Business Associations
Professor Webster
Table of Contents
Chapter 1 – Agency................................................................................................................ 2
Chapter 2 – Partnership ....................................................................................................... 22
Chapter 3 – The Nature of the Corporation........................................................................... 55
Chapter 4 – The Limited Liability Company ........................................................................... 64
Chapter 5 – The Duties of Officers, Directors, and Other Insiders .......................................... 71
Chapter 6 – Problems of Control ........................................................................................ 113
Business Associations
Professor Webster
Chapter 1 – Agency
Gorton v. Doty – Idaho, 1937
In September 1935, an action was commenced by R.S. Gorton, father of Richard Gorton, to
recover expenses incurred by the father for hospitalization, physicians’, etc., by the son, by his
father as guardian ad litem, to recover damages for injuries sustained as a result of an accident.
Richard Gorton, a minor, was a student and member of the football team of his high school. His
team had to transport to Paris to play a game against another team and the transportation was
made by several personal automobiles. One of the automobiles used for that purpose was owned
by appellant. Her car was driven by Mr. Garst, the coach of the Soda Springs High School team.
The appellant knew that the two teams were going to play. She volunteered her car for use in
transporting some of the members of the team to and from the game and that she asked the
coach, Russell Garst, that if he had all the cars necessary for the trip to Paris the next day. He
said he needed one more, that she told him he, and only him, might use her car if he drove it, that
she was not promised compensation for the use of her car and did not receive any; that the school
district paid for the gasoline used on the trip to and from the game; that she testified she loaned
the car to Mr. Garst; that she had not employed Mr. Garst at any time and that she had not at any
time “directed his work or his services, or what he was doing.”
Issue: whether Russell Garst was an agent of the appellant while and in driving her car to the
point where the accident occurred?
Holding: Agency indicates the relation which exists where one person acts for another. It has
three principal forms: 1. The relation of principal and agent; 2. The relation of master and
servant, and; 3. The relation of employer or proprietor and independent contractor. The court
found the first applicable here.
Rule: Agency is the relationship which results from the manifestation of consent by one person
to another [the Agent] that the other shall act on his behalf and subject to his control, and consent
by the other so to act (Restatement of Agency §1).
It is not the case that the relationship of principal and agent must necessarily involve some matter
of business, but only that where one undertakes to transact some business or manage some affair
for another by authority and on account of the latter, the relationship of principal and agent
Application: she designated the driver (Russell Garst) and, in doing so, made it a condition
precedent that the person she designated should drive her car.
It is not essential to the existence of authority that there be a contract between principal and
agent or that the agent promise to act as such (Restatement Agency, §§ 15, 16, pp. 54–54), nor is
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Professor Webster
it essential to the relationship of principal and agent that they, or either, receive compensation
(Restatement Agency, § 16, p. 53).
Precedent: in Willi v. Schaefer Hitchcock Co.: the fact of ownership alone, regardless of the
presence or absence of the owner in the car at the time of the accident, establishes a prima facie
case against the owner for the reason that the presumption arises that the driver is the agent of the
Objection is made to the trial statement, on page 4, to which dissent respond on page 6.
Dissent: An agent is one who acts for another by authority from him, one who undertakes to
transact business or manage some affair for another by authority and on account of the latter.
Agency means more than mere passive permission. It involves request, instruction, or command.
Miss Doty, here, would be held legally liable for each and every act done or performed by Garst
as though she had been personally present and personally performed each and every act that done
or performed by Garst, this in the absence of any contractual relationship between her and Garst
or between her and the school district.
Class 1
Agency is mainly about control. It’s a question about the principal exerting control over the
agent. At the heart of the agency relationship is about consent–it’s about consent, more than
anything, even more than control, i.e. for two parties to enter into anything they must consent.
 consent to be controlled and directed.
This case [Doty] is about the lady acting as a principal and the guy was the agent. This is the
application of the Agency test that you must know below. This court is focusing on control rather
than consent.
shows the element of agency
(1) the manifestation of one person (the Principal) to another (the Agent):
 she manifests her intent that Garst be her agent by volunteering the use of her car and
imposing a condition that Garst be the driver.
(2) the agent will act on his (the Principal’s) behalf and subject to his control
 the acceptance by Garst of the car, but more particularly, the condition that he be the
driver. He accepts the relationship.
(3) and the Agent consents to so act:
The dissent seems to say that the notion that he just drove is equal to control is too much. The
dissent looks at the benefit relationship, she is benefitting the school, so she might well be the
agent of the school. The question is whether the principal must get some benefit from this agency
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Professor Webster
Webster: correct that the principal may not necessarily receive a tangible benefit, that
decision is highly cosmetic, the court wanted somebody to pay the farmers.
Agency relationship develops because of circumstances, and they dictate the existence of the
Gay Jenson Farms Co. v. Cargill, Inc. – Minn. 1981 – ON EXAM
Plaintiffs are farmers bringing action against Cargill and Warren to recover losses sustained
when Warren defaulted on the contracts made with plaintiffs for the sale of grain. The case arose
out of the financial collapse of defendant Warren and its failure to satisfy its indebtedness to
plaintiffs. Warren and Cargill entered into a security agreement which provided that Cargill
would loan money for working capital to Warren on open account, financing up to a state limit,
which was originally set at $175,000. The drafts were imprinted with both Warrant’s and
Cargill’s names. In return for financing, Warren appointed Cargill as its grain agent for
transaction with the Commodity Credit Corporation. Cargill was also given a right of first refusal
to purchase market grain sold by Warren to the terminal market. As Warren’s indebtedness
continued to be in excess of its credit line, Cargill began to contract Warren daily regarding its
financial affairs. In early 1977, it became evident that Warren had serious financial problems.
Several farmers, who had heard that Warren’s checks were not being paid, inquired or had their
agents inquire at Cargill regarding Warren’s status and were initially told that there would be no
problem with payment.
Issue: whether in the course of dealing with Warren, Cargill had become liable as a principal on
contracts made by Warren with plaintiffs?
The court stresses the control and influence over Warren’s operations and finds that an agency
Holding: Agency is the fiduciary relationship that results from the manifestation of consent by
one person to another that the other shall act on his behalf and subject to his control, and consent
by the other so to act. In order to create an agency, there must be an agreement, but not
necessarily a contract between the parties . . . An agreement may result in the creation of an
agency relationship although the parties did not call it an agency and did not intend the legal
consequences of the relation to follow. The existence of the agency may be proved by
circumstantial evidence, which shows a course of dealing between the two parties. When an
agency relationship is to be proven by circumstantial evidence, the principal must be shown to
have consented to the agency since one cannot be the agent of another except by consent of the
1. Cargill contends that no agency relationship was established, because Cargill never consented
to the agency. The court finds that all three elements of agency could be found in the particular
circumstances of this case. By directing Warren to implement its recommendations, Cargill
manifested its consent that Warren would be its agent. Warren acted on Cargill’s behalf in
procuring grain for Cargill as the part of its normal operations which were totally financed by
Cargill. Further, an agency relationship was established by Cargill’s interference with the
internal affairs of Warren, which constituted de facto control of the elevator.
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Webster: this is problematic, because there is no evidence that Warren consented to act as
Cargill’s agent.
Can there be an implied consent based on the circumstances? Webster: you need a
meeting of the minds. The intent on the part of Warren is to intend a crime, and false
misrepresentation, and that means there is no meeting of the minds.
Holding: A creditor who assumes control of his debtor’s business may become liable as principal
for the acts of the debtor in connection with the business. Restatement Second of Agency §14O
(1958). A comment to that section:
A security holder who merely exercises a veto power over the business acts of his debtor
by preventing purchases or sales above specified amounts does not thereby become a
principal. However, if he takes over the management of the debtor’s business either in
person or through an agent and directs what contracts may or may not be made, he
becomes a principal, liable as a principal for the obligations incurred thereafter in the
normal course of business by the debtor who has now become his general agent .The
point at which the creditor becomes a principal is that at which he assumes de facto
control over the conduct of his debtor, whatever the terms of the formal contract with his
debtor may be.
A number of factors indicated Cargill’s control over Warren:
1) Cargill’s constant recommendations to Warren by telephone;
2) Cargill’s right of first refusal on grain;
3) Warrant’s inability to enter into mortgages, to purchase stock or to pay
dividends without Cargill’s approval;
4) Cargill’s right of entry onto Warren’s premises to carry on periodic
checks and audits;
5) Cargill’s correspondence and criticism regarding Warren’s finances,
officers’ salaries and inventory;
6) Cargill’s determination that Warren needed strong paternal guidance;
7) Provision of drafts and forms to Warren upon which Cargill’s name
was imprinted;
8) Financing of all Warren’s purchases of grain and operating expenses,
9) Cargill’s power to discontinue the financing of Warren’s operations.
These factors must not be viewed in isolation and must be viewed in light of all the
circumstances surrounding Cargill’s aggressive financing of Warren.
2. Cargill posits that the relationship between Cargill and Warren was that of buyer-supplier
rather than principal-agent.
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Under Restatement Second of Agency § 14K (1958), one who contracts to acquire property from
a third person and convey it to another is the agent of the other only if it is agreed that he is to act
primarily for the benefit of the other and not for himself.
Factors indicating that one is a supplier, rather than an agent, are:
(1) That he is to receive a fixed price for property irrespective of price paid by him. That is the
most important. (2) That he acts in his own name and receives the title to the property which the
thereafter is to transfer. (3) That he has an independent business in buying and selling similar
Holding: Under the Restatement Approach, it must be shown that the supplier has an
independent business before it can be concluded that he is not an agent.
Application, this relationship and reasoning cannot extend to creditor-borrower, since here the
control and the extent of direction and authority is extreme.
To understand the purpose and the form of grain elevators one must understand the grain
economy of prairie settlement. In order for settlement to be successful there had to be efficiency
in production and marketing of grain to world markets. This meant having a system to assemble
and store grain from farms and move it forward position to shipment.
They were lending because of the grain. Why didn’t Cargill take over the company? Look at the
manner in which this court applies the Agency test to these facts, it gets it wrong, because it
wants to get farmers compensated.
They fail because there is no apparent consent by Warren to act on behalf of Cargill.
Lesson from Cargill:
Rule: a creditor becomes a principal at that point at which it assumes de facto control over the
conduct of the debtor.
Consent must be based on near perfect knowledge from both parties.
The nine factors in determining that Cargill is the creditor that has taken control are very
important. The court says that some of these are common to any creditor, but the combination of
these lead to the conclusion reached in the case. Factors 3, 4, and 9 are common to a sympathetic
lender. Factors 1 and 5 represent a degree of anxiety (of a controlling creditor).
What’s important about the case is that circumstances dictate the situation and consent is
Where did Warren Consent to be an Agent? That seems to be missing here.
circumstance when the creditor becomes the principal.
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Professor Webster
Mill Street Church of Christ v. Hogan- Ky. 1990
The Church of Christ decided to hire Bill Hogan to paint the church building. The Elders decided
that another church member, Gary Petty, would be hired to assist if any assistance was needed.
Sam Hogan had earlier been a member of the church but was no longer a member. Apparently,
Waggoner made no mention to Bill Hogan of hiring a helper at that time. This was a very high,
difficult portion of the church to paint. According to both Dr. Waggoner and Hogan, they
discussed the possibility of hiring Gary Petty to help Hogan. None of the evidence indicates that
Hogan was told that he had to hire Petty. He was in fact told that Petty was difficult to reach.
Bill Hogan approached his brother, Sam, about helping him complete his job. Sam accepted the
job, started working, fell of the ladder, and broke his arm. Payne, a treasurer, told Bill that the
church had insurance and issued Bill a check for all the hours Sam worked before falling.
Petitioners contend there was neither implied nor apparent authority in the case at bar.
Implied authority is actual authority circumstantially proven which the principal actually
intended the agent to possess and includes such powers as are practically necessary to carry out
the duties actually delegated.
Apparent authority on the other hand is not actual authority but is the authority the agent is held
out by the principal as possessing. It is a matter of appearances on which third parties come to
In examining whether implied authority exists, it is important to focus upon the agent’s
understanding of his authority. It must be determined whether the agent reasonably believes
because of present or past conduct of the principal that the principal wishes him to act in a
certain way or to have certain authority. The nature of the task or job may be another factor to
consider. Implied authority may be necessary in order to implement the express authority. The
existence of prior similar practices is one of the most important factors. Specific conduct by the
principal in the past permitting the agent to exercise similar powers is crucial.
The person alleging agency and resulting authority has the burden of proving that it exists.
Agency cannot be proven by a mere statement, but it can be established by circumstantial
evidence including the acts and conduct of the parties, such as the continuous course of conduct
of the parties covering a number of successive transactions.
Here, the discussion between Bill Hogan and the Church, indicated that Gary Petty would be
difficult to reach, and Bill Hogan could hire whomever he pleased. Maintaining a safe and
attractive place of worship clearly is part of the church’s function, and one for which it would
designate an agent to ensure that the building is properly pained and maintained. Sam Hogan
relied on Bill Hogan’s representation. The treasurer even paid Bill Hogan for the half hour of
work that Sam had completed prior to the accident.
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 This case shows how authority is delegated.
 There are two authorities: (1) implied, because necessarily incidental to painting here you
need to hire an additional worker in light of the size of the task (implied by the
circumstances, nature of the task). (2) apparent, from the past, because he needed help in
the past.
Class 1
The management of LLC is conducted much more of a partnership like than a general
corporation. It’s also tax efficient, (corps are taxed twice), but LLC is taxed once. So corporate
governance, and tax purposes.
In the US, there is an assertive activist shareholder problem: shareholders are the pain for the
corporate governors.
You would know about derivative actions: shareholders can act when they perceive harm from a
corporation, they have invested in.
Class 2
Types of Authority:
(1) Actual Express authority,
(2) Actual Implied Authority,
(3) Apparent Authority,
(4) Inherent Agency Power,
(5) Ratification, and
(6) Estoppel.
See slide 11, class 1.
We need to know how much power we are delegating to our agent. The agent creates
relationships with third parties, and you as the principal need to know the extent to which the
agent can bind you.
The law wants to categorize the types of authorities the agent may have. In many ways, it doesn’t
matter if you classify them into labels. It’s more important to know what authority the agent
enjoys as a result of express circumstances or the situation the agent finds himself.
Actual Express Authority:
e.g. Caleb is going to Modena tomorrow to buy Webster a Ferrari. Since these instructions are
expressed, then the authority is actual express. If you qualify the authority with a provision or
conditions, then you revoke the express authority, but the third party may not necessarily know.
Actual Implied Authority:
It is linked to the story that Caleb is involved and that is carried out to perform the task. Means
necessary to the achievement of the task (you need transportation). For example, Webster
forgetting to tell him to get a plane ticket. The stuff that we forgot are implied. It may be other
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things that the principal simply doesn’t cover in her instruction, that are necessarily incidental to
the achievement of the task. Actual Implied Authority involves third parties most often.
it involves an authorized approach by a person to a third party that seeks to create an opportunity
for somebody. It’s only about a decision to accept an authorized and unpermitted arrangement by
someone else (not an agent). It can be either authorized or unpermitted or both, that’s the beauty
of ratification. Consent is inherently excluded, because it’s an unauthorized approach.
Class 3
Authority and Power are topics most important and frequent in governance issues. To analyze
authority, consider all the circumstances, including what the standard of the industry is, the
nature of the job and relationships. Past experiences are important in this domain.
See page 16 questions.
Q1. no, we are principally concerned about the relationship between the church leaders and
Hogan. Sam’s belief is not important, what matters is the relationship between the church leaders
and Bill.
Hypo: if you know the agent is really not an agent of the principal you shouldn’t deal with them.
Q2. a. yes, because he has express authority.
b. implied (maybe). If he had asked Ann to manage but has not given express authorization on
how the management of the building must be conducted. The standard is objective by which you
determine the conduct.
c. No, because the custom of the area matters. So, you would have to go with custom. Paul is
bound with the contract with the janitor (based on the express authority by custom). Revisit
Historical practices as the implied authority to hire other people.
Three-Seventy Leasing Corporation v. Ampex Corporation- 5th Cir. 1976
370 seeks damages from Ampex for breach of a contract to sell six computer core memories. 370
was formed by Joyce, at all times its only active employee, for the purpose of purchasing
computer hardware from various manufacturers for lease to end-users. Kays, a salesman of
Ampex and friend of Joyce arranged a meeting between Kays, Joyce, and Mueller, Kays’
superior at Ampex to purchase stuff from Ampex. Joyce was informed that Ampex could sell to
370 only if 370 could pass Ampex’s credit requirements. Joyce informed the two that he did not
think this would be a problem. Joyce began negotiations with EDS, which resulted in EDS’s
verbal commitment to lease six unites of Ampex computer core memory from 370. They drafted
a document, which specified that delivery was to be made to EDS. The document also contained
a signature block for a representative of 370 and a signature block for a representative of Ampex.
The document was never executed by a representative of Ampex.
Ampex contends that the document was nothing more than a solicitation which became an offer
to purchase upon execution by Joyce, and that this offer was never accepted by Ampex. 370
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argues that even if the document when signed by Joyce was only an offer to purchase, the offer
was later accepted by representatives of Ampex.
The 5th Circuit found that the document was an offer to purchase when it was signed by Joyce
which was later accepted by Ampex.
The count reasons that the fact that the document had a signature block for a representative of
Ampex which was unsigned at the time it was a submitted to Joyce, in the absence of other
evidence, negates any interpretation that Ampex intended this to be an offer to Joyce, without
any further acts necessary on the part of Ampex. Thus, the document when signed by Joyce, at
most constituted an offer by him to purchase.
Also, Mueller issued an intra-office memorandum that requested all contracts with 370 be
handled through Kays. Kays later sent a letter to Joyce which confirmed the delivery dates for
the memory units.
Holding: in light of the circumstances surrounding these negotiations, that the district court was
not clearly erroneous when it found that Kays had apparent authority to accept Joyce’s offer on
behalf of Ampex . . . the letter can be reasonably understood as an acceptance.
Rule: An agent has apparent authority sufficient to bind the principal when the principal acts in
such a manner as would lead a reasonably prudent person to suppose that the agent had the
authority he purports to exercise . . . Further, absent knowledge on the part of this parties to the
contrary, an agent has the apparent authority to do these things which are the usual and proper to
the conduct of the business which he employed to conduct.
Relevant facts: Ampex did nothing to dispel this reasonable inference that Kays, as a salesman,
had ample authority to execute. Rather, its actions and inactions provided a further basis for this
belief. First, Kays, at the direction of Mueller, submitted the controversial document to Joyce for
signature. Second, Joyce indicated to Kays and Mueller that he wished all communications to be
channeled through Kays. Also, Joyce was never informed of any communication limitations
which would indicate any limitation of apparent authority.
Takeaway: contracts entered into on the principal’s behalf by an agent lacking actual authority
can still be binding on the principal if the agent has apparent authority.
Restatement Third of Agency § 2.03: Apparent authority exists when a third party reasonably
believes the actor has authority to act on behalf of the principal and that belief is traceable to the
principal’s manifestations.
Restatement Third of Agency § 1.04(2)(b): A principal is undisclosed if, when an agent and a
third party interact, the third party has no notice that the agent is acting for a principal.
Class 3
Joyce is a one man show company. The issue is whether Kays, a salesman, binds a principal?
