elect Directors
1. RMCA §6.01(c)
2. CA §400(a)
3. Lehrman v. Cohen (565): there are 4 directors initially. One of the 2
original shareholders dies and conflicts begin to arise between Cohen
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and Lehrman’s son. To resolve the conflicts, Cohen and Lehrman
decide to have a 5th director on the board to be elected by Danzansky
who holds AD stock and solely elects the 5th tie-breaking director.
a. There are 3 classes of stock.
ii. AD
iii. AL
b. There is no difference between AC and AL stocks  identical
number and same rights of control and financial rights.
c. AD stock only has voting rights and no financial rights.
d. For 15 years the tie breaking director is unnecessary. Then in 1964
a tie breaker is necessary.
Danzansky and Cohen decide that Danzansky should be the
president of the corporation and he is appointed over the
objection of lehrman.
ii. When Danzansky becomes president he resigns as board
member and appoints Millard F. West, Jr. as the 5th director.
e. Lehrman sues saying that the creation of the AD stock created an
illegal voting trust by not complying with the Voting Trust Statute.
The court found that this did not create a voting trust
because there was no separation of voting rights from the
other attributes of ownership.
ii. The court found that although there was dilution there was
no divesture of voting rights and so there was no voting
f. Lehrman’s Public Policy Argument
Should not have a director being the arbitrator of the
ii. Danzansky has no financial rights and so may not care
about the best interest of the company.
iii. Proxies are only irrevocable if coupled with an interest in
the company.  This may create a harm to people with a
financial interest in the company.
g. The court finds that because the shareholders followed the proper
procedures, the public policy arguments are not compelling.
H. Use of Stock Transfer Restrictions
1. RMBCA §6.27
a. The articles of incorporation, the bylaws, an agreement between
shareholders or an agreement between the shareholders and the
corporation may impose restrictions on the free transfer of shares
from the corporation. The restriction must be noted
conspicuously on the front or back of the certificate or in the
information statement required by §6.26(b). If the person has
no knowledge of the restriction, it is not enforceable.
2. CA §204(b) and §418(a)
a. Reasonable restrictions upon the right to transfer are binding.
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b. The certificate must have written statements that state the shares
are subject to restrictions upon transfer.
3. Ling & Co. v. Trinity Savings and Loan Association (573): Bowman
took out a loan with Trinity Savings and Loan Associations pledging
stock in Ling and Company, Inc. as security for the loan. D did not pay
back the loan and Trinity sued Bowman for the balance of the loan to try
and foreclose on the certificate for the shares of stock.
a. The company’s articles of incorporation required that D would
have to obtain the written approval of NYSE if the corporation was
a member of the exchange and that before selling to an outsider the
corporation and then the other holders of the same class of stock
must have the opportunity to purchase the stock.
b. When the borrower defaulted the bank wanted to foreclose on the
certificate for the shares of stock, but the corporation objects
because the corporation’s stocks are not freely transferable.
c. The court found that the restrictions were not valid because the
stock certificate did not give conspicuous notice of the restrictions.
d. Reference was made on the face of the certificate to the restrictions
described on the back of the stock certificate, but the state requires
that the restriction be conspicuous and there is nothing
conspicuous about the notice on the certificate. The statute also
requires that the restrictions be reasonable and in this case the
court found that the restrictons were not unreasonable.
I. Use of Buy-Sell Agreements
1. If there is a buy-sell agreement, upon the triggering event, a mandatory
obligation to carry out the agreement occurs.
2. These agreements are different from “rights of first refusal” because
rights of first refusals are options that may or may not be exercised.
The Problems of Dissension and Deadlock
A. Gearing v. Kelly (584): there is a 4 person board. The bylaws state that a
majority of the 4 directors was necessary to constitute quorum. One of the
directors resigns and the others want to elect her successor. One of the directors
intentionally does not show up to prevent quorum, but the other 2 directors
conducted the meeting and appointed a director giving these 3 control of the
1. The court found that a director who intentionally is absent from a board
meeting for the purpose of preventing a quorum cannot later complain
that the board transacted business in the absence of a quorum absent
some other wrong-doing.
2. Dissent
a. Gearing effectively and unfairly becomes a minority shareholder.
b. Gearing will be unable to fix this inequity.
B. In Re Radom & Neidorff, Inc. (587): Neidorff and Radom were brothers in law
for 30 years and they formed a corporation to engage in the business of
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lithographing or printing musical compositions. Each held 80 shares of the
company’s stock. Upon his death, Neidorff left his shares to his wife, Radom’s
Sister, Anna. Anna and Radom did not get along. Radom acted as the president
and Anna who was supposed to write his salary checks has refused to do so.
Radom has offered to buy-out Anna, but she has refused. Radom petitioned the
court to dissolve the corporation 5 months after Henry Neidorff’s death, but
because of a will contest to determine the ownership of Henry’s stock, the petition
was not answered for 3 years.
1. Although David Radom had the legal right to request a dissolution to the
court, the statute does not guarantee that it will be granted.
2. The court found that there is no stalemate or impasse as to the
management of corporate affairs and the corporation is thriving.
3. Dissolution is not necessary for the corporation or the stockholders.
4. Radom’s failure to receive a salary may be remedied by other court
5. The court found that the main question in deciding dissolution is
whether judicially imposed death will be beneficial to the stockholders
or members and not injurious to the public.