The situation is different here, because Ampex has given excess authority to Kays, who is
Joyce’s friend, so they can seal the deal. The crucial difference here is the document from
November 7th. It’s sent back without being signed, the crucial part of the story is the November
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Professor Webster
17th document, that talks about delivery and the schedule for delivery. The court states that the
letter states that Kays speaks for the company and that binds the company. So, Ampex gives Mr.
Kays excess authority to work with Joyce and the work more efficiently.
The complication is that there is nothing in the communication between Kays and Joyce, that
would tell Joyce that there is a limitation on Kays authority and for that reason the court says that
Joyce reasonably relied on Kays authority. Kays gets clothed with extra authority. (i.e. nobody
tells Joyce that Kays is just a salesman).
It may have been the case that Kays extended and gave more benefits.
look at the facts of the matter to determine the whole thing.
Watteau v. Fenwick
Humble (defendant) carried on business at a beerhouse called the Victoria Hotel, which business
he had transferred to the defendants, a firm of brewers. After the transfer of the business,
Humble remained as defendants’ manager; but the license was always taken out in Humble’s
name, and his name was painted over the door. The plaintiff gave credit to Humble, and to him
alone, and had never heard of the defendants. The business, however, was really the defendants’.
The action was brought to recover the price of goods delivered at the Victoria Hotel over some
years, for which it was admitted that the plaintiff gave credit to Humble (defendant) only. The
trial court found for the plaintiff and found the defendants liable.
Holding: the liability of a principal for the acts of his agent, done contrary to his secret
instructions, depends upon his holding him out as his agent–that is, upon the agent being clothed
with an apparent authority to act for his principal. Where, therefore, a man carries on business in
his own name through a manager, he holds out his own credit, and would be liable for goods
supplied even where the manager exceeded his authority.
Question: cannot you, in such a case, sue the undisclosed principal on discovering him?
Holding: only where the act done by the agent is within the scope of his agency; not where there
has been an excess of authority. Where there has been no holding out, proof must be given of an
agency in fact in order to make the principal liable.
Judge Boydell Houghton, for the plaintiff: Here the defendants have so conducted themselves as
to enable their agent to hold himself out to the world as the proprietor of their business, and they
are clearly undisclosed principals. All that the plaintiff has to do, therefore, in order to charge the
principals, is to show that the goods supplied were such as were ordinarily used in the business–
that is to say, they were within the reasonable scope of the agent’s authority.
J. Wills: Once it is established that the defendant was the real principal, the ordinary doctrine as
to principal and agent applies–that the principal is liable for all the acts of the agent which are
within the authority usually confided to an agent of that character, notwithstanding limitations, as
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between the principal and the agent, put upon that authority. The law of partnership is nothing
but a branch of the general law of principal and agent, and it appears to me to undisputed and
conclusive on the point now under discussion.
Inherent agency power (this is to an apparent agent)- allows for an undisclosed principal
even if the activities with respect which seeks to recover are prohibited.
 A third party can recover from an UNDISCLOSED PRINCIPAL must show that the
event or something that is usually done in the business, the and that such conduct by the
agent might change their position, but did not take reasonable steps to notify them of the
The Restatement (Second) of Agency § 8A – “inherent agency power” – all page 22
The Restatement (Second) of Agency § 194
The Restatement (Second) of Agency § 195
The Restatement (Third) of Agency § 2.06 – Liability of Undisclosed Principal:
 in sum it states that the principal is liable “if the principal, having notice of the agent’s
conduct and that it might induce others to change their position, did not take reasonable
steps to notify them of the facts.”
Do the problems on Page 24.
Class 3
Inherent Agency Power is applicable here. The plaintiff is unaware of the defendants. In
addition, Humble is buying cigars and Bovril and other things from the plaintiff, in fact, he is
prohibited from buying. So Humble acts outside the authority he is given.
Going forward, the principal does not have to be disclosed. Inherent agency power in
America is used to help the party that is on the end that deals with an agent with an
undisclosed principal, but this may also apply even in cases that the principal is disclosed
or presumes to be, e.g. Nancy’s power as an agent in Assignment 1. See question (b).
Totality of the circumstances of the industry matters, what is the type of approaching, for
example, acceptable for law firms to approach in hiring decisions. The principal is likely
the executive committee so you know the principal.
If you look at the common business practices is not only to allow people to buy and transact, but
the general practice may allow for a certain practice.
Here you have an undisclosed principal, the identity of the owners is not known.
Holding: Undisclosed Principal is personally liable for debts incurred by Agent even when
agent’s acts are prohibited as long as those acts are within the scope of other agents engaged in
similar activities.
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For that reason, Humble has Inherent Agency Power. The court develops this principal here
because the real owners are undisclosed.
This power is invented to protect the innocent buyers from secret bosses and secret investors
who then say no we don’t want liability.
Note: If the principal’s identity is undisclosed it’s IHP, but if it’s disclosed then the agent has
apparent authority.
Ratification is like saying “my agent didn’t have the right to enter into this contract, but I’m
glad she did so. Accordingly, I’ll affirm the transaction and agree to be bound by the
contract. Any ratification case involves two critical questions:
First, what types of acts constitute an affirmation by the principal?
Second, what effect should we give to that affirmation?
 So its adobting, confirming the deal that was a prior deal that did not bind a person and
gives clear freedom to adopt or confirm the K.
 Accepting and permitting the option to buy the deal.
Botticelo v. Stefanovicz, Conn., 1979
The issue is whether an agreement of the sale of real property can be enforced when that
agreement has been executed by a person owning only an undivided half interest in that
The defendants, Mary and Walter acquired as tenants in common a farm. The plaintiff, Anthony
became interested in the property. The plaintiff and Walter, after a series of negotiation, agreed
upon a price of $85,000 for a lease with an option to purchase, during these negotiations. Mary
states that she would not sell the property for less than that amount. The agreement was drawn up
by Walter’s attorney after consultation with Walter and the plaintiff, it was then sent to, and
modified by, the plaintiff’s attorney. The agreement was signed by Walter and by the plaintiff.
Neither the plaintiff nor his attorney, nor Walter’s attorney, was then aware of the fact that
Walter did not own the property rights. The plaintiff was a successful businessman with many
experiences in this matter. His lawyer never did any title search either. Walter never represented
to the plaintiff or the plaintiff’s attorney, to his own attorney, that he was acting for his wife.
The plaintiff took possession of the property. He made substantial improvements on the property
and properly exercised his option to purchase. When the defendants refused to honor the option
agreement, the plaintiff commenced the present action against both Mary and Walter, seeking
specific performance, possession of the premises, and damages.
The trial court found the issues for the plaintiff and ordered specific performance of the option to
purchase agreement.
1. The defendants appealed and said that Mary was never a party to the agreement, and its terms
may therefore not be enforced to her. The plaintiff alleged, and the trial court agreed, that
although Mary was not a party to the lease and option to purchase agreement, its terms were
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nonetheless binding upon her because Walter acted as her authorized agent in the negotiations,
discussions, and execution of the written agreement.
Holding: Agency is defined as the fiduciary relationship which results from manifestation of
consent by one person to another that the other shall act on his behalf and subject to his control
and consent by the other so to act. Restatement Second Agency § 1.
Three elements are required:
(1) a manifestation by the principal that the agent will act for him, (2) acceptance by the agent of
the undertaking, and (3) an understanding between the parties that the principal will be in control
of the undertaking.
The existence of an agency relationship is a question of fact. The burden of proving an agency is
on the plaintiff and it must be proven by a fair preponderance of the evidence. Marital status
cannot in and of itself prove the agency relationship. Nor does the fact that the defendants owned
the land jointly make one the agent for the other.
Reasoning: the finding indicates that when the farm was purchased, and when the couple
transferred property to their sons, Walter handled many of the business aspects, including
making payments for taxes, insurance, and mortgage. A statement that one will not sell for less
than a certain amount is by no means the equivalent of an agreement to sell for that amount.
Moreover, the fact that one spouse tends more to business matters than the other does, does not
absent further evidence, constitute the delegation of power as to an agent. Also, Mary
consistently signed all the deed, mortgage, or mortgage notes in connection with their jointly
held property.
2. The plaintiff next argues that even if no agency relationship existed at the time the agreement
was signed, Mary ratified the terms by her subsequent conduct. Trial court accepted this position.
Appellate disagrees.
Rule: Ratification is defined as “the affirmance by a person of a prior act which did not bind him
but which was done or professedly done on his account. Restatement Agency § 82. Ratification
requires acceptance of the results of the act with an intent to ratify and with full knowledge of all
the material circumstances.
Reasoning: at most, Mary observed the plaintiff occupying and improving the land, received
rental payments from the plaintiff time to time, knew that she had an interest in the property, and
knew that the use, occupancy, and rentals were pursuant to a written agreement she had not
signed. Moreover, the fact that the rental payments were used for “family” purposes indicates
nothing more than one spouse providing for the other.
3. The plaintiff makes the argument that Mary ratified the agreement simply by receiving its
benefits and by failing to repudiate it.
Holding: Before the receipt of benefits may constitute ratification, the other requisites for
ratification must first be present. Thus, if the original transaction was not purported to be done on
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account of the principal, the fact that the principal receives its proceeds does not make him a
party to it.
Reasoning: since Walter at no time purported to be acting on his wife’s behalf, as is essential to
effective subsequent ratification, Mary is not bound by the terms of the agreement, and specific
performance cannot be ordered as to her.
Class 3
Takeaways: You cannot ratify a deal without knowing all the details. Mary couldn’t ratify a deal
she did not know anything about. She wasn’t a party and was neither ignorant of anything.
Also, Mary did not ratify because she did not accept the payments or benefits “with an intent to
ratify, and with full knowledge of all the material circumstances.”
In addition, marital relationship is not enough to make one spouse the agent of another.
Hoddeson v. Koos Bros.
The plaintiff Mrs. Hoddeson went to a furniture store and liked a furniture at display. She also
borrowed money from her aunt and later went to purchase the furniture. At the time, she was
faced with a person who through acts, acted as if she was the salesman for the store and without
receiving any receipt and notice, she provided the cash and “purchased” the furniture. The
imposter told her that they had to send her another furniture because that money was a model at
display and she accepted. Later, as promised, there was no furniture delivered. She sued the store
for the loss of money and they found out that it was a con.
Holding: where a party seeks to impose liability upon an alleged principal on a contract made by
an alleged agent, as here, the party must assume the obligation of proving the agency
relationship. It is not the burden of the alleged principal to disprove it.
The liability of a principal to third parties for the acts of an agent may be shown by proof
disclosing: (1) express or real authority which has been definitely granted, (2) implied authority,
that is, to do all that is proper, customarily incidental and reasonably appropriate to the exercise
of the authority granted, and (3) apparent authority, such as where the principal by words,
conduct, or other indicative manifestations has “held out” the person to be his agent.
 Must show deliberate or negligent conduct that shows Apparent authority, where
the P relies on which she sees.
 The negligently created authority – in which the person changes the position in response
to the negligently created authority.
o The CHANGE IN POSITION = in that the person demonstrates a type of
affirmative response where the person does an affirmative action.
 The Court’s look at whether there is a change in position.
Reasoning: the plaintiff’s evidence in the present action does not substantiate the existence of
any basic express authority or project any question implicating implied authority.
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Question: would the defendant be immune as a matter of law from liability for the plaintiffs’
Holding: where a proprietor of a place of business by his dereliction of duty enables one who is
not his agent conspicuously to act as such and ostensibly to transact the proprietor’s business
with a patron in the establishment, the appearances being of such a character as to lead a person
of ordinary prudence and circumspection to believe that the impostor was in truth the
proprietor’s agent, in such circumstances the law will not permit the proprietor defensively to
avail himself of the impostor’s lack of authority and thus escape liability for the conceptual loss
thereby sustained by the customer.
Reasoning: certainly, the proprietor’s duty of care and precaution for the safety and security of
the customer encompasses more than the diligent observance and removal of banana peels from
the aisles. Broadly stated, the duty of the proprietor also encircles the exercise of reasonable care
and vigilance to protect the customer from loss occasioned by the deceptions of an apparent
Class 3
The court creates a tort doctrine of dereliction of authority and they compensate Mr. Hoddesson.
So, it’s authority by the way or estoppel.
Three elements you need to prove to make a case for estoppel:
(1) Acts or omissions by the principal, either intentional or negligent, which create an appearance
of authority in the purported agent,
 they haven’t taken steps to ensure that authorized personnel are only working there.
(2) the third party reasonably and in good faith acts in reliance on such appearance of authority,
 he looks like the real deal
(3) the third party change her position in reliance upon the appearance of authority.
 she’s out of money now (she pays money out)
The court combines tort and agency.
 To ESCAPE liability for an agent:
a. must reveal that they are acting for a principal,
b. reveal the principal,
c. and the third-party does not need to Inquire, rather it is the duty of the agent.
Atlantic Salmon v. Curran, Appeals Mass. (reverse and remand)
Issue: the personal liability of an agent who at the relevant times was acting on behalf of a
partially disclosed or unidentified principal.
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Facts: the defendant began doing business with the P’s, representing himself in various positions
on behalf of Boston International Seafood Exchange Inc., and repeatedly transfer money to the
plaintiffs as the treasurer of that company. At the time, however, no such Massachusetts or
foreign corp. had been formed by the defendant or had existed. Plaintiffs were asking for the
money for salmon sold to the defendant. The defendant says that by using “inc” he was telling
them that they were dealing with a corp.
1. Defendants argue that he was acting as an agent of Marketing Designs (a company that the
seafood inc had changed its name into) and that he incurred the debt on the company’s behalf.
Holding: “if the other party to a transaction has notice that the agent is or may be acting for a
principal but has no notice of the principal’s identity, the principal for whom the agent is acting
is a partially disclosed principal.” Restatement Second of Agency § 4(2)
Unless otherwise agreed, a person purporting to make a contract with another for a partially
disclosed principal is a party to the contract.
It is the duty of the agent, if he would avoid personal liability on a contract entered into by him
on behalf of his principal, to disclose not only that he is acting in a representative capacity, but
also the identity of his principal.
Reasoning: the trial judge reasoned that since the defendant had filed a certificate with the City
of Boston that Marketing Designs was doing business as Boston Seafood Exchange, the plaintiffs
could have discerned “precisely with whom they were dealing by reference to public records
before the 1988 credits were extended.
The appeals judge: it was not the plaintiff’s duty to seek out the identity of the defendant’s
principal, it was the defendant’s obligation to fully reveal it.
It is not sufficient that the plaintiffs may have had the means, through a search of records of the
Boston city clerk, to determine the identity of the defendant’s principal.
Holding: actual knowledge is the test. It is not enough that the other party has the means of
ascertaining the name of the principal, the agent must either bring to him actual knowledge or
what is the same thing that which to a reasonable man is equivalent to knowledge or the agent
will be bound.
If he does not do this, it may well be presumed that he intended to make himself personally
Reasoning: Finally, the defendant’s use of trade names or fictitious names by which he claimed
he conducted its business is not in the circumstances a sufficient identification of the alleged
principal so as to protect the defendant from personal liability . . . Indeed, the defendant’s own
testimony expresses the impossibility of any rational connection.
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Duties During Agency:
2. duty of absolute loyalty
3. act solely for the benefit of the Principal
4. entitled to reasonable compensation
5. but NO secret profits
6. NO supplementary benefits
7. must NOT put his interests or those of a third party above those of the Principal
8. must NOT secretly conduct business with the principal or deal with him as an adverse
Class 3
Two things agents owe to the principal: (1) a duty of loyalty, and (2) a duty of care.
Loyalty here is to ensure that you do not put your own interest or anybody else above the
principal. As the agent, you serve the principal that demonstrates loyalty and fidelity. It’s a
marriage type of quality involved.
Duty of care involves carrying out his duties with a reasonable skill and care like an individual in
that similar circumstance.
Of course, an agent is entitled to a reasonable compensation that he is entitled to.
Reading v. Regem (army guy)
The plaintiff had not had any opportunities of making money but there were found standing to
his credit at banks in Egypt, several thousands of pounds, and he had more thousands of pounds
in notes in his flat. He made a statement, from which it appears that they were paid to him by a
man by the name of Manole in these circumstances. Manole handed him an envelope with a lot
of money.
The plaintiff alleges that these moneys are his and should be returned to him by the Crown.
These were bribes received by you by reason of your military employment, and you hold the
money for the Crown.
Issue: the question is whether or not the Crown is entitled to the money. It is not entitled to it
simply because it is the Crown–moneys which are unlawfully obtained are not ipso facto
forfeited to the Crown. The claim of the Crown rests on the fact that at the material time it was
the plaintiff’s employer.
Holding: it is a principle of law that, if a servant takes advantage of his service and violates his
duty of honesty and good faith to make a profit for himself, in the sense that the assets of which
he has control, the facilitates which he enjoys, or the position which he occupies, are the real
cause of his obtaining the money as distinct from merely affording the opportunity for getting it,
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that is to say, if they play the predominant part in his obtaining the money, then he is accountable
for it to his master.
Reasoning: it matters not that the master has not lost any nor suffered any damage, nor does it
matter that the master could not have done the act himself. This case is different from cases
where the service merely gives the opportunity of making money. The master has a claim for
damages for breach of contract, but he has no claim to the money. Although the Crown has
suffered no loss, the court orders the money to be handed over to the Crown, because the Crown
is the only to whom it can properly be paid.
Holding: if the servant has unjustly enriched himself by virtue of his service without his master’s
sanction, the law says that he ought not to be allowed to keep the money, but it shall be taken
from him and given to his master, because he got it solely by reason of the position which he
occupied as a servant of his master.
Rule: Restatement Third Agency § 8.02:
An agent has a duty not to acquire a material benefit from a third party in connection with
transactions conducted or other actions taken on behalf of the principal or otherwise
through the agent’s use of the agent’s position.
An agent has a duty (1) not to use property of the principal for the agent’s own purposes
or those of a third party.
Class 4
The enrichment here has nothing to do with his principal, it’s why Readings lawyers say why
should he return the money to the King. The duty of honesty to the employer has been violated,
simply by abusing his employment position (wearing the uniform of a soldier).
Page 75 Problems:
Q1. The same result, his acting in his capacity, because he has the uniform on (the creation of the
impression matters–abusing the uniform is the focus here). Impersonating a soldier can be a
criminal offense in some countries.
Q2. Shouldn’t give up, because he has done the actions that merits bravery and medals and he is
entitled to benefits of this.
Q3. This is okay, because he has a history of doing great things.
Q4. This is common, CEOs write about their experience, so it’s okay
Q5. Lebron James can exploit his name
 The Rights of Publicity – everybody has a right of publicity to use their image, name,
signature, etc. that is unique to them specifically.
Q6. Harvard status doesn’t matter, publicity helps the school.
Q7. this is insider trading and they have to disgorge.
Don’t make profits off of your principal’s situationally created position.
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Rash v. J.V. Intermediate
Clayton Rash was hired to manage a company division and signed an agreement for a base
salary. The contract stated that Rash “devote his full work time and efforts.” Rash continued to
serve as manager until 2004, even though his contract was till 2001, without any written contract
extension. The company, however, claims that Rash actively participated in and owned at least
four other businesses, none of which were ever disclosed to JVIC.
Issue 1. is there a fiduciary relationship?
Holding: the agent to principal relationship gives rise to a fiduciary duty.
Under Restatement Second of Agency § 387, unless otherwise agreed, an agent is subject to a
duty to his principal to act solely for the benefit of the principal in all manners connected with
his agency. The court concluded that Rash was an agent of JVIC.
Reasoning: First, Rash has sole operational management. Second, he was to devote his full work
time and efforts to the business. Third, Rash was an agent.
Issue 2: did Rash breach his fiduciary duty?
Holding: It turns on the scope of that duty. Courts inquire whether a fiduciary duty exists with
respect to the particular occurrence or transaction at issue. Rash violated when he did not
An employee’s independent enterprise cannot compete or contract with the employer without the
employer’s full knowledge.
Because Rash has general management responsibility, he was aware of the principal’s interests
and a general prohibition against the fiduciary’s using the relationship to benefit his personal
interest. By failing to inform, he violated his duty.
 There is a fiduciary duty in regards to the entire responsibility to disclose on ALL
 If the person is crucially involved in selecting a subcontractor, and employed by JVIC,
then it will be based on the same (scaffolding business)
Class 4:
The question is whether Rash violated a fiduciary duty by failing to disclose that he owned the
contractor company?
Webster’s recommendation: when in doubt, disclose.
You must disclose any area of potential conflict. Central to agency is consent, but you cannot
give proper and informed consent if you don’t know. This case is only about potential conflict.
Analysis on Page 79 –
Q2. The court says you should have told the principal and disclose: so you must put it in writing
and that would satisfy the disclosure requirement.
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Town & Country House & Home Services, Inc. v. Newbery,
This action was brought for an injunction and damages against appellants on the theory of unfair
competition. The individual appellants were in plaintiff’s employ for about three years before
they severed their relationships and organized the corporate appellant through which they have
been operating. The complaint is basically saying that the plaintiffs’ enterprise was unique,
personal and confidential and that appellants cannot engage in business at all without breach of
the confidential relationship in which they learned of its trade secrets, including the names and
individual needs and tastes of its customers.
The business is about house cleaning. It’s “unique” because of the mass production methods.
They have been instructed by the housewife but work without her supervision. The appellate
reversed the judgment for the defendant on a ground that while in plaintiff’s employ, appellants
conspired to terminate their employment, form a business of their own in competition with
plaintiff and solicit plaintiff’s customers for their business.
Holding: the trial court erred in dismissing the complaint. The list of customers was confidential.
Reasoning: he may not solicit the latter’s customers who are not openly engaged in business in
advertised locations or whose availability as patrons cannot readily be ascertained but “whose
trade and patronage have been secured by years of business effort and advertising, and the
expenditure of time and money, constituting a part of the good will of a business which
enterprise and foresight have built up.
This is done in light of the fact that the customers could not be looked up and had to be screened
from many customers.
Class 4:
It’s about grab, and go, this is about industrial espionage. They are after the trade secrets: list of
the customer. Customer lists are industrial secrets, they should not be allowed to do this.
 Duty of loyalty may indeed continue after termination of agency agreement
(termination of employment)
 Trade Secrets
 Defendants accessed customer lists and information compiled with concerted
effort over a considerable period of time.
 There must be a reasonable opportunity for a client to choose, to stay, or to leave.
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Professor Webster
Chapter 2 – Partnership
Partnerships are governed by statute (UPA, RUPA, and common law).
What is a partnership?
Under UPA (1914) § 6(1): “a partnership is an association of two or more persons to carry on as
co-owners of a business for profit”
Nelson v. Abraham, 29 Cal.2d 745, 177 P.2d 931 (Cal. 1947) :
“A partnership connotes coownership in the partnership property with a sharing in the profits and
losses of a continuing business.”
Characteristics of Partnership 1:
 agreement between 2 or more, not necessarily in writing
 share profit and control (both of these must be present) (it’s an element test)
 partnership like a marriage
 relationship of equality
 each partner assumes responsibility for debts and obligations of others
 partners may make decisions that bind other partners
 voting generally by majority
 partners act as agents for one another
 no written agreement required (partnership could be determined from conduct/ the
totality of the circumstances)
 Fiduciary duties owed by partners= RUPA s. 409
1. Duty of Care
 essentially refraining from gross negligence, reckless conduct, intentional
2. Duty of Loyalty
 to account for any benefit derived from using partnership property or
appropriating a partnership opportunity
 to refrain from dealing with the partnership in any adverse manner
 to refrain from competing with the partnership in the conduct of its business
There are a variety of partnerships, but the characteristics above are only for general partnership.
The other types of limited partnerships (there must be at least one general partner for
management). These characteristics are default unless otherwise agreed.
Partners are agents for each-other. Whatever an association calls itself, if they have profit and
they share and control that allocation, they are partners.
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Advantages of Partnership
 Simplicity
 Single layer of taxation
 More resources than sole prop.
 Cost sharing
 Broader skill and experience base relative to sole partnership
 Unlimited liability (compare and contrast with the limited liability of Corporations)
 Potential for conflict
 Expansion, succession, and termination issues.
Common Clauses in Partnership
 Ownership of partnership and partnership assets
o Presumed to be equal unless stated otherwise
 Accounting procedures
o including maintenance of capital account belonging to each partner, etc.
 Distribution of profits and losses
o Presumed to be equal unless stated otherwise
 Liability of each partner to the others
 Compensation for services
o presumed to be none unless stated otherwise
 What happens if a partner resigns or dies
o Default rule: the partnership terminates
 Dispute resolution
o including arbitration clause, if desired
 Termination and what happens upon termination
 Other miscellaneous clauses, as negotiated, including:
o How notice is given to each party
o How agreement is modified
o Costs and attorney fees
o Life insurance agreements
 Agreement must be executed by all parties.
 intentions of the parties matter
 Fiduciary duty: it is very important
 Disclosure is essential in pursuing further business opportunities
 Unless otherwise agreed, partners are agent for each other.
Fenwick v. Unemployment Compensation Commission:
Rule of Law
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Professor Webster
A partnership exists when two or more persons act as co-owners of a business for profit.
Fenwick (plaintiff) employed Chesire as a cashier and receptionist at his beauty parlor. Chesire
initially worked for $15 per week, but after several months she demanded a raise. Not wanting to
lose Chesire, Fenwick agreed to increase her compensation if his beauty parlor made more
money. Fenwick and Chesire executed an agreement which described their association going
forward as a “partnership,” and each of them as a “partner.” The agreement provided that
Chesire would continue her current duties and be paid her existing salary plus 20 percent of the
profits “if the business warrants it.” The agreement also stipulated that Chesire would make no
capital investment in the beauty parlor, and that Fenwick would retain complete control of it and
be solely responsible for its debts. Chesire continued to work as cashier and receptionist for three
years after the agreement was executed. She subsequently terminated the agreement and quit her
job to stay home with her child. A case was brought before the New Jersey Unemployment
Compensation Commission (Commission) (defendant) to determine whether Chesire was
Fenwick’s partner or employee. If Chesire was Fenwick’s employee, Fenwick would be
responsible for paying into the state unemployment compensation fund. The Commission found
that Chesire was Fenwick’s employee, holding that the agreement was simply an instrument used
by the parties to set the level of Chesire’s salary. The New Jersey Supreme Court reversed,
relying heavily on the terms of the agreement and ruling that Fenwick and Chesire were partners.
Is a partnership established by an agreement stating that two parties are partners, if one party
retains sole ownership of the business and the parties conduct themselves as employer and
Holding and Reasoning
No. In order for a partnership to be formed, the parties involved must have co-ownership of a
business. Courts consider a number of factors in determining whether or not a partnership exists.
The evidence in this case shows that Fenwick and Chesire were not partners in the beauty shop.
The first factor is the intention of the parties and language of the agreement. Although the
agreement listed Fenwick and Chesire as “partners,” the intent of the parties in entering into the
agreement was to give Chesire the possibility of a salary increase at her current job while at the
same time protecting Fenwick from having to pay it if his business did not improve. Hence, the
agreement was intended simply to memorialize the agreed-upon financial relationship between
an employer and employee, and Chesire was excluded from most of the rights of a partner.
Another factor is the right to share in the profits and losses of an enterprise.
The agreement gave Chesire the right to share in some of the profits, but the losses were to be
borne solely by Fenwick.
A further factor is ownership, management, and control of the partnership property and business.
Fenwick provided all the capital for the beauty parlor, and the agreement gave Fenwick complete
ownership rights and control over managing the business.
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Professor Webster
Another factor is the conduct of the parties toward third persons. While Fenwick and Chesire
told the Commission they were partners and filed partnership income tax returns, they did not
hold themselves out as partners to anyone else. Fenwick and Chesire carried on their business
relationship as employer and employee.
The final factor concerns rights upon termination of the partnership. When Chesire quit her job,
she simply left her position, and the business continued. There was no “winding up the
partnership” or any indication that a partnership had been dissolved. Considering the evidence in
light of these factors, it is clear that Fenwick retained sole ownership in the beauty parlor after
the agreement was executed. Hence, no partnership existed between Fenwick and Chesire. The
judgment of the supreme court is reversed.
It’s only the language, but there is no substance to that language. By necessity, partnership has to
have control and profits. This is a new wage agreement, and it misses the control element. See
paragraph 5 of the agreement.
Question 3 on page 87: to draft something that said you have the power to consult and confer
based on your interest in the partnership/investment in the partnership.
important, review for final.
Martin v. Peyton
Rule of Law
In order for a creditor to be a partner in a firm, the creditor must be closely enough
associated with the firm so as to make it a co-owner carrying on the business for profit.
~ compare with Cargill:
In Cargill, they put their own people in charge, here, Hull is a friend in charge, so it’s not
that they exercise control.
In Cargill you have active participation, there they had their people dispatching their
people in the office of the other party to control the purchase, expenditure, etc. There, the
intention was initially to lend, and Cargill ultimately wanted to get the grain and they got
the grain.
Rule: the status of the parties, their intention to associate with the other parties (whether
to make money) matters in determining whether the association is a partnership or not.
Cargill is active participation
Martin is all about passivity
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Professor Webster
Passivity: the fact that they are trustees and are passive in control.
In Cargill, the court looks at the pocket of the business themselves, and the poor farmers.
Also, here, they look at the rich people who have been betrayed by their friends. It’s a
matter of timing and political arena as well.
The brokerage firm of Knauth, Nachod & Kuhne (KN&K) made a series of bad investments,
which resulted in the firm suffering severe financial difficulties. In order to save KN&K, one of
its partners, Hall, entered into a transaction with Peyton (defendant) and other persons (lenders)
for a loan of $2,500,000 worth of securities to KN&K. In return for the loan, the lenders were to
receive 40 percent of KN&K’s profits until the debt was repaid. The transaction was based on
three documents: an agreement, indenture, and option.
The agreement provided that:
(1) two of the lenders were appointed “trustees” who were to be informed of transactions
affecting them, paid dividends and income from those transactions, had the power to buy and sell
their loaned securities and substitute those securities with those of equal value, but could not
commingle those securities with KN&K’s other securities, and were required to keep the
securities valued at a certain level;
(2) Hall was given the power of directing the management of KN&K until the loan was repaid,
and his life was to be insured for $100,000 with the insurance policies given to the trustees as
additional collateral;
(3) the trustees were to be kept informed of the important matters of KN&K’s business, could
inspect the books, and had the power to veto certain business decisions that could affect their
collateral; and
(4) each KN&K member was to assign their interest in the firm to the trustees, member could
receive a loan from KN&K, the members’ draw amount was fixed, and no other distribution of
profits could be made.
The indenture was basically a mortgage on the collateral delivered by KN&K to the trustees.
The option: (1) gave the lenders the opportunity to buy into KN&K by buying 50% or less of the
members’ interest at a listed price; (2) enabled the formation of a corporation to replace KN&K
if its members and lenders agreed; and (3) provided for the resignation of any KN&K member at
the demand of Hall. Martin (plaintiff), a creditor of KN&K, sued the lenders, claiming that their
transaction with KN&K, as illustrated by the agreement, indenture, and option, made them
partners in that firm and thereby liable for KN&K’s debts. The trial court held that the lenders
were not partners of KN&K.
Do agreements intended to protect the financial interests of creditors necessarily make them
partners of a debtor firm?
Holding and Reasoning
No. A partnership is not formed unless two or more parties are closely associated so as to be coowners carrying on a business for profit. When, as here, creditors have executed loan documents
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with a debtor firm that contains provisions for the collection of collateral, this court must
examine the extent to which those documents associate the creditors with the business operations
of the firm. In this case, no partnership was formed. The agreement’s providing for appointment
of two of the lenders as trustees, for example, does not indicate a partnership. The trustees were
in charge only of transactions affecting their collateral, and they were prohibited from
commingling the collateral with KN&K’s other securities.
Similarly, Hall’s life insurance and management power does not imply an association with
KN&K because Hall was trusted by the other lenders to keep an eye on KN&K and work to
ensure that it was run efficiently enough to return to profitability and pay back the lenders. And,
the trustees’ veto power does not indicate a partnership, as it gave them the ability only to
safeguard against bad investments concerning their collateral. The trustees had no authority to
initiate transactions on half of KN&K, nor bind the firm by their actions. Further, the assignment
of firm interest to the lenders is not indicative of a partnership, because the intent was to protect
the firm’s profits, which represented the lenders’ compensation for the loan.
The indenture was a mortgage, containing the terms of KN&K’s performance of the loan. The
indenture did not contain any terms of partnership. The option’s provision giving Hall the right
to demand the resignation of KN&K members was unusual, but as the intent was to protect the
lenders against speculative transactions that could render the option itself worthless, it does not
show that a partnership was formed. Questions of whether a partnership is formed between
various entities are a matter of degree, to be determined on a case-by-case basis. In this case, the
loan documents do not show that a partnership existed between the lenders and KN&K.
Class takeaway:
 Partners compared with Lenders. (remember the Cargill (lender) case in the context of
o KNK in serious financial difficulties
o Hall (a KNK partner) asks friends at PPF for loan
o Loan granted – subject to conditions
o Conditions include: provision for return on their investment, right of inspection,
veto and personnel selection (in advance resignation letters, which is a bit of a
tight control).
o There is no agency argument, because the relationship is not of a nature that
would have authority and all that.
o The claim for partnership here fails, because control is lacking.
 The issue here is also whether the terms assure the lender’s needs for the return of their
 Hull isn’t their puppet (agent) because of the foreign currency speculation: he never
warned the others when he should have! That’s another way of looking at it.
Question 2 on page 92: all of their investment
Question 3: they couldn’t probably argue for anything more. There is no real enforcement, rather
than just asking whether Hull was truthful to them.
What could you put into the contact that would have taken out the control element?
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Professor Webster
Take out the language on deciding the business strategy and the letters of resignation.
There is no intention on the part of lenders to associate themselves with KNK to make profit,
they just want to make sure they are getting their money back.
The comparison with Cargill is important here. The prohibition of the foreign currency
transaction is at the gist of the fact pattern, it facilitates the scheme for creditors to come in and
point fingers to someone to recover ~ creditors want to establish partnership to use the joint and
several liability.
There needs to be an intention to go into business.
Southex Exhibitions, Inc.
Rule of Law
The question of whether a partnership has been formed is determined by examining the
totality of the circumstances.
Sherman Exposition Management, Inc. (SEM), the predecessor in interest to Southex
Exhibitions, Inc. (Southex) (plaintiff), executed an agreement with the Rhode Island Builder’s
Association, Inc. (RIBA) (defendant) to produce RIBA home shows at a local civic center. The
agreement’s term was five years, renewable upon mutual agreement. The agreement’s preamble
stated that RIBA wished to participate in the home shows as sponsors and partners. The
agreement further provided that: (1) SEM would put up all the necessary capital for the shows
and indemnified RIBA for losses from the shows; (2) the net profits would be divided between
SEM (55%) and RIBA (45%); and (3) both parties would mutually determine the show dates and
admission prices for the shows. During the contract negotiations, SEM’s president, Sherman,
told RIBA representative Dagata that if he was not happy after the first year, he would give back
the shows to RIBA. Sherman consistently referred to himself as the producer of the shows.
Twenty years after the agreement was executed, Southex acquired SEM’s interest under the
agreement. Southex continued to enter into third-party contracts under its own name, and never
filed partnership tax returns. Four years later, Southex decided that it would likely renegotiate the
agreement. RIBA told Southex that it was dissatisfied with Southex’s performance and then
signed a contract with a rival producer. Southex sued RIBA alleging that RIBA breached its duty
to Southex by wrongfully terminating the agreement and contracting with the competing
producer. The district court entered judgment for RIBA, holding that the agreement created no
partnership between RIBA and SEM.
Does an agreement for production of shows, and the parties’ actions pursuant to that agreement,
indicate the formation of a partnership under the totality of the circumstances test?
Holding and Reasoning
No. A partnership requires the association of two or more parties to carry on as co-owners of a
business for profit. The determination of whether a partnership has been formed requires an
examination of the totality of the circumstances in a given case. The agreement contained a finite
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Professor Webster
term, while partnership agreements typically run for indefinite terms. The law presumes that
partners share proportionately in partnership losses, but SEM agreed to indemnify RIBA against
losses related to the shows. A partner by nature is a co-owner of a business, but RIBA did not
involve itself in major business decisions. And, when Southex assumed SEM’s interest, Southex
continued to transact business with third parties under its own name and did not file either
federal or state partnership tax returns.
Moreover, Sherman continually referred to himself only as a producer of RIBA’s shows, and
disclaimed ownership of them by saying the he would “give them back” to RIBA if he was
dissatisfied with their profitability. The state partnership statute provides that the sharing of
profits is prima facie evidence that a partnership has been formed. In the present case, it is
undisputed that the parties did share profits. However, it does not necessarily follow that
evidence of profit sharing absolutely requires this court to find that a partnership exists,
particularly in light of evidence showing a lack of intent to form a partnership. Such evidence, as
has been described above, shows that the parties did not intend to form a partnership. Finally,
the fact that the parties labeled themselves as partners in the agreement is unavailing, due to
RIBA’s and SEM’s lack of intent to form a partnership. Based on the totality of the
circumstances, this court finds that no partnership existed in this case.
Young v. Jones
Rule of Law
A person who represents, or permits another to represent, that he or she is a partner in an
existing partnership or with other persons who are not partners, is liable to third parties
who rely on that representation.
Young and other investors (investors) (plaintiffs) deposited more than $500,000 in a bank, and
the entire amount disappeared. The investors claimed that when they deposited their money in
the bank, they relied on an audit letter from Price Waterhouse, Chartered Accountants (PWBahamas) confirming a financial statement that turned out to be falsified. The audit letter was
printed on letterhead with a trademark signed “Price Waterhouse.” The investors contend that
PW-Bahamas and Price Waterhouse’s partnership in the U.S. (PW-US) operated as partners by
estoppel, and therefore PW-US can be held liable for the alleged negligence of PW-Bahamas
regarding the audit letter. The investors argue that Price Waterhouse held itself out as a
partnership with offices around the world, and PW-US made no distinction between itself and
other PW entities around the world. As proof that PW-Bahamas and PW-US held themselves out
as partners, the investors offer a Price Waterhouse brochure stating that Price Waterhouse is a
large and respected global entity, with 400 offices throughout the world. The investors aver that
the brochure was intended to present an image of a large international accounting firm, and that
PW-US promoted that image to give the public confidence in Price Waterhouse’s stability and
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Does a partnership by estoppel exist when a third party does not rely on any statement or act by
two companies it alleges were holding themselves out as partners, and when no credit was
extended based on the representation of a partnership?