C. Dissolution
1. RMBCA §14.40
The Modern Remedies for Oppression, Dissension and Deadlock
A. The Evolving Standard of “Oppression” and the Emerging Remedy of a Court
Ordered Buy-Out
1. Davis v. Sheerin
B. Use of Provisional Directors
1. Abreu v. Unica Industrial Sales, Inc.
C. Today, the court could order a buy-out which was not a remedy at the time of
Radom v. Neidorff.
Action by Directors and Authority of Officers
A. The Meeting Requirement for Board Action
1. In order to have valid board action there must be a meeting.
B. Board Action by Written Consent
1. To have valid action without a board meeting, there must be written
consent by the ENTIRE board on that action.
2. The statutes require unanimity because there is no useful purpose to be
served to require everyone to be present for a meeting when everybody
agrees.  Alternatively, if no unanimity, the theory is that the
corporation will benefit from the exchange of ideas.
3. RMBCA §8.21
a. Requires unanimity.
4. CA §307(b)
a. Requires unanimity.
C. Mechanics of Board of Director meetings
1. RMBCA §8.20-8.24
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a. Board Meetings: board of directors may permit any or all
directors to participate in a regular or special meeting unless the
articles of incorporation or bylaws provide otherwise.a director
participating in a meeting by this means is deemed to be present in
person at the meeting. The board of directors may hold regular or
special meetings in or out of the state.
b. Action without meeting: each director must sign a consent
describing the action to be taken and deliver it to the corporation.
c. Notice of meeting: Unless the articles of incorporation or bylaws
provide otherwise, regular meetings of the board of directors may
be held without notice of the date, time, place, or purpose of the
meeting. (?????ONLY IF FIXED as in CA?????)
Unless the articles of incorporation or bylaws provide for a
longer or shorter period, special meetings of the board of
directors must be preceded by AT LEAST 2 days notice of
the date, time, and place of the meeting. The notice need
not describe the purpose of the special meeting unless
required by the articles of incorporation or bylaw
ii. (????Why the different rule for directors v.
shareholders wherein the purpose has to be stated and
cannot be exceeded at the meeting?????)
d. Waiver of Notice: a director may waive any notice required by
this Act, the articles of incorporation, or bylaws before or after the
date and time stated in the notice. Except as provided by
subsection (b), the waiver must be in writing, signed by the
director entitled to the notice, and filed with the minutes or
corporate records. A directors attendance at or participation in a
meeting waives any required notice unless the director at the
beginning of the meeting objects to holding the meeting or
transacting business at the meeting and does not thereafter vote for
or assent to action taken at the meeting.
e. Quorum: majority of the fixed number of directors if the
corporation has a fixed board size; or a majority of the number of
directors prescribed or if no number is prescribed the number in
office immediately before the meeting begins, if the corporation
has a variable range size board. The articles or bylaws may
authorize a quorum of a board of directors to consist of NO
FEWER than 1/3 of the fixed or prescribed number of directors.
f. Voting: if a quorum is present when a vote is taken, the
affirmative vote of a majority of directors present is the act of the
board of directors unless the articles of incorporation or bylaws
require the vote of a greater number of directors.
2. CA §307
a. Board Meetings: Meetings of the board may be called by the
chair of the board or the president or any vice president or the
secretary or any 2 directors.
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b. Notice: regular meetings of the board may be held without notice
if the time and place of the meetings are fixed by the bylaws or the
board. Special meetings shall be held upon 4 days notice by mail
or 48 hours’ notice delivered personally or by telephone, including
a voice messaging system or other system or technology designed
to record and communicate messages, telegraph, facsimile,
electronic mail or other electronic means. The articles or bylaws
MAY NOT dispense with notice of a special meeting. A notice, or
waiver of notice, need not specify the purpose of any regular or
special meeting of the board.
Notice of meeting need not be given to a director who signs
a waiver of notice or a consent to holding the meeting or an
approval of the minutes thereof, whether before or after the
meeting, or who attends the meeting without protesting,
prior thereto or at its commencement, the lack of notice to
that director.
c. Adjournment: a majority of the directors present, whether or not
a quorum is present may adjourn any meeting to another time and
place. If the meeting is adjourned for more than 24 hours, notice
of an adjournment to another time or place shall be given prior to
the time of the adjourned meeting to the directors who were not
present at the time of the adjournment.
d. Participation: members of the board may participate in a meeting
through use of conference telephone, electronic video screen
communication or other communications equipment…
e. Quorum: a majority of the authorized number of directors
constitutes a quorum of the board for the transaction of business.
The articles or bylaws MAY NOT provide that a quorum shall be
less than 1/3 of the authorized number of directors or less than 2,
whichever is larger, unless the authorized number of directors is
one, in which case one director constitutes a quorum.
f. Board Action: an act or decision done or made by a majority of
the directors present at a meeting duly held at which a quorum is
present is the act of the board, subject to the provisions of §310
and subdivision (e) of §317. The articles or bylaws MAY NOT
provide that a lesser vote than a majority of the directors present at
a meeting is an act of the board. A meeting at which a quorum is
initially present may continue to transact business notwithstanding
the withdrawal of directors, if any action taken is approved by at
least a majority of the required quorum for that meeting.
3. Hypothetical
a. Facts
7 person board
ii. 4 directors required for quorum
iii. 2 directors vote yes
1 director votes no
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1 director abstains
b. Under the RMBCA and CA, the vote does not pass because the
majority of the directors PRESENT is considered approval.