Holding and Reasoning
No. A partnership by estoppel is created when a third party relies on the representation of a
person that he or she is part of an actual or apparent partnership. The investors present no
evidence that they relied on any statement or act by PW-US that it was a partner of PWBahamas. Nor do the investors claim that they relied on the brochure when they decided to put
their money in the bank. According to the state statute cited by investors in their complaint, a
person who holds him or herself out as a partner is liable to a third party who has given credit to
the partnership based on the person’s representation. There is no allegation that the investors
extended credit to PW-Bahamas or PW-US. Additionally, there is no contention that PW-US had
anything to do with the audit letter upon which the investors claim they relied when depositing
their money in the bank. This court finds no evidence of the existence of a partnership by
Arguments: PWC Bahamas and US are (1) partners in fact, because they licensed their
names to be used by accounting firms in various parts of the world.
The second argument is (2) partnership by estoppel: that you have to materially rely and
present yourself as partners to the others. (Plaintiffs fail here because they cannot show
If they are partners by estoppel, then PW-US would be liable – under general partnership
law principles – for the negligent acts of PW-B.
Question 2 on page 101:
In terms of being a partner you need a consensual relationship, by the way of either profit sharing
or control. By reliance, you need a response to holding out.
Giving your name (PwC) to an entity doesn’t make you partners.
See Section 409. Standards of Conduct for Partners. on Page 107:
(b) A partner’s duty of loyalty to the partnership and the other partners is limited
to the following:
(1) to account to the partnership and hold as trustee for it any property, profit, or
benefit derived by the partner:
(A) in the conduct or winding up of the partnership’s business;
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Professor Webster
(B) from a use by the partner of the partnership’s property; or
(C) from the appropriation of a partnership opportunity;
(2) to refrain from dealing with the partnership in the conduct or winding up of
the partnership business as or on behalf of a person having an interest adverse to
the partnership; and
(3) to refrain from competing with the partnership in the conduct of the
partnership’s business before the dissolution of the partnership.
Some actions which may violate this fiduciary duty of loyalty include:
 Competing with the partnership
 Taking a business opportunity away from the partnership
 Using partnership property for private profit
 Conflicts of interest
Meinhard v. Salmon, very important on duty of loyalty
Rule of Law
Co-adventurers, like partners, have a fiduciary duty to each other, including sharing in any
benefits that result from the parties’ joint venture.
Class: Rule of the necessity of disclosing an opportunity in a partnership capacity.
Salmon (defendant) executed a 20-year lease (Bristol Lease) for the Bristol Hotel which he
intended to convert into a retail building. Concurrent with his execution of the Bristol Lease,
Salmon formed a joint venture with Meinhard (plaintiff). The joint venture’s terms provided that
Meinhard would pay Salmon half the amount required to manage and operate the property, and
Salmon would pay Meinhard 40 percent of the net profits for the first five years, and 50 percent
thereafter. Both parties agreed to bear any losses equally. The joint venture lost money during
the early years, but eventually became very profitable. During the course of the Bristol Lease
another lessor acquired rights to it. The new lessor, who also owned tracts of nearby property,
wanted to lease all of that land to someone who would raze the existing buildings and construct
new ones. When the Bristol Lease had four months remaining, the new lessor approached
Salmon about the plan. Salmon executed a 20-year lease (Midpoint Lease) for all of new lessor’s
property through Salmon’s company, the Midpoint Realty Company. Salmon did not inform
Meinhard about the transaction. Approximately one month after the Midpoint Lease was
executed, Meinhard found out about Salmon’s Midpoint Lease, and demanded that it be held in
trust as an asset of the joint venture. Salmon refused, and Meinhard filed suit. The referee
entered judgment for Meinhard, giving Meinhard a 25% interest in the Midpoint Lease. On
appeal, the appellate division affirmed, and upped Meinhard’s interest in the Midpoint Lease to
Is a co-adventurer required to inform another co-adventurer of a business opportunity that occurs
as a result of participation in a joint venture?
Holding and Reasoning (Cardozo, C.J.)
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Yes. As sharers in a joint venture, co-adventurers owe each other a high level of fiduciary duty.
A co-adventure who manages a joint venture’s enterprise has the strongest fiduciary duty to other
members of the joint venture. The Midpoint Lease was an extension of the subject matter of the
Bristol Lease, in which Meinhard had a substantial investment. Salmon was given the
opportunity to enter into the Midpoint Lease because he managed the Bristol Hotel property.
Because Salmon’s opportunity arose as a result of his status as the managing co-adventurer, he
had a duty to tell Meinhard about it. Salmon breached his fiduciary duty by keeping his
transaction from Meinhard, which prevented Meinhard from enjoying an opportunity that arose
out of their joint venture. Accordingly, the judgment of the appellate division is affirmed, with a
slight modification. This court holds that a trust attaching to the shares of stock should be
granted to Meinhard, with the parties dividing the shares equally, but with Salmon receiving an
additional share. The additional share enables Salmon to retain control and management of the
Midpoint property, which according to the terms of the joint venture Salmon was to have for the
entire length of that joint venture.
The two were in it jointly, for better or for worse.
Joint adventures, like partners, owe to one another, while the enterprise continues, the
duty of the finest loyaltyexcluding the chance to compete with him.
A trustee is held to something stricter than the morals of the market place.
Dissent (Andrews, J.)
Salmon did not breach his fiduciary duty to Meinhard. The joint venture’s purpose was to exploit
the Bristol Lease exclusively, for a limited duration of 20 years. Salmon fulfilled his duty to
Meinhard by managing the Bristol Hotel property and distributing Meinhard’s share of the
profits during the term of the Bristol Lease. Salmon’s fiduciary duty to Meinhard was restricted
to matters pertaining to the Bristol Lease, and ended when the Bristol Lease expired. The
judgment of the lower courts should be reversed, and a new trial ordered.
The UPA focuses on the disclosure on anything that arises from partnership opportunity. The
problem is that no one defines partnership opportunity.
 The lesson is that partners should have sat down and discuss what they wanted to do.
 The question becomes what if you simply disclose? even with a limited duration, the
question is how crucial was Salmon’s money for this venture?
 You must put an arbitration clause and expect and address conflict in the agreement.
 Duty of care is that partners don’t behave in a careless way.
 The rule here is that partnership opportunity must be disclosed.
 Partnership opportunity may be the opportunity that arises from the ordinary course of
business that the partnership engages in. It’s something that arises from the agreement. In
other word, but for this partnership opportunity, the business opportunity would not arise.
That business opportunity, however you define it, belongs to the partnership as a whole
for this business opportunity to work you need to have consent of the other.
Page 107
Q1: we don’t really know the agreement in fact.
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Professor Webster
Q2: the opportunity so that they both could take advantage of it.
Planning and Policy
2. Salmon could have given Meinhard: (1) notice opportunity, (2) guarantee that they both would
take on any new opportunity, and (3) limited duration partnership.
very important case, you must know it very well. Defines business opportunity.
A good lawyering for the agreement here would have to have the proper exit clause  you need
the dissolution clause.
Sandick v. LaCrosse
Rule of Law
A joint purchase of a lease for the purpose of selling the lease for profit can constitute a
joint venture.
In May 1996, Sandvick (plaintiff), Bragg (plaintiff), LaCrosse (defendant), and Haughton
(defendant) jointly purchased three oil and gas leases (the Horn leases) for the purpose of selling
them for profit during their five-year terms. Empire Oil Company (Empire Oil), which was
owned by LaCrosse, held title to the Horn leases. The purchase was made using credits that each
of the parties had in Empire Oil’s checking account. The Horn leases had no provisions for
extensions or renewals. In November 2000, six months before the expiration of the Horn leases,
Haughton and LaCrosse purchased three five-year oil and gas leases (the Horn top leases) that
were, in effect, extensions of the Horn leases. The terms of the Horn leases and the Horn top
leases were identical, except that Sandvick and Bragg were not parties to the Horn top leases.
Sandvick and Bragg were not informed of Haughton and LaCrosse’s acquisition. Sandvick and
Bragg brought suit against LaCrosse and Haughton, alleging that they breached their fiduciary
duties by failing to offer Sandvick and Bragg the chance to participate in the purchase of the
Horn top leases. The district court ruled that neither a partnership nor a joint venture existed with
respect to the Horn leases and that, therefore, no fiduciary duty was owed.
Does a joint purchase of a lease for the purpose of selling the lease for profit constitute a joint
Holding and Reasoning
Yes. Here, no partnership existed among the parties. In North Dakota, a partnership consists of
two or more persons who associate to carry on a business as co-owners for profit. A partnership
exists where there is: (1) an intent to be partners; (2) co-ownership of the business; and (3) a
profit motive. A business is defined as a series of acts that are aimed at a particular goal. Here,
the parties are not carrying on a business, since the parties’ purchase of three oil and gas leases
for a limited period of time does not constitute a series of acts. Therefore, the district court
properly found that a partnership did not exist.
However, a joint venture did exist among the parties. A joint venture is like a partnership but
limited in scope and duration. A joint venture is found where: (1) there is a contribution made by
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Professor Webster
each party; (2) the parties share a proprietary interest and mutual control over the property; (3)
there is an agreement for the sharing of profits; and (4) there is an agreement showing that a joint
venture exists. Here, the Horn leases were purchased from each party’s Empire Oil credits, the
property was titled in Empire Oil’s name, and the parties intended to sell the leases and share the
profits. Thus, a joint venture existed among the parties. Principles of partnerships apply to joint
ventures, such as the duties of loyalty and care. Here, LaCrosse and Haughton’s purchase of the
Horn top leases was incompatible with their duty of loyalty. By purchasing the Horn top leases
six months before the expiration of the Horn leases, LaCrosse and Haughton created a conflict of
interest because it was no longer in their best interest to sell the Horn leases before they expired.
The duty of loyalty required LaCrosse and Haughton to offer Bragg and Sandvick the
opportunity to participate in the purchase the Horn top leases. Therefore, the decision of the
district court is reversed.
Even if a joint venture was in fact formed, it is possible that the parties agreed to limit their duty
of loyalty. However, this court simply presumes that a full duty of loyalty existed. In the absence
of a written contract, the majority should not overlook the district court’s findings of fact, which
were made after the district court had the benefit of seeing and hearing the witnesses before
determining the scope of the parties’ obligations. Therefore, the judgment of the district court
should be affirmed.
 The rules relating to partnerships apply to joint ventures as well, there is no difference in
terms of rules.
 Rules of disclosure also applies here.
P. 113:
 Partnerships envisage a continuing relationship, a long-term relationship. v. a joint
venture focuses on a short-term project for a specific purpose (limited duration).
 Webster believes that Meinhard Salmon was a joint venture not a partnership.
Meehan v. Shaughnessy,
Rule of Law
A partner has a fiduciary duty to provide, on demand of another partner, true and
complete information of any and all things affecting the partnership.
Meehan and Boyle (plaintiffs), disgruntled partners in the law firm of Parker, Coulter, Daley &
White (Parker Coulter) (defendants), decided to quit that firm and form their own legal
partnership. Meehan and Boyle were subject to a Parker Coulter partnership agreement which
provided that partners leaving the firm could, for a fee, take clients who they themselves had
originated, subject to the right of the clients to remain at Parker Coulter. While still employed at
Parker Coulter, Meehan and Boyle secretly began preparing to take some clients with them.
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Professor Webster
Meehan met with a big client to discuss transferring that client’s business to the new firm. Boyle
prepared form letters on Parker Coulter letterhead addressed to a number of clients, inviting them
to become clients of the new firm. During Meehan and Boyle’s last few months at Parker
Coulter, various partners asked them if they were planning to leave. Meehan and Boyle denied
their intentions, preferring to wait until the end of the year to give Parker Coulter one month’s
notice of their resignation. Almost immediately after tendering his resignation, Boyle sent his
solicitation letters to selected Parker Coulter clients, and contacted attorneys who could refer
additional clients to the new firm. The Parker Coulter partners asked Boyle for a list of clients he
and Meehan planned to take with them, so they could inform the clients that they could stay with
Parker Coulter if they wished. Boyle waited several weeks to provide that list. Meanwhile,
Meehan and Boyle obtained authorizations from many Parker Coulter clients, agreeing to
become clients of the new firm. After leaving Parker Coulter, Meehan and Boyle sued their
former firm for compensation they claimed was unfairly withheld from them. Parker Coulter
filed a counterclaim alleging that Meehan and Boyle had breached their fiduciary duty by
unfairly acquiring consent from clients to remove cases from Parker Coulter. The trial court
found in favor of Meehan and Boyle and denied Parker Coulter’s counterclaim.
Is it a breach of fiduciary duty for partners, while associated with a partnership, to secretly solicit
the partnership’s clients for their own gain, while denying their intentions to other partners?
Holding and Reasoning
Yes. Partners owe each other a fiduciary duty to act with loyalty and in good faith to each other.
Consequently, partners may not use their status as partners to purely benefit themselves,
particularly if their actions harm the other partners. Meehan and Boyle took unfair advantage of
the other Parker Coulter partners by acting in secret to solicit clients, falsely denying their plans
to the other partners, and delaying the release of the list of clients they planned to take with them
until after they had won their business. Also, the content of Boyle’s client letters was unduly
harmful to Parker Coulter. Pertinent ethical standards require that when attorneys planning to
leave a firm solicit clients, they must state that the clients have a choice of staying with the firm
or transferring their business to the departing attorneys’ new firm. Boyle did not put that
information in his solicitation letters. This court finds that Meehan and Boyle’s actions
constituted a breach of their fiduciary duty to the other Parker Coulter partners. The decision of
the trial court is reversed and remanded for further findings and hearings consistent with this
 Nugget: what is it you are allowed to do as partner in a law firm.
 The focus of the court is bizarre to Webster, because he thinks they shouldn’t have let go
of these people.
 Once the rumor comes out, you have to face the rumor and ask whether it’s true or not.
Acceptable practices:
 Solicit fellow partners to leave too
 Contact clients before leaving firm, so long as
o disclosed fact of leaving to firm
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Professor Webster
o Remind clients of right to have counsel of own choice
o Locate space etc....
 Take desk files
 Keep plans confidential
 Solicit subordinates
Clearly improper:
 Take client files
 Contact clients before announce departure
 Not informing clients of the right to have counsel of own choice
 Lying about plans
See page 121 Analysis
Q3: he might not be affected by the partnership relations, but he might have had other
obligations/duties to the employer. He doesn’t have the same duty as the partners did: he’s at
will, he can leave. He may have some sort of ethical obligations by ethical duties, but that’s a
weak argument.
Q4. probably
 What is the law firm’s partner fiduciary duties to other partners? they are different in
some sort to other people. cf. Lawlis below: demonstrated the freedom for partners to
agree on whatever they want to agree, they have more latitude to agree upon things.
It’s okay to leave if you don’t steal and don’t solicit.
Lawlis v. Kighlinger & Gray
Rule of Law
When a partnership exercises its power under a partnership agreement to expel a partner,
it must be done in good faith and for a bona fide reason, otherwise the agreement is
Lawlis (plaintiff) had been a senior partner in the law firm Kightlinger & Gray (K&G)
(defendant) for a number of years when he developed an alcohol problem in 1982. Lawlis missed
a lot of work time in 1983 and 1984 as he sought treatment for his addiction. Lawlis revealed his
condition to K&G in mid-1983. In accordance with K&G’s partnership agreement that Lawlis
had signed, K&G reduced Lawlis’s work units while he was recovering. Lawlis also signed a
Program Outline, which set conditions for Lawlis’s continuing partnership with K&G. The
Program Outline stated that there was “no second chance” if Lawlis drank again. Lawlis started
drinking again in March 1984, but K&G gave him another chance, allowing him to remain as
senior partner as long as he stopped drinking permanently and met other conditions. Lawlis
subsequently stopped drinking permanently. Two years after he ceased drinking, Lawlis asked
K&G’s Finance Committee to increase his work units. In late October 1986, Wampler, a member
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of the Finance Committee, told Lawlis that the committee was going to recommend severing
Lawlis’s senior partnership with K&G no later than June 30, 1987. K&G’s partnership
agreement stated that a senior partner may be involuntarily expelled from K&G if two-thirds of
senior partners voted to do so. In December 1986, the senior partners voted to accept the Finance
Committee’s recommendation. All the senior partners except Lawlis voted in favor of the
recommendation, which resulted in an addendum to the partnership agreement, providing that
Lawlis would be given one unit of work and retain his senior partner status until he was
terminated in June 1987. Lawlis refused to sign the addendum, and the remaining senior partners
voted to expel Lawlis in February 1987. Lawlis sued K&G, alleging that K&G breached the
partnership agreement’s implied duty of good faith and fair dealing by expelling him for a
“predatory purpose” of increasing the firm’s partner to lawyer ratio. Lawlis based his allegation
on a November 1986 memo which stated that K&G should increase its lawyer to partner ratio
during the coming years in order to increase partner profits. The district court granted K&G’s
motion for summary judgment.
Does a partnership act in bad faith by expelling an unproductive partner who violated terms and
conditions to which that partner agreed?
Holding and Reasoning
No. A partnership owes a duty of good faith to each of its partners. That duty includes exercising
good faith in critical matters such as involuntary expulsion of a partner. A partnership that
terminates a partner in bad faith breaches its agreement with that partner. This court finds no
such breach here. Lawlis contends that he was expelled because K&G sought to get rid of a
senior partner to increase the partner to lawyer ratio to increase partner profits, as stated in the
Memo. However, the Memo’s purpose was to obtain more billable hour production from the
associates in order to increase partner profits, not to reduce the number of senior partners. The
Memo also recommended that Lawlis be permitted to retain his senior partnership status for
several more months, in order to ease his transition out of the firm. Moreover, K&G went above
and beyond its requirements in the Program Outline, which Lawlis signed. The Program Outline
stated that Lawlis would not get a second chance if he resumed drinking. Lawlis did
subsequently resume drinking, but K&G gave him another chance and retained him as senior
partner for an extended period of time. This court finds no “predatory purpose” in K&G’s
expulsion of Lawlis. As there is no genuine issue of fact concerning K&G acting in good faith
when it expelled Lawlis, this court affirms the district court’s grant of K&G’s summary
judgment motion.
 You need to think about in the shoes of the law firm, what is going to happen to the
client, do you want to have this lawyer appear before the clientthe second chance may
harm the client’s interest down the road.
 What does the partnership agreement say, what does it allow them to do?
o “A 2/3 majority of the senior partners, at any time, may expel any partner from
the partnership upon such terms and conditions as set by said senior partners.”
o They can’t withhold money and they can’t act in bad faith.
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Professor Webster
Reconstructing the Freeway- Exercise
T-Corp/Abigail: she does not have express authority, from the perspective of the cement
provider, Abigail has inherent authority, believing that she would have the power to make
contract, because T called Charlie and the secretary told that Abigail has authority by Charlie.
Bill/Charlie: Charlie does not have the express authority from the board, but knowing the
industry requirement would help in determining whether the CEO would have the authority to
contract for this magnitude.
In re Fulton
This matter is on the plaintiff’s claim that the debtor wrongfully scheduled a trailer tractor as an
asset. Plaintiff, Mr. Carroll, and the debtor Fulton operated a trucking business under the name of
C&F Trucking. Carroll contributed a semi-truck which the debtor drove for the business. The
profits earned from the business were to be divided between the parties. Carroll received a wire
from his grandmother in the amount of $9,000, of which he used $4,600 to purchase the trailer.
The seller’s invoice for the trailer listed C&F as the purchaser of the trailer. Title was signed by
the debtor and listed C&F as the owner. Debtor filed for BK Chapter 7.
(1) who owns the trailer?
(2) whether the chapter 7 estate has any interest in the trailer?
Carroll agreed to provide the capital necessary to run the business while the debtor agreed to
drive the Truck. Based on this evidence, Carroll and the debtor were in a partnership.
In determining whether property is partnership property owned by an individual, the court must
focus on the intentions of the partners at the time the property was acquired.
Rule: the intent of the partners determines what property shall be considered partnership property
as distinguished from separate property. Such intention of the partners must be determined from
their apparent intention at the time the property was acquired, as shown by the facts and
circumstances surrounding the transaction of purchase, considered with the conduct of the parties
toward the property after the purchase.
The testimony establishes that the trailer was purchased by Carroll for the use in C&F and that
the debtor actually used the trailer for the business. Since a partnership is a legal entity separate
from its partners, a partner cannot claim title in partnership property.
Rule: when a partner files for bankruptcy, the partner’s estate obtains whatever partnership
interest was held by the filling partner.
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Professor Webster
Rule: when the debtor filed bankruptcy, the partnership of C&F if not already dissolved was
dissolved by operation of law.
Rule: Under UPDA § 40(b), debts to creditors other than partners are paid first, debts to partners
for contributions other than for capital and profits are paid second, debts owning to partners in
respect of capital contributions are paid third, and finally, debts owing to partners in respect of
profits are paid last.
Holding: the money loaned by the plaintiff, grandma, to the plaintiff, Carroll, was a loan to
Carroll and not to the partnership of C&F trucking.
partnership properties are only for one person, they belong to the
The court focuses on the intention of the parties at the time of the
Problem Page 121:
Current law firm gives the interest and opportunities, you must divulge to your partner. This is
not an ordinary business of the partnership, and it’s because of the opportunity that you’re
engaged in the firm, that you got this work.
The right of each partner to participate in the operation of the business in some way will be an
implicit term of the partnership agreement. Section 18(e) of the UPA provides that in the absence
of an agreement to the contrary, “all partners have equal rights in the management and conduct
of the partnership business” and . . . “any difference arising as to ordinary matters connected
with the partnership business may be decided by a majority of the partners.”
UPA (1914) § 9(1): “every partner is an agent of the partnership for the purpose of its business,
and the act of every partner . . . for apparently carrying on in the usual way the business of the
partnership of which he is a member binds the partnership,
“unless the partner so acting has in fact no authority to act for the partnership in this
particular matter, and the person with whom he is dealing has knowledge of the fact that
he has so no such authority
You only need to know these two important principles from the UPA, not the title
or specific provision as amended.
the default rule is that you have apparent authority with respect to the ordinary
course of business. You are also bound by the acts and obligations of the
partnership (this can be a joint and several liability).
But this is the default rule, you can delegate and change the authority.
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Professor Webster
UPA (1997) § 301(1): “each partner is an agent of the partnership for the purpose of its business.
An act of a partner, including the signing of an instrument in the partnership name, for
apparently carrying on in the ordinary course the partnership business or business of the kind
carried on by the partnership binds the partnership, unless the partner did not have the authority
to act for the partnership in the particular matter and the person with which the partner was
dealing knew or had notice that the partner lacked authority.”
Absent to the contrary, the partnership voting system is by a majority vote.
Agency rules apply, and that partners are responsible for the ordinary course of business.
National Biscuit Company (NBC) v. Stroud
Rule of Law
In a general partnership with two partners, each party has the power to bind the
partnership in matters pertaining to the partnership’s business.
Stroud (defendant) and Freeman formed a general partnership to sell groceries. The partnership
agreement did not limit either partner’s authority to conduct ordinary business on behalf of the
partnership. Several months before the partnership was dissolved, Stroud told a National Biscuit
Company (NBC) (plaintiff) official that he would not be personally liable for any bread sold to
the partnership. Freeman subsequently ordered more bread on behalf of the partnership, and
NBC delivered that bread to the partnership. Shortly thereafter, the partnership was dissolved,
and Stroud refused to pay for the bread delivered at Freeman’s behest. NBC sued the partnership
and Stroud for the price of the bread. The trial court found in favor of NBC.
Can one general partner restrict another partner from conducting business on behalf of a twoperson partnership?
Holding and Reasoning
No. Each partner has an equal right in the management and conduct of a partnership, and
differences within a partnership are decided by a majority of the partners. However, when there
are only two partners there can be no majority, and neither partner can prevent the other from
binding the partnership in the ordinary course of business. Freeman’s purchase of bread was a
binding transaction, done pursuant to the partnership’s business. Stroud, as Freeman’s sole copartner, had no authority to negate Freeman’s purchase. The partnership sold the bread that
Freeman bought, and consequently Stroud, as well as Freedman, benefited from that purchase.
Partner Agent of Partnership as to Partnership Business:
Every partner is an agent of the partnership for the purpose of its business, and the act of every
partner, including the execution in the partnership name of any instrument, for apparently
carrying on in the usual way the business of the partnership of which he is a member binds the
partnership (This is apparent authority per Webster), unless the partner so acting has in fact no
authority to act for the partnership in the particular matter, and the person with whom he is
dealing has knowledge of the fact that he has no such authority.
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All partners are jointly and severally liable for the acts and obligations of the partnership.
Problem in the case is that there is no majority, and that one partner cannot change the
ordinary course of business (buying grocery is a long-established practice, which is the
ordinary course of business). For Stroud to contact and say I’m not going to do such and
such, he’s violating the ordinary course of business he simply cannot do that without a
It doesn’t matter what NBC thinks or feels here, in partnership every partner is
responsible for debts and obligations of the partnership.
The difference between the two cases, in Summers, the conduct of the parties is at the heart of
the question, whereas the question in Biscuit is the ordinary course of the business.
On an exam, when a partnership question comes up:
(1) Do they share the profit, and do they have control?
They have economic interest in the enterprise, and they have the right to management.
NBC: all partners are agents of the partnership and can bind the partnership.
Summer: all partners have equal rights to participate in the management of the
Nutshell: he did not have authority to act in the partnership.
demonstrates the frigidity of the partnership.
Summers v. Dooley
Rule of Law
In a general partnership, each partner has an equal right in managing the partnership’s
Summers (plaintiff) and Dooley (defendant) were co-partners in a trash collection business. Both
partners operated the business. The partners agreed that when one partner was unable to work, he
could hire a replacement at his own expense. Several years after the formation of the partnership,
Summers asked Dooley if he would agree to hire an additional employee. Dooley refused, but
Summers hired the worker anyway and paid him out of his own pocket. In spite of the fact that
the new worker was a good employee, Dooley would not agree to pay him out of the partnership
funds. Summers sued Dooley, seeking reimbursement for the expenses Summers incurred in
hiring the new employee. The trial court granted Summers only partial relief, which he appealed.
Is a partner who refused to hire an additional employee liable to a co-partner for expenses
incurred in hiring a new worker?
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Holding and Reasoning (Donaldson, J.)
No. In a general partnership, each partner has equal rights regarding the management of the
ordinary affairs of the partnership. Unless there is an agreement to the contrary, differences
between the partners about everyday business are to be decided by a majority of the partners.
When a partnership consists of only two partners, one partner cannot unilaterally bind the
partnership by incurring expenses over the objection of the other. In this case, Summers hired the
additional worker after Dooley clearly expressed his objection. Under these circumstances, it
would be unfair for Dooley to be forced to pay an expense that Summers incurred for his own
benefit, rather than for the benefit of the partnership.
The partnership has an obligation to compensate the necessary courses of dealing. Since
Summers doesn’t have the majority, he loses. The veto is effective here, the scope is the
relationship between the partners, not the ordinary course of business here.
There wasn’t an agreement between the two, because of the lack of existence, the partnership is
clearly not liable.
Day v. Sidley & Austin
Rule of Law
Partners have a fiduciary duty to make full disclosure of information of value to the
partnership and may not advantage themselves at the expense of the partnership.
Day (plaintiff) was the senior underwriting partner in the Washington office of the Sidley &
Austin law firm (S&A) (defendant). S&A’s partnership agreement, which Day signed, provided
that all matters of firm policy would be decided by the executive committee, of which Day was
not a member. In early 1972, S&A’s executive committee discussed merging S&A with another
law firm (Lieberman Firm). In July 1972, the merger was approved by a vote of S&A’s
underwriting partners. Day himself voted in favor of the merger. After several more meetings of
the underwriting partners, the terms of the merger were entered into an amended partnership
agreement, which Day signed. Soon thereafter, the executive committee of the combined firm
decided to move S&A’s office to a new location and appoint a former chairman of the
Lieberman firm as co-chairman of the new firm. Day resigned soon thereafter, stating that the
appointment of the co-chairman and office move made his job “intolerable.” Day subsequently
filed suit against S&A, alleging that S&A violated its fiduciary duty by commencing merger
negotiations without consulting non-executive committee partners, and by not informing those
partners of the changes that would result from the merger.
Is it a breach of fiduciary duty for “executive” law firm partners to not consult with all the other
partners regarding proposed changes to the internal structure of the partnership?
Holding and Reasoning
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No. Partners have a fiduciary duty to act in the interest of the partnership. Hence, partners may
not withhold any information that results in them being personally enriched while harming the
partnership. That did not occur in this case. The executive S&A partners did not gain financially,
nor did they increase their authority as a result of the merger. Those partners were already
members of the executive committee and had a good deal of power within the firm. Moreover,
Day himself signed the partnership agreement and the amended agreement, both of which clearly
provided that the executive committee would have authority to make decisions concerning firm
policy. Neither agreement guaranteed that Day would maintain any position of status within the
firm either before or after the merger. Accordingly, Day’s complaint against S&A is denied.
 he is not entitled to anything, it’s ego and secondly, it’s also the fact that just being a
partner doesn’t mean you’re a top shot.
 The executive committee is more powerful than the partner in this case.
Why have an Executive Committee? Comes down to Consensus v. Authority
Collective decision-making
Used when constituents have:
 Similar interests
 Comparable information
 Low collective action problems
Partnership optimized for these characteristics
Central decision-making body:
 Needed when constituents have:
o Differing interests
o Asymmetric information
o Serious collective action problems
 Corporation optimized for these characteristics
When a partner retires or leaves, the old partnership is dissolved and when new partners continue
their practice there is a new partnership.
Under UPA, if a partner retires pursuant to an appropriate provision in the partnership agreement
(and in various other situations), there is a “dissociation” rather than a “dissolution.” Where there
has been a dissociation, the partnership continues as to the remaining partners and the dissociated
partner is entitled, in the absence of an agreement to the contrary, to be paid an amount
determined as if “on the date of dissociation, the assets of the partnership were sold at a price
equal to the greater of the liquidation value or the value based on a sale of the entire business as a
going concern without the dissociated partner,” plus the interest from the date of dissociation.
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In a strictly legal interpretation, the guy was not contractually entitled to the job.
It highlights the importance of the executive committee.
UPA § 32(1)(c) and (d): provide that a partnership may be judicially dissolved where a partner’s
conduct prejudices the carrying on of the business or where the partner willfully and persistently
breaches the agreement or where he conducts himself in such a way as to make it impractical to
carry on the business with him
Owen v. Cohen
Rule of Law
A court may order the dissolution of a partnership when the parties’ quarreling makes it
impossible for them to cooperate, or when one partner’s acts materially hinder the
partnership’s business.
Owen (plaintiff) and Cohen (defendant) entered into an oral agreement to become partners in a
bowling alley. Owen loaned the partnership $6,986.63 to buy the necessary equipment, which
the parties agreed would be paid back to Owen from the profits of the business. While the
business proved immediately profitable, the parties started quarreling over issues such
as management and policies of the enterprise, and their rights and duties under their partnership
agreement. Cohen insisted on being the dominant partner and was openly hostile toward Owen in
front of customers and employees. Cohen refused to do any manual work, and appropriated
partnership funds for personal use. Cohen further demanded that a gambling room be added to
the bowling alley, which Owen vehemently opposed. The partners’ constant arguments resulted
in a steady decline of the bowling alley’s monthly receipts. Realizing that the parties could not
resolve their differences, Owen offered Cohen the choice of either buying out Owen’s interest in
the bowling alley or selling Cohen’s interest to Owen. Cohen refused to reasonably entertain
either option, insisting that the business be continued until he was ready to sell at a price he
would set himself. Owen subsequently filed an action in equity to dissolve the partnership. The
trial court found that Cohen’s behavior in relation to the business made it impossible for the
partnership to continue, and decreed dissolution of the partnership. The trial court also appointed
a receiver to sell the partnerships’ assets, ordering that Owen receive half the proceeds, plus
$6,986.63 as payment for the loan he made to the partnership.
Should a partnership be dissolved when one partner engages in a series of hostile actions that
harm the partnership?
Holding and Reasoning
Yes. A partner has a duty to act in the best interest of the partnership. When a partner continually
antagonizes the other partner to the extent that business is adversely affected, the partnership can
rightly be dissolved. Cohen contends that he and Owen’s arguments were trivial, and that such
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minor disagreements do not warrant dissolution of a partnership. While it is true that small
quarrels between partners would not justify breaking up a partnership, if such quarrels in the
aggregate work to the detriment of the partnership’s business, a court will properly grant a
complaint for dissolution. Cohen’s persistent cajoling and belittling of Owen, and his insistence
on having his own way in policy matters, severely harmed the partnership’s business. This is
illustrated by the monthly reduction in gross receipts that grew worse as the partners’ business
relations deteriorated. The evidence shows that under these circumstances, it would be
impractical for the partnership to continue. Cohen also argues that Owen should not be paid
$6,986.63 out of the proceeds, as the parties agreed that Owen’s loan would be repaid from the
business’s profits. This court disagrees. Cohen’s behavior made it impossible for the business
continue, let alone remain profitable. Cohen’s acts violated his fiduciary duty to act in the best
interest of the partnership. Accordingly, the trial court was justified in dissolving the
partnership, decreeing the sale of assets, and ordering the distribution of the proceeds as it did.
The decision of the trial court is affirmed.
He wants to get a court decree because he doesn’t want to breach the contract, because he loaned
the money to the partnership over a period of time, and if they break it before the time he would
be losing his money.
This partnership is not at-will (it’s oral, open-ended, and there is no time limit. It’s not the case
here, because the implied term was that he would get his money by the profits and the
partnership would go on until he would be paid), because his understanding is that this
partnership has a duration, and if he walks out without dissolving, he would open himself to the
risk of being sued for damages, because the repayment was depended on time duration.
This is a partnership determined in terms of duration by an Implied Term the default rule is
that partnership are at will. If there are no agreement, then there is no implied term, here, the
court finds an implied term of duration. It’s unquantifiable, however. Because the repayment is
depended upon a time factor (implicit), then the court implies a time factor.
Takeaway: if the partnership cannot work for the mutual advantage of the parties, it is best to
dissolve. It’s in the mutual advantage to separate and dissolve.
If the purpose of making a profit, which is an element of the partnership, has been frustrated,
then it’s probably the case that impracticability has occurred.
for dissolution purposes.
Collins v. Lewis
Rule of Law
A partner does not have a legal right to force dissolution of a partnership if the other
partner fulfills his or her duties under the partnership agreement.
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Collins (plaintiff) and Lewis (defendant) each owned 50% interest in a partnership formed to
own and operate a cafeteria. Their partnership agreement provided that Collins would provide
funds to build and open the cafeteria, while Lewis would oversee the construction of the cafeteria
and manage it once it opened for business. Lewis guaranteed repayment to Collins at a minimum
rate of $30,000 plus interest the first year, and $60,000 plus interest annually thereafter. Collins
initially advanced $300,000, based on Lewis’s initial estimate of the cost to build and open the
cafeteria. After a substantial delay in completing the cafeteria and increases in expenses, the
initial cost had increased to $600,000. Collins expressed his displeasure about the cost increase,
but he advanced the entire amount. Soon after the cafeteria opened, Collins discovered that the
expenses far exceeded the receipts. Collins demanded that Lewis immediately make the cafeteria
profitable, or he would cut off additional funding. Lewis accused Collins of unauthorized
interference in the management of the business, while Collins charged that Lewis had
mismanaged the building and opening of the cafeteria. Collins also made serious threats during
the first year of the cafeteria’s operation, forcing Lewis to lose his interest in the business. Lewis
tried, but failed, to find financing to buy out Collins. Collins subsequently filed suit, seeking
dissolution of the partnership. The trial court denied dissolution, based on the jury’s findings
that: (1) there was not a reasonable expectation of profit if Lewis continued managing the
cafeteria; (2) but for Collins’s conduct which decreased the earnings during the first year, there
would be a reasonable expectation of profit; and (3) Lewis was competent to manage the
Can a partner legally force dissolution of a partnership when but for that partner’s actions, the
other partner could have performed his or her required duties?
Holding and Reasoning
No. In an action in equity, a court will force the dissolution of a partnership when, for example, a
partner has breached his or her fiduciary duty to the partnership or the other partners. When a
partner has performed his or her obligations and has not otherwise harmed the partnership,
another partner cannot force dissolution through the courts. Collins asks this court to dissolve his
partnership with Lewis, complaining that he should not be forced to continue in a partnership
which the jury found has no reasonable expectation of profit. Collins’s complaint ignores the
other jury findings that Lewis was competent to manage the cafeteria, and that but for Collins’s
actions there would have been a reasonable expectation of profit from that enterprise. Lewis’s
duties under the partnership agreement were to oversee the construction, manage the cafeteria,
guaranteeing repayment to Collins at the stipulated minimum rate. The jury found that Lewis
could have performed his duties had not Collins interfered the way he did. Under these
circumstances, the court finds that Collins has no right to have this court force dissolution of the
partnership. Collins has the power to dissolve the partnership without the intervention of the
courts, but he may thereby be liable for breach of the partnership agreement. The decision of the
trial court is affirmed.
The court does not have a sympathy for Collins. Lewis says that but for Collins’ actions they
would make money and that Lewis’ action hinders him. Collins would want his money back and
the dissolution would give his money back.
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Planning on P. 149:
one could be changing the repayment term instead of operational opening v. fund distribution.
Also, why not put a ceiling on what Collins is willing to invest?
By the same token, Lewis’ time has value and can be valued.
Collins Takeaway: conflict between the partners (bad blood) is not enough for the court to say
we grant the dissolution
Giles v. Giles Land Company
Rule of Law
Under Kansas law, dissociation is appropriate if a partner engaged in conduct relating to
the partnership business that makes it not reasonably practicable to carry on the business
with the partner.
Giles Land Company, L.P. (partnership) (defendant) was a family-owned farming company. The
partners were all related. The partnership held a meeting to consider converting the partnership
to a limited liability company (LLC). One of the Giles children, Kelly (plaintiff), was unable to
attend the meeting, but later received notice of the partnership’s determination to convert to an
LLC. Kelly formally requested the partnership’s books and records for his review. He was not
satisfied with the books and records turned over, so he brought suit against the partnership and
the other partners (defendants), claiming that he was improperly denied access to the books and
records. The defendants filed a counterclaim, arguing that Kelly should be dissociated from the
partnership. The defendants presented evidence that Kelly had threatened them and that the
family relationship was broken beyond repair. The defendants also presented evidence that they
did not trust Kelly and vice versa. The trial court ruled in favor of the defendants on all counts,
finding that it was not practicable to continue the partnership with Kelly as a partner. Kelly
appealed the trial court’s order regarding his dissociation from the partnership to the Kansas
Court of Appeals, arguing that he had not engaged in conduct relating to the partnership.