D. Authority of Officers: Revisiting Agency Law Principles of Authority
1. Scope of Officers’ Actual Authority
a. RMBCA §4.4 (H&M 614)
2. Scope of Officers’ Apparent Authority
a. Black v. Harrison Home Co. (610): were the actions of the
president within the ordinary or extraordinary course of business?
The court will look at the reasonable belief of the 3rd party.
1) Ordinary and extra-ordinary are a matter of
industry practice/standard.
3. Importance of Certified Board Resolutions
a. RMBCA §8.40(c)
b. CA §314
c. In RE Matter of Drive-In Development Corporation (608):
Officers of Drive In induced National Blvd. Bank to make a loan to
Tastee Freez by executing documents whereby D guaranteed the
loan. Bank requested a copy of the resolution authorizing the
guarantee. A document purporting to be a copy of the resolution
was certified by D’s secretary and delivered to the P. P relied on
the resolution and the guarantee and loaned money to Tastee
The court found that the secretary of the corporation had
the authority to bind the corporation because it is generally
the duty of the secretary to keep the corporate records and
make proper entries of the actions and resolutions of the
ii. Statements made by an officer or agent in the course of a
transaction in which the corporation is engaged and which
are within the scope of his/her authority are binding upon
the corporation.
iii. If the bank was on notice that the secretary’s certification is
not accurate, the state estops the bank from denying that
they were on notice.
In the absence of a Board Approved Resolution, the courts
will fall back on the relationship between the officer and
the 3rd party.
Corporate Governance in the Publicly Traded Corporation
What are (Should Be) the Goals of a Publicly Held Company?
A. Traditional View: Primacy of Shareholder Interests
1. The role of the corporation is to maximize the profits for the benefit of
the shareholders.
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2. Principles of Corporate Governance §201: can take ethical
considerations when making decisions.
B. The Scope of Corporation’s Social Responsibility
1. Even though companies exist as extractions, because it consists of
human beings, human interests are going to be taken into account.
2. The company has a character and persona and has a social responsibility.
C. Publicly Held Companies and the Agency Costs of Separation of Ownership from
Control: To Whom is Management Accountable?
1. The management is held accountable by the shareholders.
2. The “Reputation Market” for Corporate Managers
a. The reputation market acts as a disciplining mechanism for
corporate officers.
b. Apart from stock ownership incentives, officers in large publicly
held corporations have an incentive to increase the profitability of
the corporation and manage the corporation successfully because
of their reputations.
3. Use of Incentive Stock Options to Align Managers’ and Shareholders’
a. Provide officers an ownership interest in the corporation to better
align the interests of the managers and the shareholders.
4. Promulgation of “Other Constituency Statutes”
The Role of Shareholders
A. Exercise of the “Wall Street Vote”: Shareholder vs. Stakeholder
1. In a large publicly held corporation, if the shareholder is unhappy with
the management the shareholder will share his/her stock in the
a. The shareholder will “vote with his/her feet” and exercise his/her
“Wall Street” vote.
B. “Street Name” Ownership: The Use of Nominees
1. The sheer volume of stocks that are traded would make it cumbersome
to require all sellers to sign their stock certificates and physically
transfer the stock certificates to the buyers.
2. The system has moved to “certificate-less” trading which is done purely
with book-keeping without physical stock certificate exchange.
3. Large depository institutions, such as Cede and Co., hold the certificates
and act as the record owner.
C. Concept of “Control”
1. Majority or Voting Control
a. When a shareholder has a majority of the shares and therefore has
control of the corporation.
b. In most largely held corporations, such as Disney, no discrete
group controls the majority of the shares.
2. Minority or Working Control
a. A discrete and identifiable minority owns the stock.
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b. Example: 30% of a company’s stock is owned by an identifiable
management group and no one else owns more than 2% of the
shares. The 30% group probably has effective working control.
3. Management Control
a. The management controls the actions of the corporation.
D. Publicly Held Companies and the Efficient Market Theory
1. There is a cost to overseeing management.
2. In a large publicly held corporation, nobody has a big enough interest to
expend his/her resources to hold corporate management accountable.
3. There is a disincentive to take on the costs of holding management
responsible because the shareholder will bear the entire cost, but the
other shareholders and the corporation will benefit.
4. This means that rather than hold management accountable, people are
going to sell their stocks and so all the remaining shareholders will be
those who are satisfied with the management or don’t care.
E. The “Market for Corporate Control”
1. Proxy Contests
a. Like a referendum.
b. Either a contest with another management team or a showing of
dissatisfaction by withholding votes.
2. Negotiated Acquisitions (Board Approval and Shareholder Approval)
a. The efficient market says that all the publicly available information
about the company is impounded into the pricing of the stock, but
the market price does not tell you the inherent value of the stock.
b. The value of the company is not the price of the stock times the
number of outstanding stock.
Market capitalization = outstanding shares x trading price.
c. The premium for one company taking over another is negotiated
and approved by the board and the shareholders.
3. Tender Offers (Direct Offer to Shareholders)
F. Institutional Stock Ownership
1. Who are these “Institutional” Shareholders?
a. Institutional shareholders are plans/funds established so that
normal everyday people can invest in the market with a fund
manager monitoring the corporations.
b. Way to diversify an investor’s portfolio when the investor does not
have enough money to do it him/herself.