Is dissociation appropriate where the partner engaged in conduct relating to the partnership
business that makes it not reasonably practicable to carry on the business in partnership with the
Holding and Reasoning
Yes. Dissociation may be proper based on impracticability or a partner’s wrongful conduct.
Dissociation on account of impracticability is based on dissolution law. Dissociation is
appropriate if the partner engaged in conduct relating to the partnership business that makes it
not reasonably practicable to carry on the business in partnership with the partner. Just as “an
irreparable deterioration of a relationship between partners is a valid basis to order dissolution,
[it is also, therefore] a valid basis for the alternative remedy of dissociation.” Alternatively,
dissociation may be ordered if a partner has engaged in wrongful conduct that adversely and
materially affected the partnership. Under the impracticable route to dissociation, despite Kelly’s
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claims that he had not engaged in the alleged conduct relating to the partnership, threats against
family members are related to a business when: (1) the business is a family business, and (2)
those threatened family members are the other partners in the business. Kelly’s threats against
his family members were thus related to the partnership, because his family members were the
other partners in the partnership. Those threats combined with the lack of trust make it not
reasonably practicable to carry on the partnership with Kelly as a partner. The trial court thus did
not err by ordering Kelly’s dissociation. Additionally, the trial court did not err by finding that
Kelly was subject to dissociation for the same actions based on the wrongful conduct route to
dissociation. Due to Kelly’s wrongful conduct, the partnership was at a standstill until the issues
with him were resolved. Accordingly, Kelly’s conduct adversely and materially affected the
partnership. As a result, the trial court’s ruling in favor of dissociation is affirmed.
 Disassociation is a modification to the death of a partner, it leaves a voluntary choice for
the partnership to continue and the option for the survivors to collect the interest of the
 General partnerships share profits and loss, and control. This is the default rule.
 A limited partnership requires at least a general partnership (responsible for management)
and other partners become passive (Cf. Cargill). Limited partners cross the line when they
give advice, friendly advice, or hints, etc.
(on page 151) Rule: a partner is dissociated from a partnership upon the occurrence of any of the
following events:
(e) on application by the partnership or another partner, the partner’s expulsion by
judicial determination because:
(1) The partner engaged in wrongful conduct that adversely and materially
affected the partnership business;
(3) the partner engaged in conduct relating to the partnership business which
makes it not reasonably practicable to carry on the business in partnership with
the partner.
(3) is applicable here, because of the reasonable practicality: in Webster’s perspective,
Collins does not make sense in a business perspective. It is also the case that this judge
was sympathetic to the family.
Prentiss v. Sheffel
Rule of Law
When a partnership is legally dissolved, any partner acting in good faith may purchase the
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Prentiss (defendant) and two other individuals, Sheffel et al. (plaintiffs), made an oral agreement
to enter into a partnership to buy and operate a shopping center. The agreement did not specify
any term for the partnership’s existence, nor did it delineate the operational or management
duties of the respective partners. Sheffel et al. owned a total of 85% interest in the partnership,
while Prentiss owned 15% interest. The partners engaged in many serious arguments concerning
the title of partnership property, which resulted in an irreparable rift between Prentiss and Sheffel
et al. Prentiss added to the problems by being unable to pay his proportionate share of the
shopping center’s operating losses. Sheffel et al. subsequently excluded Prentiss from all
management duties and sought dissolution of the partnership, alleging that Prentiss had been
derelict in his partnership duties. Sheffel et al. also sought a court-supervised dissolution sale
whereby they would bid on all the partnership assets. Prentiss filed a counterclaim, seeking to
prevent Sheffel et al, from bidding on or purchasing the partnership assets. Prentiss contended
that he had been wrongfully frozen out of the partnership and would unfairly disadvantage
if Sheffel et al. were permitted to buy the partnership assets at a judicial sale. The trial court
found that a partnership at will existed, and that Sheffel et al. dissolved it when they froze out
Prentiss. The trial court also ordered a judicial sale of the assets and denied Prentiss’s request to
prohibit Sheffel et al. from bidding on the partnership’s assets at that sale. Sheffel et al. were the
high bidders in the judicial sale, and the trial court entered an order confirming the sale of the
assets to them.
May partners who legally excluded a third partner from management duties be permitted to buy
partnership assets at a judicially-supervised dissolution sale?
Holding and Reasoning
Yes. Partners may dissolve a partnership-at-will by excluding another partner from management
duties, as long as they act in good faith. Such partners may also bid on and purchase any assets
in a dissolution sale. The record shows that Sheffel et al. excluded Prentiss from management
duties and broke up the partnership because the dissention Prentiss caused made it impossible for
the partnership to effectively continue. Prentiss did not offer any evidence that Sheffel et al.
acted in bad faith or had any ulterior motive in dissolving the partnership-at-will. Consequently,
there is nothing to prevent them from purchasing the assets at a dissolution sale. Also, Prentiss
was not disadvantaged by Sheffel et al.’s participation in the asset sale. Sheffel et al.’s bids visà-vis the other participants resulted in a final sales price that was higher than it would have been
had they not bid on the assets. Consequently, Prentiss’s 15% interest in the partnership was
enhanced by Sheffel et al.’s bidding. The judgment of the trial court is affirmed.
 The court has the tough interpretation of contracts: this is the agreement you made, and
the risk you took in this capacity.
 The court doesn’t allude to any evidence that the plaintiffs took advantage of the
Analysis and Planning on Page 159:
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1. assuming that the plaintiffs want to exclude the defendant. The concern is that any action that
would exclude him from partnership participation: the solution is to invite him to meetings, give
him information, allow him to give his contribution, and then vote, but he’s without power.
But why not just dissolute? it would be a problem, in terms of contractual obligation. That would
be a court action, and the determination of whether the valuation would be based on the value of
the business or just the market?
note that the distribution of the money is not affected by whichever partner starts the dissolution
In light of the fact that this is an at-will partnership, whichever of the partners can start the
dissolution proceedings.
Pav-Saver Corporation v. Vasso Corporation
Rule of Law
The terms of a partnership agreement cannot override the statutory law governing
partnerships in the jurisdiction.
Pav-Saver Corporation (plaintiff) entered into a Partnership with Vasso Corporation (defendant)
to manufacture and sell paving machines. Pav-Saver contributed certain intellectual property to
the Partnership. Pav-Saver’s principal would manage the operation. The partnership agreement
stated that the partnership would be permanent unless both partners agreed to terminate. The
partnership agreement also stated that if one party terminated unilaterally, Pav-Saver would take
back its intellectual property, and that the party not terminating would receive liquidated
damages. Illinois had adopted the Uniform Partnership Act, which provided that when a
partnership is terminated in violation of the partnership agreement, the non-terminating partners
may continue the enterprise, as long as they pay the terminating partner the value of their
interest, not counting good will value. Eventually, Pav-Saver terminated the partnership
unilaterally. Vasso responded by taking over the Partnership’s operations, including retaining
control over the intellectual property contributed by Pav-Saver. Pav-Saver sued to recover its
intellectual property, and Vasso countersued for a declaration that it was entitled to the property.
The trial court found that Vasso was entitled to retain control of the intellectual property and to
liquidated damages.
Can the terms of a partnership agreement override statutory law?
Holding and Reasoning
No. The agreement stated that the partnership would be perpetual, except by mutual agreement
of the parties. The parties agreed that by ending the partnership unilaterally, Pav-Saver ended it
wrongly. Because the partnership was terminated wrongfully, the Uniform Partnership Act gave
Vasso the right to continue the business. Vasso elected to continue the business, and to continue
in possession of the partnership property. That property includes the intellectual property
contributed by Pav-Saver, which is absolutely essential to the manufacture and sale of paving
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machines. While the partnership agreement stated that Pav-Saver was entitled to return of its
property, that agreement does not override the Partnership Act in force. Thus, Pav-Saver cannot
win the return of its patents. The Partnership Act requires Vasso to pay the exiting partner the
value of his interest. In this case, the only evidence of value that Pav-Saver introduced was
testimony of good will. The Partnership Act specifically states that good will not be considered
when determining the value of a terminating partner’s interest. The decision of the lower court to
assign liquidated damages is affirmed.
Meersman drafts this agreement, it’s odd: “partnership goes on,” and it provides a
formula for damages upon separation. It looks as if Meersman is taking an advantage of
this agreement. Meersman wants to continue this business under section 38, Dale is
happy and hoping for to receive his money back.
Webster thinks the decision is wrong, because there are two readings to Paragraph 11 of
the agreement: (1) no dissolution permissible, unless either pay damages, or (2), which
the court adopts, any act of dissolution is a wrongful act, and the damages are a
Ultimate decision, under §38, Meersman can continue the business. But what the heck
does the business means without the technology. They give him the technology.
The judicial reading here is also rewarding Meersman who is a cheat a bit. And the court
is acting a bit conservative.
In this case and the last case, dissolution is a perfect avenue, but the consequence of
dissolution is what affects the parties, and here, it is depended on the judicial reading as
The Uniform Partnership Agreement recognizes that a partnership is governed by the partnership
agreement. In this case, the partnership agreement directly addressed the status of Pav-Saver’s
intellectual property in the event of termination. The majority was wrong to allow Vasso to retain
control of Pav-Saver’s property in direct contravention of the terms to which the parties agreed.
Note: Under § 701 of the UPA (1997), if a partner withdraws from a partnership in
contravention of the partnership agreement, the partnership does not necessarily dissolve.
If it does not, the partnership must buy out the withdrawing (“dissociated”) partner for an
amount equal to his or her share of the value of the assets of the partnership if sold at a
“price equal to the greater of the liquidation value or the value based on a sale of the
entire business as a going concern without” the dissociated partner.
This amount is reduced by any damages for wrongful dissociation.
There is no reduction for the value of goodwill.
Kovacik v. Reed
Rule of Law
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Monetary losses will be apportioned equally between partners who make capital
Kovacik (plaintiff) and Reed (defendant) entered into a partnership to remodel kitchens. Kovacik
would contribute funds to the enterprise in the amount of $10,000. Reed would contribute labor
and skill, acting as an estimator and superintendent of the projects without compensation. The
partners did not discuss the apportionment of losses. While the two received some jobs, they lost
money. Kovacik asked Reed to contribute money to cover half of the total losses. Reed refused,
and Kovacik filed this lawsuit. The lower court held that the partners had agreed to share profits
and losses equally, and Reed was thus liable for half the shortfall.
Is a partner who contributed only skill and labor liable for the monetary losses of the enterprise?
Holding and Reasoning
No. When there is no explicit agreement as to losses, losses are to be divided equally between
the partners, without regard to the amount each partner contributed to the venture. That rule,
though, is only applied in cases where each of the partners contributed capital to the enterprise.
In cases where one party contributed only labor and the other only capital, the rule is not applied
because the partner contributing labor takes a loss in the form of his lost labor. In this case, both
partners have endured losses: Kovacik with the loss of his monetary investment, and Reed
through the time and effort he contributed that went uncompensated. Reed is not liable for any of
Kovacik’s monetary losses. Accordingly, the decision of the lower court is reversed.
This is a service partnership: one partner puts up money and the second partner puts
up the work. In a service partnership, the service partner has no obligation of the loss
of the partnership because she has done nothing beyond giving her service.
The relevant Restatement provisions are UPA (1914) §§ 18(a) and 40.
Kovacik rule: the services-only partner does not share in loss of the amount initially
invested by the capital-only partner.
Under §18(a):
The rights and duties of the partners in relation to the partnership shall determined, subject to any
agreement between them, by the following rules:
(a) Each partner shall be repaid his contributions, whether by way of capital or advances
to the partnership property and share equally in the profits and surplus remaining after all
liabilities, including those to partners, are satisfied; and must contribute towards the
losses, whether of capital or otherwise sustained by the partnership according to his share
in the profits.
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Section 40(b) provides that, subject to any contrary agreement, upon dissolution, liabilities of the
partnership shall be paid in the following order:
Those owing to creditors other than partners,
those owing to partners other than for capital and profits,
those owing to partners in respect of capital,
those owing to partners in respect of profits.
Subsection 40(d) further provides that “partners shall contribute, as provided by section 18(a) the
amount necessary to satisfy the liabilities” in section 40(b).
A buy-out, or buy-sell, agreement is an agreement that allows a partner to end his or her
relationship with the other partners and receive a cash payment, in return for her or his interest in
the firm. A good buy-out agreement must be tailored to the needs and circumstances of each
firm. Outline of some of the issues and alternatives:
“Trigger” events
a. Death
b. Disability
c. will of any partner
Obligation to buy versus option
a. Firm
b. Other investors
c. Consequences of refusal to buy
1. if there is an obligation
2. if there is no obligation
a. Book value
b. Appraisal
c. Formula (e.g. five times earnings)
d. Set price each year
e. Relation to duration (e.g. lower price in the first five years)
Method of payment
a. Cash
b. Installments (with interest?)
Protection against debts of partnership
Procedure for offering either to buy or sell
a. First mover sets price to buy or sell
b. First mover forces others to set price
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G&S Investments v. Belman
Rule of Law
A partner’s capital account is calculated by adding up the cost basis of all contributions the
partner has made to the partnership, then subtracting all distributions the partner has
G & S Investments (plaintiff) and Thomas Nordale (defendant) were two of four partners in an
enterprise to own and operate an apartment building. The partnership agreement stated that in the
event of the death or disability of one of the partners, the remaining partners may continue the
business, but that if the partners continued the business, they must buy out the departing partner
using a formula based on the partner’s capital account and the partnership’s profits. Nordale,
who lived in one of the apartments, became erratic and unreliable starting in 1979, accosting
renters and insisting on business decisions with which the other partners disagreed. G & S
Investments filed suit to dissolve the partnership and buy out Nordale’s interest. Nordale passed
away soon after the suit was filed, and his estate continued the suit. Nordale argued that his
capital account should be calculated by reference to the fair market value of the assets of the
partnership. G & S Investments argued that the capital account should be calculated on a cost
basis. The trial court held that the capital account must be calculated on a cost basis, and
Nordale’s estate appealed.
Should a partner’s capital account be calculated by reference to the fair market value of their
Holding and Reasoning
No. General accounting principles require the books of a partnership to be kept on a cost basis. If
a partner contributes money to the partnership, the partner’s capital account is equal to the
money he contributes. If the partner contributes more in the future, that new sum is added. If the
partner receives a distribution from the partnership, that amount is subtracted from his account.
This amount will stay the same, regardless of the value of the partnership as a whole. The
partnership agreement in this case did not explicitly define the term “capital account,” but this is
not an ambiguous term. At trial, it became clear that cost basis is the customary way of
calculating a capital account. In the partnership agreement, the term “capital account” means the
total amount of a partner’s contributions, plus partnership profits minus losses, minus any
distributions received, without any regard to total partnership assets. Accordingly, the decision of
the trial court is affirmed.
 The court decides that this is not going to be looked at by the way of market cap. rather it
would the GAAP principles.
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Chapter 3 – The Nature of the Corporation
The Articles of Incorporation is the foundation for corporations, it’s varied state by state. The
number of shares, the number of issues, who the incorporator is, who signs it, and there are
optional provisions.
 Shielding the shareholders of personal liabilities (the most important).
 tax advantage
Bylaws need to be established: governing mechanism for the business to operate. But they are
worthy, because they must be adhered to and observed.
Major takeaway: corps have a separate entity to that of the owners. In order to protect the shield,
protect the shareholders:
In terms of the personal liability and risk, if shareholders observe the formalities of
corporations there is no piercing of corporate veil  they must observe the corporate
formalities (at least one meeting per year, separate funds/accounts, personal funds should be
separated from the corporate funds, they need to keep the books and account).
Make sure the shareholders observe the corporate formalities.
Legal entity
 Formation depends on compliance with state laws
 Separate entity from owners – stockholders
 Treated as a legal person
 Can only operate through its appointed agents – namely its directors and officers
 NONE of people involved is personally liable for corporation’s losses/obligations
 Creditors are limited to corporate assets to meet their claims
 Unlimited life
 Ownership can be transferred easily
 Central management
 Investors elect Board of Directors who in turn hire managerial staff
 Formation
There are two important topics about the corporations: Derivative actions v. direct actions.
Derivative Actions
They are all about actions that shareholders take against the corporation on the basis that they
(shareholders) allege that some wrong/damage has occurred to the corporation, as a result of
mismanagement. It’s not about the damage to the shareholder personally, but damage to the
corporation. Damage is harm, like loss or image, to the company. The mechanism is very
complex. These actions always settle, so it’s very lucrative for lawyers. The recoup would be to
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pay the sanction to the corporation for the benefit of the shareholders. There is some degree of
shareholder harm.
Direct Action
Concerns harm to the shareholder herself. For example, you invest in Microsoft and you await
your dividend, for whatever reason you’re expecting the money, but you don’t get it. That would
a personal loss to you and it’s worth considering an action.
Walkovszky v. Carlton,
Rule of Law
A creditor cannot pierce the corporate veil without a showing that there is a substantial
unity of interest between the corporation and its shareholders.
Carlton (defendant) owned 10 corporations (defendants), including, notably, Seon Cab
Corporation. Each of the corporations owned one or two cabs, and the minimum amount of
automobile insurance required by law. One of the cabs owned by Seon Cab was in an accident
with Walkovszky (plaintiff). Walkovszky sued the cab’s driver, as well as Seon Cab (under a
respondeat superior theory), Carlton (under a piercing the corporate veil theory), and all of
Carlton’s other cab companies. In the lower court proceeding, Walkovszky claimed that the cab
companies did not act as separate organizations but were set up separately to avoid liability. The
lower courts found that Carlton’s companies were set up to frustrate creditors, and that a creditor
could sue Carlton. Carlton and his companies appealed.
Can a personal injury plaintiff sue the owners of a cab company because of injuries the plaintiff
sustained from one of the company’s cabs?
Holding and Reasoning
No. A plaintiff can pierce the corporate veil and hold a company’s owners liable for the debts of
the company if the company is a dummy corporation, whose interests are not distinguishable
from those of the owner or owners. It is very relevant to the discussion of veil-piercing if a
business is undercapitalized, because this suggests that the business is a fraud intended to rob
creditors of the ability to fulfill their debts. It is also relevant that the formal barriers between
companies are not respected. That said, a business enterprise may divide its assets, liabilities, and
labor between multiple corporate entities, without impinging the limited liability of the
shareholders. In this case, Seon Cab Company was undercapitalized, and carried only the bare
minimum amount of insurance required by law. However, while this is relevant, it is not enough
to allow a plaintiff to pierce the veil, otherwise, owners would be on the hook every time their
corporation accrued liabilities outstripping its assets, and limited liability would be meaningless.
Instead, there must be some evidence that the owners themselves were merely using the
company as a shell. While Walkovszky alleged that each of Carlton’s companies was actually
part of a much larger corporate entity, he could offer no proof to that effect. The mere fact that
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Walkovszky might not have been fully able to recover his damages was not enough to justify
letting him pierce Seon Cab’s veil. Accordingly, the judgment of the lower courts is reversed.
the courts will disregard the corporate form, or, to use accepted terminology, “pierce
the corporate veil” whenever necessary to prevent fraud or to achieve equity.
whenever anyone uses control of the corporation to further his own rather than the
corporation’s business, he will be liable for the corporation’s acts upon the principle
of respondeat superior applicable even where the agent is a natural person.
The fact that the fleet ownership has been deliberately split up among many
corporations does not ease the plaintiff’s burden. The corporate form may not be
disregarded merely because the assets of the corporation, together with the mandatory
insurance coverage of the vehicle which struck the plaintiff, are insufficient to assure
him the recovery sought.