2. The Role of Institutional Shareholders: What are their Options?
a. Because institutional investors represent a group of people and
because they have long term interests in the investment, they have
incentives to hold management accountable.
3. Institutional Shareholders as “Investor Activists”
a. Institutional investors should be the active shareholders that bear
the cost of holding management accountable.
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b. The institutional investor bears the cost, but because of the long
term interest, the cost will not be so onerous as it would be to an
individual investor.
The Respective Roles of Officers and Directors in Public Companies
A. Who Manages the Business Affairs of the Modern Publicly Held Corporation?
1. The Board of Directors manages the business affairs of the corporation.
2. However, the Corporate Officers manage the day-to-day operations of
the corporation.
B. What is the Function of the Modern Board of Directors
1. Bayless Manning Article (692)
a. The decisions of the Board are fluid.the board’s function is to
oversee and monitor the officers and the operations of the
2. The modern board of directors serves an oversight function and the day
to day management of the corporation is done by the Corporate officers.
C. The Role of Outside Directors
1. Management vs. Non-Management Directors – also known as “Inside”
or “Outside” Directors
2. OR Who qualifies as a truly “independent” director?
The Reforms Adopted AS part of the Sarbanes-Oxley Act (SOX)
A. The Increasing Use of Board Committees Consisting (Entirely?) of Independent
1. The Audit Committee
a. Must be entirely outside directors.
b. A financial expert must head the audit committee.
2. The Compensation Committee
3. The Nominating Committee
B. The Gatekeeper Function: The Role of Lawyers and Auditors of Public
Federal Proxy Regulations
A. Scope of Federal Regulation of the Solicitation of Proxies: Definition of
“Reporting Company”
1. A reporting company is a §12 company and comes in 2 types
a. Any company whose stock is listed in a stock exchange (NYSE);
b. Any company who has at least $10 million in assets and 500 or
more shareholders (NASDAQ).
2. A reporting company has to file period reports
a. Annual report: Form 10-K
b. Quarterly report: Form 10-Q
3. The federal proxy rules require an annual report by the corporation to
the shareholders.
a. Like the Form 10-K but more accessible to the everyday investor.
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b. Along with the annual report must be a notice of the meeting and
the proxy statement (information about what you are being asked
to vote on).
4. SEC Rule 14(a)(8): Proxy Statements
B. Proxy Solicitation materials: Proxy Forms, Proxy Statements and Annual Reports
1. State law permits voting by proxy, but the Federal Rules regulate the
process of proxy voting.
2. The federal government requires that for proxy voting to be adequately
C. False and Misleading Proxy Solicitation Material: Rule 14(a)-9
1. Implied Civil Liability for Violations of Rule 14(a)-9
a. The private remedy for a violation of this rule is to invalidate the
vote and require the corporation to reissue the proxy statement and
have a properly administered election.
b. The courts order a revised proxy statement and a new election to
be consistent with congressional intent.
c. The SEC gives a private remedy for an administrative regulation to
reserve the resources of the SEC and to give more effect and power
to the regulation.
2. Rule 14(a)-9 Liability for “materially” Misleading Proxy Statements
a. TSC Industries, Inc. v. Northway, Inc.
b. Standard for Materiality
D. Rule 14(a)-8: Shareholder Proposal Rule
Management’s Fiduciary Duties
The Duty of Care and the Business Judgment Rule
A. The Traditional Statement of the Business Judgment Rule
1. Shlensky v. Wrigley (807): P is a minority shareholder of the Cubs and
is suing the Wrigley family because of the Board’s decision not to install
lights and play day games.
a. The court found that it is not the job of the shareholder or court to
determine whether or not the board has made the “right” decision.
b. Business Judgment Rule
Absent fraud, illegality or conflicts of interest by the Board,
the court will not review business decisions made by the
ii. The court defers to the judgment of the board.
c. The court would have to find no business justification for the
decision for the court to intervene.
d. The Board has a fiduciary duty to the corporation, not the
2. Negligence Cause of Action for Breach of Fiduciary Duty
a. Duty of Care.
b. Duty may be breached in 2 ways
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Misfeasance  Affirmative action taken by the board that
was taken with honesty or good faith.
1) The outcome of the decision is NOT
determinative of whether the duty of care was
breached or fulfilled.
ii. Nonfeasance  Failure to act
c. Fundamental Tension
The board’s job is to act as a reasonable Board would in the
same situation.
ii. The board is also expected to act in the best interest of the
company, even if that means taking risks to make money.
1) The board has to take risks, but they have to be
3. RMBCA §8.30 exists to eliminate the “chilling” effect this rule may
have on the Board by not imposing tort liability.
4. CA §309: Director Duty Statutes
a. CA permits the imposition of tort liability on the Board and
implements a standard of due care and negligence.
b. Does this statute discourage the Board from taking risks?
B. The Modern Statement of BJR
1. Smith v. Van Gorkum (818): Trans Union Board got sued for decision
regarding a cash out merger of New T. Co. and Trans Union. Marmon
funds New T. Co. Pritsker decides whether or not to allow for the
completion of the merger. The Priskers are the sole shareholders of
Marmon and the parties in interest. Van Gorkum, the CEO of Trans
Union, met with Pritsker and formed a business deal for the transaction.
a. Van Gorkum did not inform the CFO, but went to the controller to
run the numbers at 2 given prices
Van Gorkum did this without consulting with the senior
executives and without going to the Board.
ii. Van Gorkum and Pritsker had decided on a $55 selling
b. This is a different situation than Wrigley because this is a one shot
chance to get a premium.