When the legislature passed the automobile insurance minimum, it assumed that companies that
could afford insurance above the minimum would in fact purchase additional insurance. The goal
of the act was to ensure that there was a pot of money provided for victims of automobile
accidents. Seon Cab was profitable enough to afford more than the minimum insurance
coverage, but the company was kept intentionally undercapitalized. The insurance minimum
should not be used here to prevent Walkovszky from the type of recovery that the law was meant
to provide for, and Carlton should not be allowed to benefit from a corporate form he adopted
merely to abuse it.
The purpose of PCV is to get behind the corporate shield of protection and to get at the personal
assets of the shareholder or shareholders. This wall creates a protection for shareholders,
workers, etc.
Here, the exposure is huge and significant. The corporate entity permits the shareholders to
externalize the cost of doing business. But, the intention here is to shield from liability.
Piercing the corporate veil happens so rare, that it’s almost non-existent. That’s why if you
observe the corporate formalities, the corporate wall won’t fall. But if you don’t observe them as
shareholder, the court would not be friendly in thinking that the creditor would be safe in
securing their interest in your corporation.
Carlton has done nothing wrong. The fact that you have inadequate insurance or the inadequate
bases, is not sufficient to PCV.
Crucial lesson: corporate veils will be lifted in: (elements test)
(1) unity of interest: there is no observance of the separate identities of the corporation and the
shareholders. If the distinction between the two becomes blurred by bad behavior, the corporate
protection does not extend.
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(2) Fraud or injustice: there must be a finding that absent veiling, there would be fraud or
See page 206 (Sea-Land)
Sea-Land Services, Inc. v. Pepper Source,
Rule of Law
When a company’s owner does not take care to observe the formal separation between
himself and his business, the business’s creditors can collect their debts directly from him.
Gerald Marchese (defendant) owned six separate business entities (defendants). Marchese ran all
of the companies out of a single office. The companies shared expense accounts in common and
lent funds to each other, as well as regularly lending money to Marchese for his personal
expenses. None of these companies had internal governing documents such as bylaws. One of
those businesses, Pepper Source, contracted with a shipping company, Sea-Land Services, Inc.
(plaintiff) for the delivery of some peppers. Pepper Source failed to pay for these services, and
Sea-Land filed a collection suit against Pepper Source. Pepper Source never appeared, and had in
fact been dissolved for failure to pay business taxes. Sea-Land then brought suit against
Marchese and all of his companies, seeking to pierce Pepper Source’s veil and collect from
Marchese, and then to “reverse pierce” Marchese’s other companies and collect from them. The
lower court held that Sea-Land could collect Pepper Source’s debt from Marchese and the
companies he owned. The defendants appealed.
When multiple companies share all the funds and staff with each other and with their owner, can
a creditor to one of those businesses collect its debt from the other companies?
Holding and Reasoning (Bauer, C.J)
Yes. Veil piercing requires two things: first, that there be a strong alignment of interest between
the shareholders and the business itself, and second, that observing the corporate form would
promote injustice or fraud. The courts look for a handful of factors that suggest that the interests
of a corporation and those of its shareholders are sufficiently aligned to allow veil-piercing. The
following factors are relevant: (1) if the corporation fails to observe corporate formalities; (2) if
the business fails to keep its assets separate from those of shareholders and each other; and (3) if
the business is undercapitalized. In this case, the first requirement for veil-piercing was met.
Marchese shared money with his companies, and they shared money with each other. Because
Marchese often withdrew money from Pepper Source, it was not sufficiently capitalized to meet
its obligation to Sea-Land, and did not even have enough assets to maintain its own existence.
None of the companies had bylaws, articles of incorporations, or minutes from regular board
meetings. However, simply because Sea-Land would not have been able to collect its debt does
not mean that an injustice was being perpetrated. Plaintiffs only seek to pierce the veil when
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there are insufficient assets in one company; if this was always an injustice, the second
requirement would be meaningless. Injustice must mean that there is some wrong beyond the
harm to the creditor. Often, this means that some legal obligation or rule would be undermined,
or that some scheme to place liabilities and assets in different companies would be successful. In
this case, there may in fact be such a scheme, but there is not enough evidence to justify such a
holding. Instead, the court reverses the lower court and orders them to hold a new hearing on
whether the scheme will allow an injustice in the absence of veil-piercing.
The court focuses on four factors in determining whether a corporation is so controlled by
another to justify disregarding their separate identities:
1. the failure to maintain adequate corporate records or to comply with corporate
a. never got the corporation to adopt its articles of incorporation.
2. the commingling of fund and assets,
a. used corporate funds for personal expenses.
3. undercapitalization, and
a. undercapitalized the corporation
4. one corporation treating the assets of another corporation as its own.
a. moved funds back and forth between the corporation.
i. the parent company may have a corporate governance mechanism that
allows it to go in. The parent may be fed, in an authorized manner.
See page 206.
The weird twist is here that the appellate allows for a PCV, because tax fraud existed on remand,
it’s just an equity argument for the court to allow equity for the victim.
Note on Corporate Groups:
In many situations, one corporation owns all the shares of common stock of another corporation.
The first corporation is the parent and the second is the subsidiary. Advantages:
The parent is not liable for the debts of the subsidiary.
Like an individual shareholder, a corporate shareholder must be aware of the danger that
if it is not careful, the creditors of the subsidiary may be able to pierce the corporate veil
of the subsidiary.
Coke’s decision to form a JV with a weed company is protected by the Business Judgment Rule.
Shareholders delegate the managerial supervision of the company and the corporate life to the
managers, so you don’t need the Board of Directors to be interfered by the shareholders. You
want to immunize them, as long as there is no gross negligence, no fraud, no illegality. Coke
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likely talked to many consumer agencies and initiated many reports on the feasibility and
suitability of the move.
The decision
Two things we need to know about the Business Judgment Rule:
The decision has a rational basis and have considered the best interest of the business.
Dodge v. Ford Motor Co.
Rule of Law
A company cannot take actions that harm its shareholders and are motivated solely by
humanitarian concerns, not by business concerns.
The Ford Motor Company (defendant) was incorporated in 1903 and began selling motor
vehicles. Over the course of its first decade, despite the fact that Ford continually lowered the
price of its cars, Ford became increasingly profitable. On top of annual dividends of $120,000,
Ford paid $10 million or more in special dividends annually in 1913, 1914, and 1915. Then, in
1916, Ford’s president and majority shareholder, Henry Ford, announced that there would be no
more special dividends, and that all future profits would be invested in lowering the price of the
product and growing the company. The board quickly ratified his decision. Henry Ford had often
made statements about how he wanted to make sure people were employed, and generally run
the company for the benefits of the overall community. The Dodge brothers (plaintiffs), who
owned their own motor company, were minority shareholders in Ford, and sued to reinstate the
special dividends and stop the building of Ford’s proposed smelting plant. The lower court
ordered the payment of a special dividend and enjoined Ford from building the smelting plant.
Ford appealed.
Can a company choose to stop paying dividends and instead invest its profits in the communities
in which it is active?
Holding and Reasoning (Ostrander, J.)
No. A business exists to conduct business on behalf of its shareholders. It is not a charity to be
run for its employees, or neighbors. In this case, Ford was even more profitable in 1916 than it
was in 1915, when it paid over $10 million in dividends. However, in 1916, Ford paid only its
$120,000 dividend. While a corporation may choose to invest in future ventures, and may choose
to maintain cash on hand to plan for future shortfalls, Ford had done that in prior years and still
managed to pay special dividends. These actions, combined with Henry Ford’s statements about
putting profits into the business to provide for the workers, suggest that the decree against new
special dividends was not motivated by any business concern. By taking an action with no
business concerns motivating it, Henry Ford and the Ford directors who supported his decision
were acting arbitrarily, to the direct detriment of the shareholders in whose interest they were
supposed to be acting. The portion of the lower court opinion enjoining Ford from investing in
the smelting plant is reversed, but the portion ordering Ford to pay out a multi-million dollar
special dividend is sustained.
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Webster believes that the court gets this wrong, to say you must pay the dividend. You can either
look at it from the corporate responsibility perspective, or from the business judgment rule.
Dodge brothers want dividends and stop the plant being constructed.
Maybe Ford screwed up, because no witness would say that the purpose was egalitarian.
The lesson here is that corporations are there to make as much money as possible. The strategy
was not simple altruism. Paying higher wages was also to the end of self-interest, not just
altruism. If you’re also selling your cars cheaper, you’re likely having a broader market.
The Business Judgment Rule is designed to protect you and ensure that there is no stupidity. That
if the board of directors are making stupid decisions, they will be protected by this rule.
Shlensky v. Wrigley
Rule of Law
As long as a corporation’s directors can show a valid business purpose for their decision,
that decision will be given great deference by the courts.
The first game of night baseball was played in 1935, and since then, every team except the
Chicago Cubs began playing night games. Most major league games were night games, except
those played on weekends. The Cubs did not play night games. As a result, the Cubs sold fewer
tickets and were less profitable than any other major league team. Philip Wrigley (defendant), the
President of the Chicago National League Ball Club (defendant), which owned the Cubs, was
opposed to playing night games, claiming that night games would be damaging to the
neighborhood in which the Cubs played. Shlensky (plaintiff) filed a suit claiming that it would be
financially practicable for the Cubs’ stadium to install lights and begin playing night games, and
would be very profitable in the long run. Shlensky alleged that the only reason the Cubs did not
play night games is because Wrigley felt it was somehow against the spirit of baseball. The trial
court dismissed the action, and Shlensky appealed.
Can a single aggrieved shareholder sue a board of directors alleging that the board is not
maximizing profits?
Holding and Reasoning
No. A corporation’s president and board have authority to determine what course of action is
best for the business. While the president and board must have a valid business purpose behind
their actions, a decision motivated by a valid business purpose will be given great deference. In
this case, while Shlensky may disagree with the board’s course of action, Wrigley could have
reached the legitimate business conclusion that the Cubs were better off not playing night games.
Wrigley and the board may be concerned about maintaining goodwill in the community from
which the Cubs draw their fans; or they may be concerned about the costs of operating the lights.
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Wrigley and the board may have determined that night games would not have brought in
additional revenue. Indeed, while Shlensky was able to prove correlation between night games
and ticket sales for other teams, he did not prove that night sales would actually be beneficial to
Cubs shareholders. Shlensky did not prove that night games would increase ticket sales, and did
not prove that any potential increases in ticket sales would offset potential increases in costs. No
convincing showing has been made that Wrigley and the board were acting in anything but the
corporation’s best interest. Accordingly, the trial court’s determination that the complaint should
be dismissed is affirmed.
In a purely business corporation . . . the authority of the directors in the conduct of the
business of the corporation must be regarded as absolute when they act within the law,
and the court is without authority to substitute its judgment for that of the directors.
 Courts may not decide these questions in the absence of a clear showing of dereliction of
duty on the part of the specific directors and mere failure to “follow the crowd” is not
such a dereliction.
§ 2.01 of the Principles of Corporate Governance:
a) Subject to the provisions of Subsection (b) and § 6.02, a corporation should have as its
objective the conduct of business activities with a view to enhancing corporate profit and
shareholder gain.
b) Even if corporate profit and shareholder gain are not thereby enhanced, the corporation,
in the conduct of its business:
a. Is obliged, to the same extent as a natural person, to act within the boundaries set
by law;
b. May take into account ethical considerations that are reasonably regarded as
appropriate to the responsible conduct of the business; and
c. May devote a reasonable amount of resources to public welfare, humanitarian,
educational, and philanthropic purposes.
 Usually, the burden is on the plaintiff to demonstrate the harm resulting from the
directors’ actions.
 Here, the plaintiff has a causation problem, they can’t point out the particularity of the
problem here to make a causation.
Problems on page 231
1. If we look at Dodge, only to produce high quality salami, then Bill would lose (if he doesn’t
care about the impact it has on the corporation).
However, if he states that he wants to protect the long-term prospects of the business (wholefood
product), he would probably win. But, he has to produce independent expert information that its
reasonably chosen and selected.
Takeaway: so, they have to produce information for the court to consider, and the standard is
different by the court. So, if Bill says I want to make money and profit, then he is bound to go by
Carol’s recommendation (similar to Henry Ford’s testimony). But, if Bill also says that this is
what I want, but also preserve the wholesome nutrition and shit like that, then he’s probably
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rational in the way he decides (the Baseball case, the court said yeah, the guy was talking about
multiple reasons). Either way, he has to produce rational basis, which is the production of expert
Van Gorkom was problematic, because the process was faulty, he didn’t go and communicate, or
talk to the board. The courts are preoccupied with the process.
The Public Benefit Corporation – page 231
Webster: it’s only a motivation for the company to feel good about itself and its mission.
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Chapter 4 – The Limited Liability Company
LLC is an alternative form of business organization that combines certain features of the
corporate form with others more closely resembling general partnerships. Investors are called
members. Like the traditional corporation, LLC provides a liability shield for its members. It
allows a bit of flexibility than the corporation in developing rules for management and control.
The LLC may be managed by all members or by managers, who may or may not be members (as
in a corporation). The LLC offers advantageous tax treatment as compared with a corporation. A
corporation pays tax on its profits as earned and the shareholders pay a second tax when those
profits are distributed to them. Investors in an LLC are taxed, like partners, only once in profits,
as those profits are earned. A corporation’s losses can be carried forward to offset any future
profit but cannot be used by its shareholders. The LLC allows greater freedom than a corporation
in allocating profit and loss for tax purposes. The formation requires some paperwork with the
state agency.
This section also includes some formation information on LLPs, see page 233.
Corporate entity
Members (owners) NOT liable for debts/liabilities
Combine elements of corporation and partnership
Similar taxation to p/ship
Articles of organization filed w/State
It allows more flexibility than other enterprises. The beauty is the freedom of liability and the
greater managerial freedom of partnerships. This is especially important for large enterprises,
like GE, that need authoritative management, not democracy. So, in the LLC you choose the
managerial style you require or that suits you.
Partnership disadvantage: liability may attach.
Corporations are advantaged: liability is shielded.
LLC: they are like a corporation: shielding the shareholders from liability, in the case of LLC,
shielding members from liability. LLC combines the shielding (from corporations) and allowing
closer managerial ability for the members (like partners).
If you need an authoritative but with shield: LLC.
NetJets Aviation, Inc. v. LHC Communications, LLC
Rule of Law
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A court will pierce the limited liability company veil if (1) there is overall injustice or
unfairness and (2) the LLC is a mere instrumentality or alter ego of its owner, in that the
LLC and the owner operate as a single economic unit.
NetJets Aviation, Inc. (NetJets) (plaintiff) leased to LHC Communications, LLC (LHC)
(defendant) an interest in an airplane for a term of five years. LHC was a limited liability
company (LLC) whose only member-owner was Zimmerman (defendant). Zimmerman had sole
authority to make all financial decisions with respect to LHC. He often withdrew money from
LHC’s account for personal use and transferred money into LHC’s account from his own
personal account. Zimmerman did not have any written agreements with LHC regarding this
comingling of funds. Many withdrawals from LHC’s account were for personal expenses,
including a residence, phone and cleaning bills, a car, and health insurance for his family. Much
of the flight time used by LHC under the lease with NetJets was used by Zimmerman and his
family for personal trips. LHC terminated the lease agreement with NetJets about one year into
the agreement. The next year, LHC ceased operations, owing NetJets a balance of $340,840.39.
NetJets brought suit against LHC and Zimmerman. NetJets presented evidence that, among other
things, Zimmerman took more money out of LHC’s account than he put in, continued
withdrawing money for personal uses even while refusing to pay debts LHC owed to NetJets,
and identified his deposits to LHC as loans when other evidence suggests that they were capital
contributions. NetJets filed a motion for summary judgment. The district court granted the
motion with respect to LHC, but denied the motion with respect to Zimmerman’s personal
liability. The district court sua sponte granted Zimmerman, personally, summary judgment and
dismissed the claims against him. NetJets appealed.
Will a court pierce the limited liability company veil if (1) there is overall injustice or unfairness
and (2) the LLC is a mere instrumentality or alter ego of its owner?
Holding and Reasoning
Yes. A court will pierce the LLC veil if: (1) there is overall injustice or unfairness and (2) the
LLC is a mere instrumentality or alter ego of its owner, in that the LLC and the owner operate as
a single economic unit. Factors relevant to the alter ego analysis include whether: the LLC was
adequately capitalized, the owner siphoned LLC funds, and “in general, the [LLC] simply
functioned as a facade for” the owner. In this case, taking all the facts in the light most favorable
to NetJets, (1) LHC was the mere alter ego of Zimmerman, and (2) there was a sufficient levels
of fraud or at least overall injustice or unfairness to pierce the LLC veil. First, evidence indicates
that Zimmerman used LHC as his personal cash machine whenever he needed. He deposited
funds into LHC’s account and withdrew funds for his personal and his family’s use. Zimmerman
also had sole control over all financial decisions of LHC. There is enough evidence that a
reasonable fact finder could find that LHC was simply Zimmerman’s alter ego. Next,
Zimmerman did not put any of the above-referenced deposits or withdrawals in writing and
failed to consistently characterize the transactions as loans or capital contributions. There is
enough evidence that a reasonable fact finder could find that Zimmerman’s withdrawals from
LHC amounted to improper distributions that led LHC to go out of business. This would be
sufficient for a finding of overall unfairness or injustice in the operation of LHC. As a result,
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summary judgment in favor of Zimmerman and against piercing the LLC veil was inappropriate.
The order of the district court is vacated, and the case is remanded.
To prevail under the alter-ego theory of piercing the veil, a plaintiff need not
provide that there was actual fraud but must show a mingling of the operations of
the entity and its owner plus an overall element of injustice or unfairness.
The court focuses on a two-prong test: (1) whether the entity(s) in question
operated as a single economic entity, and (2) whether there was an overall
element of injustice or unfairness.
Uniform Limited Liability Company Act §303(b): the failure of a limited liability
company to observe the usual company formalities or requirements relating to the
exercise of its company powers or management of its business is not a ground for
imposing personal liability on the members or managers for liabilities of the
PCV is an extremely tough thing to do. Clients should observe the corporate formalities and not
make the courts believe that corporates and directors are the same entity (not the alter ego: the
alternative personality, i.e. the other me).
This is a classic example of failure to observe corporate formalities.
Treating it as a “piggy bank.”
Rule: on the rare occasion that a court feels that it could even entertain a PVC, is when the
members are treating the business entity and themselves as one, that there is injustice, or if there
is an evidence of illegality.
The court focuses on two things here: (1) the illegality of the loan transactions that were used to
circumvent the IRS, and (2) unfairness, the way Zimmerman treats his creditors, being
insensitive and unfair.
Questions on page 260:
2. not reach out for the money. Hire someone to be a “financial nanny.” Define a stream of
income for himself, instead of just taking money.
McConnell v. Hunt Sports Enterprises
Rule of Law
An LLC operating agreement may limit the scope of the fiduciary duties of its members.
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John McConnell (plaintiff) and Lamar Hunt (defendant) were part of a group that formed
Columbus Hockey Limited, LLC (CHL) in order to try to obtain a National Hockey League
franchise in Columbus. CHL began negotiations with Nationwide Insurance Enterprise
(Nationwide) about building an arena, which CHL would then lease. Hunt, purporting to act for
CHL, but without consulting other CHL members, repeatedly rejected Nationwide’s lease offers.