Once the premium is paid, the interest disappears.
c. Smith, a shareholder, filed a class action to rescind the merger or to
recover damages alleging
The directors breached their duty of care by selling the
company without proper valuation; and
ii. The shareholder vote was invalid because shareholders
were misinformed.
d. The court focuses on the decision making process by the Board.
The court finds that Van Gorkum should have shared and
disclosed the information to the Board.
ii. The Board should have conducted an independent valuation.
e. Dissenting Opinion
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The board members of this corporation had a lot of
cumulative experience and are best situated to know the
worth of the company.
ii. An independent valuation would have been a waste of time
and money.
f. This is NOT a conflict of interest case.
g. The court in this case applied a standard of gross negligence even
though that is not the standard in the statutes.
C. Statutory Limitations on Director and Officer Liability: a backlash?
1. Delaware §102(b)(7)  Safe Harbor Provision
a. In addition to the matters required to be set forth in the Certificate
of Incorporation by subsection (a) of this section, the certificate of
incorporation may also contain any or all of the following matters:
(7) a provision eliminating or limiting the personal liability of a
director to the corporation or its stockholders for monetary
damages for breach of fiduciary duty as a director (i) for any
breach of the director’s duty of loyalty to the corporation of its
stockholders, (ii) for act or omissions not in good faith or which
involve intentional misconduct or a knowing violation of law, (iii)
under section 174 of this Title, or (iv) for any transaction from
which the director derived an improper personal benefit. No such
provision shall eliminate or limit the liability of a director for any
act or omission occurring prior to the date when such provision
becomes effective.
b. Must amend the articles.
c. Can eliminate personal liability for some obligations but not for the
4 stated above.
2. This is an opt-in provision in the Articles.
D. Is there a fiduciary duty of disclosure?
1. In Re Caremark Intern., Inc. Derivative Litigation (836): Derivative suit
for nonfeasance. The Ps allege that D breached its duty of care for
failing to detect “kick backs” to physicians in violation of Federal
a. The shareholders want to be able to recover the money that
Caremark has to pay from the directors because the directors failed
to detect the illegal acts of the corporation’s employees.
b. The court did not hold the directors personally liable to the
shareholders and the corporation.
c. Chancellor Allen’s Opinion applies a standard of gross negligence
and tries to address the inherent tension between what a director
wants to do vs. what a director should do.
He did not impose personal liability because that would
discourage people from becoming directors.
The Duty of Loyalty and Conflicts of Interest
A. Self Dealing Transactions
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1. The Common law Rule of “Automatic Voidability”
a. Conflict of interest or self-dealing, corporation could void.
b. The common law rule was viewed as too harsh because sometimes
investors dealt with the corporation to the benefit of the
corporation and the common law rule discouraged inside investors
to transact with the company.
2. The Modern Approach
a. Marciano v. Nakash (908): Gasoline Inc. is owned 50% by the
Marciano family and 50% by the Nakash family. The company is
being dissolved and liquidated and there is a question as to
whether a loan that the Nakash family gave to Gasoline in the
amount of $2.5 million was valid.
The shareholders are fighting as to whether or not the
Nakash’s should be paid the $2.5 million as creditors
before the distribution to the shareholders.
ii. This is a self-dealing case because the Nakash’s are on both
sides of the transaction.
b. Modern Cleansing Statutes  ONLY covers SELF-DEALING
California Code §310(a)(1): Shareholder Approval
1) Full Disclosure of ALL material facts
2) Shareholder Vote in Good Faith
3) By a Majority of Disinterested Shares (Exclude
shares of interested directors)
4) No requirement that transaction is fair to the
ii. California Code §310(a)(2): Board Approval
1) Full Disclosure of ALL material facts
2) Good Faith Approval by Disinterested Directors
3) By a vote sufficient without counting vote of
interested Director
4) Transaction is fair to the corporation at time it is
iii. California Code §310(a)(3): Fairness Standard
1) Who decides fairness of the transaction?
2) Who has burden of proof on fairness?
DE §144
1) Gets rid of the rule of automatic voidability.
c. The Fairness Standard and a Shifting Burden of Proof
If the transaction is cleansed by the board the burden of
proof is on the P to show that the transaction is unfair
notwithstanding the cleansed approval.
ii. If the transaction is cleansed by the shareholders, the court
will not question the fairness of the transaction.
1) Shareholder approval is presumed fair because no
judge is going to substitute his thought process
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and decisions as to the fairness of the transaction
when the owners have decided that the transaction
is fair to the corporation.
iii. If the transaction is not cleansed, then the burden of proof
is on the D to show that the transaction is fair.
1) Under §310(a)(3) it is the burden of the interested
party to show that the transaction is fair and the
court is going to decide the fairness.
d. Self-Dealing Hypo’s
e. RMBCA Subchapter F
B. Executive Compensation
1. The Judicial Standard for “Excessive” Compensation
a. Heller v. Boylan (918): Derivative Action. P is suing to recover
bonus payments paid out to officers. The by-laws of the company
set up a lavish bonus compensation plan. Only 7 out of over
60,000 shareholders joined this action.
The incentive compensation plans are designed to align the
interests of management and owners.  Klein and Coffee.
ii. The shareholders had accepted the incentive compensation
iii. The court found that when evaluating executive
compensation packages, it will apply a standard of waste.
1) The P must be able to show that the resulting
compensation is so large that it amounts to waste
of the company’s a property.
2) Different than the business judgment rule or the
intrinsic fairness rule.
b. Brehm v. Eisner (923): Disney hires Ovitz as president and in his
employment contract there is a no fault termination provision.
Within 14 months of the appointment Ovitz leaves the company and
receives $140 million upon his termination. His option vested the
day that he left the company.
The shareholders allege that the Board breached its duty of
care by providing Ovitz with the termination package.
ii. The agreement was approved by an independent board and
there is no self dealing and so §310 does not apply.
1) For a board to be independent, there board must
not have a financial stake in the outcome of the
iii. Waste = a decision that no rational person would make.
1) So irrational that it is outside the limits of the
business judgment rule.
2) Facts that no reasonable person would agree to.
Fiduciary Duty is about both liability and an aspirational
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1) Page 925  there is a gray area between the law
of corporate fiduciary duties and remedies for
violation of those duties are distinct from the
aspirational goals of ideal corporate governance
Individually, the company may be liable for upwards of
$140 million and under Smith v. Van Gorkum the directors
may be personally liable.
1) Delaware §102(b)(7) eliminates personal
liability of directors.
2. Regarding the Nature of the Recent Controversy over the
“Reasonableness” or Executive Compensation (H&M 929)
C. Parent-Subsidiary Dealings
1. Define “Self-Dealing” in this context
a. Sinclair Oil Corp. v. Levien (934): Sinclair Oil owns 97% of its
subsidiary Sinven. The minority shareholders of Sinven sue the
controlling shareholder for breach of fiduciary duty.
The shareholders allege that the following 3 acts resulted in
a breach of fiduciary duty.
1) Declaration of Dividends
2) Contract between Sinven and Sinclair
3) Allocation of oil investment opportunities in
countries other than Venezuela.
ii. There are 2 possible standards of evaluation
1) Business judgment rule
2) Intrinsic fairness
iii. Dividends
1) The dividends are not paid to the individual board
members, but to the shareholders.
2) By virtue of the ownership interests, 97% of the
dividends are going to go to Sinclair, Inc. and
only 3% is going to go to the minority.
3) P’s assertion that the dividend is too much is only
valid if it would result in the insolvency of the
corporation of—under DE statute—the dividends
are declared in order to satisfy Sinclair’s need for
case (middle 976).
4) The court found that the dividends are not illegal
under the 1st prong because they will not result in
the company’s insolvency.
5) There is no self-dealing.  Sinclair is not
favoring itself and eliminating the minority from
participation in the dividends.
6) The court therefore evaluates this decision under
the Business Judgment Rule.
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Decision not to sue for breach of contract between Sinclair
International (a wholly owned subsidiary of Sinclair, Inc.)
and Sinven.
1) Sinven did not sue Sinclair International and
because Sinclair, Inc. wholly owns Sinclair
International it is receiving a benefit.
2) The court finds that there is self-dealing in this
3) Under Entire Fairness, the burden is on Sinclair,
inc. to show that the transaction is fair.
4) The transaction is not automatically set aside but
the board’s decision not to sue has to be fair and
the burden of proof is going to be imposed on
Sinclair and NOT on the board of Sinven because
Sinclair got the benefit of the decision.
Corporate Opportunity
1) The oil exploration opportunities were not
interests that belonged to Sinven.
2) The parent company would only be liable if it had
usurped the oil exploration opportunity without
providing Sinven’s board a chance to act on the
opportunity with full and adequate disclosure.
2. Modern Standard of Judicial Review of Squeeze-Out (Freeze-Out)
a. Weinberger v. UOP, Inc. (940)
To show instrinsic fairness must show 2 things
1) Fair Dealing
2) Fair Price
ii. The burden is on the majority shareholder to show that the
process was fair.
D. Corporate Opportunity Cases
1. Different Tests
a. Line of Business
b. Fairness
c. Interest/Expectancy
d. ALI
2. Corporate Opportunity Hypotheticals
Shareholder Derivative Litigation and the Business Judgment Rule
A. Derivative Suits
1. Brought by the shareholder on behalf of the corporation.
B. There are types of Derivative Actions
1. Shareholder/P v. 3rd Party
a. When the P wants to sue the 3rd party for harm suffered by the
corporation by the 3rd party’s action.
b. Example: Suing a competitor for an anti-trust violation.
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c. The P must make a demand on the board to file the suit on the
company’s behalf.
The basis for the demand requirement is to make sure that
the suit is truly in the best interest of the corporation and
the other shareholders.
d. RMBCA §8.01
e. CA §309
f. The board is in a better position to determine when a suit is in the
best interest of the corporation.
g. When a demand is made and refused, the shareholder can sue the
Board for breach of fiduciary duty and the Board will apply the
Business Judgment Rule when there is no duty of loyalty
complaints or Intrinsic Fairness when there is self-dealing.
2. Shareholder/P v. Directors/Officers
a. Breach of fiduciary duty.
C. What is the Appropriate Standard for Judicial Review of a Decision made by the
Company’s Board of Directors? [Or by a Special Litigation Committee (SLC)
appointed by the board?] which recommends dismissal of derivative litigation
brought by the company’s shareholders?
1. The court will apply the Business Judgment Rule absent a claim of selfdealing.
D. The Traditional Business Judgment Rule Approach
1. Gall v. Exxon Corp. (860): minority shareholder is suing the Board for
alleged payments from corporate funds as bribes or political payments.
The shareholder wants to hold the Board of Directors personally liable
for not adequately monitoring the employees who violated the rule.
a. The court did not look to whether the shareholder had made a
demand or not.
b. The Board of Directors had established a special committee of
uninterested/outside directors (directors appointed after all the
illegal payments and facts that formed the basis for P’s claims).
c. Outside Directors: not employed by the company and do not work
for the company and no financial ties to the company. No
involvement with the underlying facts.
d. The court remanded the case to determine if the directors were
truly independent.
e. Criticism of BJR Approach: Problems of Structural Bias
Whenever there is a committee of directors who will have
to deal with the other directors on a continuing basis are
they truly independent?  May be influenced by the other
non-independent board members.
f. Balancing the Competing Interests: the corporation vs. the
Derivative Plaintiff-Shareholder
E. A Broader Standard of Judicial Review
1. Zapata Corp. v. Maldonado (866): a shareholder filed derivative suit
against most of the corporation’s directors. The directors created a
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litigation committee of 2 independent directors, which claims its
business judgment permits it to dismiss the suit.
a. When bringing a suit, the shareholder has to first make a demand
on the board.
The Ps stated that they were demand excused because it
would have been futile to make the demand.
b. When the motion is demand excused
Is the board independent and did the board exercise
informed decision making?
ii. The court then decides whether it is in the company’s best
interest to dismiss the law suit.
1) This is to protect the shareholder’s interest and the
ability to bring a derivative lawsuit against the
Board for breach of fiduciary duty.
2) The P had a demand excused case and later on the
board brought in 2 people.
3) Meritorious causes of action will disappear.
F. The Demand Requirement and the Test for Demand Futility: An Unnecessary
Relic of the Past?
1. Delaware’s Approach
a. Demand Requirement in Derivative Litigation is Tied to Standard
of Judicial Review
b. Aronson v. Lewis (874): Demand excused. P can plead
particularized facts that the Board is independent and the decision
is protected by the Business Judgment Rule.
Demand will almost always be required unless a majority
of the Board is so directly self-interested in he challenged
transaction that there is serious doubt that the business
judgment rule would protect that transaction.
2. ALI’s Approach
a. Universal Demand Requirement
b. Cuker v. Mikalauskas
Insider Trading
Introduction to the Duty of Loyalty and Insider Trading: Transactions in the Company’s
Shares by Directors and Officers
A. Based on a set of rules that we have already seen wherein 2 neighboring
landowners enter into negotiations for the sale of land.
1. Landowner B has found oil in his plot of land and wants to buy A’s land.
2. If A asks B if he is drilling for oil, B must answer truthfully.
a. What if B is not drilling for oil? He can truthfully answer “no” to
A’s question.
b. Doctrine of Half-Truths
Cannot omit a material fact.
ii. Duty to speak in a completely truthful way.
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iii. Cannot give technically true answers.
B. Under Common Law fraud only applied in the case of an affirmative
misstatement of a material fact.
The (Evolving?) Approach under State Law
A. Traditional Common Law Rule
1. Goodwin v. Agassiz
2. The common law made 2 distinctions
i. Good News v. Bad News
1) Good News: the stock in the company will go up. Insiders
will buy.
2) Bad News: the stock is going to depreciate. Insiders will
(a) Goodwin (975)
(b) Diamond (976, FN 4)
ii. Open Market v. Privately Negotiated Deals
1) Open Market: anonymous dealings between the seller and
the buyer.
2) Privately Negotiated Deals: face to face dealings.
B. The Modern Approach and the Scope of Insider’s Duty to Shareholders
1. Strong v. Repide (976): Strong, the company’s manager tries to sell his
share of the business. Manager is negotiating the sale in escrow but does
not go directly to the other shareholder, but has another party 3 steps
removed purchase the stock.
i. P sued for securities fraud because D hid his identity from P in the
ii. The misrepresentation was in not disclosing the true identity of the
iii. Even in the absence of a misstatement, the court found there was
securites fraud because special facts were known to D and not
known to the shareholder.
iv. The court found that the D had a duty to disclose because he had
“special facts” (material facts a reasonably investor would want to
2. Hotchkiss v. Fischer (977): widow wants to know if a dividend is going to
be declared on her shares of stock. The board member tells her that he
does not know what the board is going to do, but gives her the numbers
and asks her to decide for herself whether or not a dividend will be
i. She sells her shares and the board subsequently decides to declare
a dividend.
ii. Case of pure fiduciary duty obligation.
iii. Minority Rule/Rule of Strict Accountability: A company
insider when dealing with the company shares has a duty to
disclose special facts.
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3. The Modern Trend towards a rule of Strict Accountability and the
common law development of the “Special Facts Doctrine”
The Development of an Implied Remedy under Rule 10b-5
A. Rule 10b-5 included the common law problem of omission of material facts.
1. The common law only dealt with affirmative misrepresentation.
B. Kardon v. National Gypsum Co.: 2 families evenly owned a company. The
Kardons contributed capital and the Slavins managed the corporation. A bidder
offers to buy the corporation and before the merger, Slavins asked the kardons if
they wanted to sell their shares. During the transaction the Kardons asked the
Slvins if they planned to sell the stock. The Slavins answered “no.”
1. Doctrine of Half-Truths: technically the Slavins were not lying because
they were not selling their shares, but their assets.
a. The Slavins omitted a material fact.
2. The court found there is an implied remedy for the violation of 10b-5
and a private cause of action for the Kardons to sue the Slavins.
3. Implied right of action for securities
The (Shrinking?) Scope of Rule 10b-5 Remedy: Elements of an Implied Cause of Action
Under Rule 10b-5
A. Jurisdiction
1. Interstate Commerce
a. Use the facilities of interstate commerce such as phones, banks, etc.
b. Rarely a barrier to bringing a 10b-5 action.
2. Security
a. Must be related to the purchase or sale of securities
B. Standing to Sue for Rule 10b-5 Violations
1. Actual Buyers or Sellers
2. The SEC
3. US Attorney’s Office to sue for a criminal violation of the SEC rule.
C. Defendant
1. Any person can be a defendant to 10b-5.
a. Natural Persons
b. Business Entities
D. The Scienter Requirement
1. Intent to Deceive, Manipulate or Defraud
a. Ernst & Ernst v. Hochfelder (987): securies fraud case wherein
the President of the securities firm defrauded people and then
committed suicide. The Ps are trying to hold the auditors liable.
The court found that there is no willful or intentional
misconduct and that the D was negligent and made a
mistake which is not enough to impose liability.
ii. The theory under which Ps went after D was aiding and
abetting President’s violation of securities laws.
1) No longer does the court impose liability for
aiding and abetting.
2. Will Recklessness suffice?
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E. Conduct that Violates Rule 10b-5
1. Securities Fraud
a. Misstatements of material facts that occur within the purchase and
sale of a security.
2. Failure to Disclose material non-public information where there is some
independent source of duty to disclose
a. Omissions or failures to disclose
3. Insider Trading – Tippee Liability
F. Material Fact
1. Test for materiality same as TSC Industries
a. What a reasonable investor would consider important.
b. Proprietary information that is not public that a reasonable investor
would consider important.
G. Reliance Requirement
1. Actual Reliance
2. “Fraud on the Market Theory”
a. Gives rise to a rebuttable presumption of reliance in cases of
Misrepresentations in open market transaction
ii. Non-disclosure
H. Damages
Insider Trading as a Violation of Rule 10b-5
A. The Nature of the Problem
B. The Genesis of the rule 10b-5 “Duty to Disclose or Abstain from Trading”
1. SEC v. Texas Gulf Sulphur Co. (1011): K55-1 problem.
a. SEC 10b-5 does not create a duty to disclose.
b. This is an undisclosed good news case.
c. The court found that K55-1 was a material fact because a
reasonable investor would want to know.
d. The court found that the Ds violated 10b-5 by not disclosing the
inside information to the investing public or abstaining from
trading until the inside information was adequately disseminated.
e. Equality of Information/Parity of Access
Reason for the insider trading rules is to prevent insiders
from having an advantage from outside investors.
C. The Modern View: The Supreme Court Scales Back the Scope of the Rule 10b-5
“Duty to Disclose or Abstain from Trading”
1. Chiarella v. US (1028): Tender offer Case. Bidder sends papers to
printer and an employee of the printer uses the information to his benefit
by purchasing stock in the Target companies.
a. The court finds that to create a duty to disclose there must be a
relationship of trust and confidence.
Mere possession of material non-public information is not
enough, there must be some independent source, i.e.
fiduciary relationship.
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2. The Supreme Court establishes that insider trading violations of Rule
10b-5 are tied to the insider’s breach of fiduciary duty and rejects the
“parity of information” theory set out in TGS and its progeny
3. The SEC responds to the Court’s ruling in Chiarella by promulgating
Rule 14e-3 which applies in the context of tender offers
a. The rule states that if a person is in possession of material, nonpublic information he/she is prohibited from trading on the rule.
D. The Misappropriation Theory of Liability for Insider Trading Violations under
Rule 10b-5
1. United States v. O’Hagan (1039): attorney comes into possession of
information during legal representation of the bidding company (Grand
a. The Supreme Court upheld the misappropriation Theory.
The duty that O’Hagan has to Dorsey and Dorsey’s clients
is what gives rise to the misappropriation theory.
ii. The government has standing to sue the D.
b. Unclear as to whether the shareholders of the target company have
standing under this theory.
E. Tipper-Tippee Liability under Rule 10b-5
1. Dirks v. SEC (1054): Secrist, insider, was a whistleblower who told
Dirks, a financial analyst and investigated the story.
a. The court found that the ban on tippee-tipper liability is based on
the tipper’s fiduciary obligations to the corporation.
Need a ban on tipping to enforce the fiduciary obligation
that Secrist has to Equity Funding.
b. Dirks will be liable for trading or tipping others in the information
he is receiving if Secrist (tipper) is giving the information for
personal benefit (pecuniary or non-pecuniary) and he knows or
should have known that it was in breach of tipper’s fiduciary duty.
c. In this case, Dirks does not inherit any 10b-5 liability because
Secrist did not disclose the information for personal benefit.
d. SEC is going after Dirks because Secrist is not trading and not
acting upon the information.
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