Nationwide then approached McConnell individually, and McConnell said that if Hunt would
not agree to the lease on behalf of CHL, McConnell would individually. Subsequently,
McConnell and his individual group signed a lease independently of CHL and Hunt. There was a
clause in CHL’s operating agreement which stated that members of CHL had a right to engage in
business ventures that may compete with CHL. McConnell then filed suit, seeking a declaratory
judgment to establish his right to operate the NHL franchise without CHL or Hunt. Hunt filed a
counterclaim, alleging that McConnell violated a fiduciary duty to CHL. The district court
directed a verdict in favor of McConnell. Hunt appealed.
May an LLC operating agreement limit the scope of the fiduciary duties of its members?
Holding and Reasoning
Yes. An LLC operating agreement may limit the scope of the fiduciary duties of its members. In
this case, therefore, the clause in CHL’s operating agreement that provides that members of CHL
have a right to engage in business ventures that may compete with CHL is valid. Moreover,
McConnell seeking to receive an NHL franchise independently from CHL is not a violation of
his fiduciary duty to CHL. The district court is affirmed.
Members of an LLC owe one another the duty of utmost trust and loyalty. However, such
general duty in this case must be considered in the context of members’ ability, pursuant
to operating agreement, to compete with the company.
The tort of interference with a business relationship occurs when a person, without a
privilege to do so, induces or otherwise purposely causes third person not to enter into or
continue a business relationship with another.
LLCs have an operating agreement, which is the equivalent of the articles of incorporation like in
Webster believes that section 3.3 on page 262 is a boilerplate, because why would you want to
limit yourself  this may be the result of a lawyer who wanted to hedge his/her own risk. The
CHL operating agreement expressly allows competition.
This case is great, because it shows how the fiduciary duty works.
Webster believes that even if the guy had not objected, section 3.3 would be dispositive. So, here
it didn’t matter that he objected.
Analysis on page 266:
1. wouldn’t change it, because the contract is unambiguous (section 3.3 is dispositive) on the
matter here, so they would be able to act.
2. probably not, because there is no mention of hockey, it is a boiler plate for that reason.
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The takeaway here is that courts consider the language in your operating agreement as something
that you understood when you sign, so you cannot argue that there was no meeting of the minds.
There is nothing wrong about dilution of the fiduciary duty to the extent it’s permissible.
Racing Investment Fund 2000, LLC v. Clay Ward Agency, Inc.
Rule of Law
A standard capital call provision may not be invoked to satisfy a judgment against a
limited liability company.
Racing Investment Fund 2000, LLC (Racing Investment) (defendant) purchased insurance from
Clay Ward Agency, Inc. (Clay Ward) (plaintiff). In May 2004, after falling behind on payments,
Racing Investment agreed to a judgment. Racing Investment, which by then had become defunct,
failed to pay the entire judgment when due. The trial court found that a provision of Racing
Investment’s Operating Agreement (Operating Agreement) requiring members to make
occasional capital infusions for business expenses was an available means to satisfy the
judgment. The trial court ordered Racing Investment to satisfy the judgment accordingly. The
Court of Appeals affirmed.
Can a standard capital call provision be invoked to satisfy a judgment against a limited liability
Holding and Reasoning
No. The Kentucky Limited Liability Act immunizes a member of a Kentucky limited liability
company (LLC) from personal liability for the debts and obligations of the LLC.
Notwithstanding this provision, the Act provides that members of an LLC may, pursuant to a
written agreement, agree to be personally liable for the debts and obligations of the LLC.
However, a member’s intent to become personally liable must be stated in clear and unequivocal
language. A standard provision in an operating agreement calling for occasional capital
infusions, without more, does not constitute a clear and unequivocal statement of a member’s
intent to be personally liable. As such, the trial court erred in ordering Racing Investment to pay
the judgment by means of the capital infusion provision of the Operating Agreement. The
judgment of the Court of Appeals is reversed.
The assumption of personal liability by a member of an LLC is so antithetical to the
purpose of an LLC that any such assumption must be stated in unequivocal term leaving
no doubt that the member or members intended to forego a principal advantage of this
form of business entity.
Any assumption of personal liability, which is contrary to the very business advantage
reflected in the name “limited liability company,” must be stated clearly in unequivocal
language which leaves no room for doubt about the parties’ intent.
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Section 4.3(a) [on page 269], is an ongoing capital infusion provision, not a debtcollection mechanism by which a court can order a capital call and, by doing so, impose
personal liability on the LLC’s members for the entity’s outstanding debts.
the odd thing here is that the company has ended its operation, but that Kentucky allows entities
to exist, during the period of liquidation and dissolution.
Members of the LLC can appoint a manager to manage an LLC, and in light of Section 4.3
above, that person was within his authority to ask for more money.
Webster thinks the legal logic here is bizarre.
Webster believes that Clay Ward is trying it on before the trial court. Clay’s lawyers realize that
there is a mandatory call for funding in the event of necessity, so they think that Clay could force
the shareholders to pay them . . . “maybe the judge would fall for it” and so he did.
Analysis on page 270:
2. Webster says this provision is unusual to the extent that the manager would be able to call the
shareholders to raise money in the event that LLC can’t raise money. We don’t know how this is
New Horizons Supply Cooperative v. Haack
Rule of Law
Upon liquidation of a dissolving LLC’s assets, a creditor may sustain a claim against a
member of the LLC if the creditor was not formally notified of dissolution procedures or
Allison Haack (defendant) ordered a gas card from New Horizons Supply Cooperative (New
Horizons) (plaintiff) and signed an agreement on behalf of Kickapoo Valley Freight, LLC
(KVF), taking responsibility for the payment of any gas purchased with the card. An amount of
$1,009.99 went unpaid on KVF’s account and Haack informed New Horizons that KVF had
dissolved. However, KVF did not file articles of dissolution, nor did it notify creditors of its
dissolution when it stopped doing business. New Horizons brought suit to recover the
outstanding amount that KVF owed. The trial court found in favor of New Horizons. Haack
Upon liquidation of a dissolving LLC’s assets, may a creditor sustain a claim against a member
of the LLC if the creditor was not formally notified of dissolution procedures or schedule?
Holding and Reasoning
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Yes. Upon liquidation of a dissolving LLC’s assets, a creditor may sustain a claim against a
member of the LLC if the creditor was not formally notified of dissolution procedures or
schedule. Although filing articles of dissolution is optional in Ohio, creditors must have the first
priority to liquidation of a dissolving LLC’s assets. When notice of dissolution is not given to
such creditors, they are entitled to go after members of the LLC individually. Here, therefore,
New Horizons is able to sustain a claim against Haack personally because she did not take the
proper steps required in dissolution to shield herself from personal liability—namely notifying
New Horizons of dissolution and an opportunity to submit a claim. As a result, because New
Horizons’s claim does not exceed the value of any liquidation distribution that Haack may have
received from KVF, New Horizons is entitled to the amount it is owed. The trial court is
Make sure you do your paperwork properly!!
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Chapter 5 – The Duties of Officers, Directors, and Other Insiders
Kamin v. American Express Company
Rule of Law
Courts will not interfere with a business decision made by directors of a business unless
there is a claim of fraud, bad faith, or self-dealing.
American Express (defendant) authorized dividends to be paid out to stockholders in the form of
shares of Donaldson, Lufkin and Jenrette, Inc. (DLJ). Kamin, et al. (plaintiffs), minority
stockholders in American Express, brought suit against the directors of American Express,
alleging that the dividends were a waste of corporate assets in that the stocks of DLJ could have
been sold on the market, saving American Express about $8 million in taxes. The American
Express directors filed a motion to dismiss the case.
Can a stockholder maintain a claim against the directors of a corporation if the stockholder
alleges only that a particular course of action would have been more advantageous than the
course of action the directors took?
Holding and Reasoning
No. Courts will not interfere with a business decision made by directors of a business unless
there is a claim of fraud, bad faith, or self-dealing. An error of judgment by directors, as long as
the business decision was made in good faith, is not sufficient to maintain a claim against them.
In the present case, the plaintiffs do not allege any bad faith on the part of the directors. The only
wrongdoing that the plaintiffs claim is that the directors should have done something differently
with the DLJ stock. This allegation without more is not sufficient to maintain a claim.
Consequently, the directors’ motion to dismiss is granted.
Courts will not interfere unless the powers have illegally or unconscientiously executed,
or unless it be made to appear that the acts were fraudulent or collusive, and destructive
of the rights of the stockholders. Mere errors of judgment are not sufficient as grounds for
equity interference, for the powers of those entrusted with corporate management are
largely discretionary.
To allege that a director “negligently permitted the declaration and payment” of a
dividend without alleging fraud, dishonesty or nonfeasance, is to state merely that a
decision was taken with which one disagrees.
All directors have an obligation, using sound business judgment, to maximize income for
the benefit of all persons having a stake in the welfare of the corporate entity.
Webster believes this was an odd case. Under the old accounting principles, the change was not
recognized in the value of the company until it was sold. Here, it would have been a huge
decline. They wanted to issue this special dividend, to take the focus away from the loss, and
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they (directors) would also get more money. Webster thinks the court gets this wrong, but since
there was a proper process, they upheld the directors’ actions, but that should have not been the
It’s bizarre that there is no finding of conflict of interest.
Takeaways: (1) plaintiffs, from the tax perspective, would think they would save money, and (2)
directors believed that the valuation of the company would be hurt.
Shows the limit of the stretch of BJR
Smith v. Van Gorkom
Rule of Law
There is a rebuttable presumption that a business determination made by a corporation’s
board of directors is fully informed and made in good faith and in the best interests of the
Jerome Van Gorkom, the CEO of Trans Union Corporation (Trans Union), engaged in his own
negotiations with a third party for a buyout/merger with Trans Union. Prior to negotiations, Van
Gorkom determined the value of Trans Union to be $55 per share and during negotiations agreed
in principle on a merger. There is no evidence showing how Van Gorkom came up with this
value other than Trans Union’s market price at the time of $38 per share. Subsequently, Van
Gorkom called a meeting of Trans Union’s senior management, followed by a meeting of the
board of directors (defendants). Senior management reacted very negatively to the idea of the
buyout. However, the board of directors approved the buyout at the next meeting, based mostly
on an oral presentation by Van Gorkom. The meeting lasted two hours and the board of directors
did not have an opportunity to review the merger agreement before or during the meeting. The
directors had no documents summarizing the merger, nor did they have justification for the sale
price of $55 per share. Smith et al. (plaintiffs) brought a class action suit against the Trans Union
board of directors, alleging that the directors’ decision to approve the merger was uninformed.
The Delaware Court of Chancery ruled in favor of the defendants. The plaintiffs appealed.
May directors of a corporation be liable to shareholders under the business judgment rule for
approving a merger without reviewing the agreement and only considering the transaction at a
two-hour meeting?
Holding and Reasoning
Yes. Under the business judgment rule, a business determination made by a corporation’s board
of directors is presumed to be fully informed and made in good faith and in the best interests of
the corporation. However, this presumption is rebuttable if the plaintiffs can show that the
directors were grossly negligent in that they did not inform themselves of “all material
information reasonably available to them.” The court determines that in this case, the Trans
Union board of directors did not make an informed business judgment in voting to approve the
merger. The directors did not adequately inquire into Van Gorkom’s role and motives behind
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bringing about the transaction, including where the price of $55 per share came from; the
directors were uninformed of the intrinsic value of Trans Union; and, lacking this knowledge, the
directors only considered the merger at a two-hour meeting, without taking the time to fully
consider the reasons, alternatives, and consequences. The evidence presented is sufficient to
rebut the presumption of an informed decision under the business judgment rule. The directors’
decision to approve the merger was not fully informed. As a result, the plaintiffs are entitled to
the fair value of their shares that were sold in the merger, which is to be based on the intrinsic
value of Trans Union. The Delaware Court of Chancery is reversed, and the case is remanded to
determine that value.
The determination of whether a business judgment is an informed one turns on whether
the directors have informed themselves “prior to making a business decision, of all
material information reasonably available to them.”
Under the business judgment rule there is no protection for directors who have made “an
unintelligent or unadvised judgment”
The concept of gross negligence is the proper standard for determining whether a
business judgment reached by a board of directors was an informed one.
The combined experience of the Trans Union board of directors warrants a finding that they
would not have entered into the merger without being fully informed. They were “more than well
qualified” to make an informed business judgment and under the business judgment rule, they
should not be liable.
The fact that the guy was near the retirement age means that there was a conflict there. The court
believes the problem here is the fact proving the intrinsic value of the company.
Decisions must be informed and rational.
The problem is that there was no expert here.
Takeaway: the essential question here is how you would trust the director here as a shareholder,
if the board of directors are uninformed themselves. In other words, how do you want to trust the
CEO when the board members are not informed as well.
Bayer v. Beran
Rule of Law
Directors have an obligation not to put their own interests before the interests of the
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The directors (defendants) of the Celanese Corporation of America (CCA) started a radio
advertising campaign for the corporation. CCA had advertised before, but never on the radio. In
making its decision to start advertising on the radio, the directors reviewed studies given to them
by CCA’s advertising department, brought in a radio consultant to help them determine the
station and time to advertise, and hired an advertising agency to produce the ad. In addition, the
advertising commitments were subject to cancellation at any time, and the board voted to renew
the advertising contract after it had been running for a year and a half. One of the singers on the
program on which CCA decided to advertise was the wife of Camille Dreyfus, one of CCA’s
directors. The plaintiff brought suit, claiming that the advertising campaign was started due to
the benefit to Mrs. Dreyfus as it “subsidized” her career and was “a vehicle for her talents.”
Does a director necessarily breach his duty of loyalty to a corporation by advertising the
corporation’s product on a program on which the director’s wife is a singer?
Holding and Reasoning
No. Directors have an obligation not to put their own interests before the interests of the
corporation. This duty of loyalty supersedes the business judgment rule so that fraud may be
avoided. The burden of establishing that the duty of loyalty is not violated is on said directors.
However, that burden may be met if after “rigorous scrutiny” it is determined that the transaction
in question was made in good faith and would have been made even in the absence of the
personal interests of the director. In the present case, the court finds that the directors did not
violate their duty of loyalty to CCA by advertising on Mrs. Dreyfus’s program.
The directors went through an involved process to determine whether to advertise on the radio,
and on what station and channel to advertise. Although the advertising choice may have
enhanced Mrs. Dreyfus’s career, it also greatly benefited CCA and the evidence supports a
conclusion that the same decision on advertising would have been made if Mrs. Dreyfus was not
on the program. Accordingly, the court finds in favor of the CCA directors.
The general rule is that directors acting separately and not collectively as a board cannot
bind the corporation. Two reasons: (1) that collective procedure is necessary in order that
action may be deliberately taken after an opportunity for discussion and an interchange of
views, and (2) that directors are the agents of the stockholders and are given by law no
power to act except as a board . . . liability may not be imposed on directors because they
failed to approve the radio program by resolution at a board meeting.
Delaware law favors and defers to the Business Judgment Rule and protects stupidity. As long as
there is (1) no fraud, (2) no illegality, and (3) no conflict of interest, the business judgment rule
protects everything that the board of director does, so long as they meet their duty of care.
The Duty of care is the reasonable person of the ordinary circumstances.
But the question is the whether the board members came to a rational decision that is rooted in a
sustained basis. This basis can be satisfied by showing reports that would positively agrees that
this proposition is a good idea.
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Takeaway: there is a presumption that the business judgment rule would always
immunize the board members from liability, as long as the requirements up top are
If you are making a decision that has impact on the nature of the business, you should have
consultation to show your proposition is sound. If it’s a dramatic moment in the life of the
corporation, you need to go to experts.
CEOs serve at the pleasure of the board of directors: they should be obedient and at the pleasure
of the board “no surprises or fait accompli (accomplished facts).” In Van Gorkom, the CEO
was doing both here, he went to the board without having consulted with them. Compare with
Dodge v. Ford, because there was an agency-principal relationship there as well, there Ford was
the majority shareholder, but when the Dodge bros and other minority shareholders buy stock,
they are hiring Henry Ford to be their agent in ensuring the collective good health (embracing the
Ford interest and the Dodge bros. interests as well) of the Ford Motor Company.
BJR does not apply here, because there is a conflict of interest. Think about the conflict.  this
is the takeaway.
The burden on those who are charged is on them to demonstrate the fairness of the transaction:
(1) pay is the same
(2) no advantage in career advancement
(3) the program gave them the going rate
This case is an illustration/example of the conflict in existence here.
According to this court, if it’s a conflict case, the board can escape, if they can demonstrate the
fairness of the transaction (is this a fair deal). Fairness is an individual examination of the deal;
the courts consider every angle in their analysis.
Broz v. Cellular Information Systems, Inc.
Rule of Law
Under the corporate opportunity doctrine, it is not required that the director in question
formally present the opportunity to his corporation’s board of directors if the corporation
does not have an interest in or the financial ability to undertake the opportunity.
Robert Broz (defendant) was a director of Cellular Information Systems, Inc. (CIS) (plaintiff).
He was also the president and sole stockholder of RFB Cellular (RFBC), a competitor of CIS in
the cellular telephone service market. At the time in question, CIS had recently undergone
financial difficulties and had begun divesting its cellular licenses. Mackinac Cellular Corp.
(Mackinac), a third-party cellular service provider, was seeking to sell one of its licenses.
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Mackinac thought that RFBC would be a potential buyer and contacted Broz about the
possibility. The license was not offered to CIS. Broz spoke informally with other CIS directors,
all of whom told him that CIS was not interested in the license and could not afford the license
even if it were interested. At about the same time, a fourth service provider, PriCellular, had
undergone discussions with CIS about PriCellular purchasing CIS. PriCellular had also been in
negotiations with Mackinac about purchasing the license in question. In September 1994,
PriCellular agreed on an option contract with Mackinac about purchasing the license. The option
was to last until December 15, 1994, but if any competitor offered Mackinac a higher price
during that time, Mackinac would be free to sell the license for that higher offer. On November
14, 1994, Broz, on behalf of RFBC, offered Mackinac a higher price for the license and
Mackinac agreed to sell to RFBC. Nine days later, PriCellular completed its purchase of CIS.
CIS then brought suit against Broz, alleging that Broz breached his fiduciary duties to CIS by
purchasing the license for RFBC when the newly formed PriCellular/CIS corporation had had
the option open to make the same purchase. The Delaware Court of Chancery found that Broz
had violated his fiduciary duties to CIS because he did not take into account PriCellular’s future
plans regarding the purchase of CIS, and because Broz did not formally present the opportunity
to CIS’s board of directors. Broz appealed.
Under the corporate opportunity doctrine, must the director in question formally present the
opportunity to his corporation’s board of directors if the corporation does not have an interest in
or the financial ability to undertake the opportunity?
Holding and Reasoning
No. The Delaware Court of Chancery improperly wrote additional requirements into the
corporate opportunity doctrine. There is no requirement that the director take into consideration
future interests of an at-that-time third party corporation, and there is no requirement that the
director in question formally present the opportunity to his corporation’s board of directors if the
corporation does not have an interest in or the financial ability to undertake the opportunity. In
the instant case, at the time Broz closed the deal for the license on behalf of RFBC, PriCelluar
had no equitable interest in CIS. He was under no duty to consider the “the contingent and
uncertain plans of PriCellular.” In addition, it was clear that at the time CIS could not financially
afford to purchase the license and that it in fact had no interest in purchasing the license. This
was not only clear given CIS’s financial troubles and divesting of other licenses, but because
directors of CIS told Broz as much during informal discussions. Consequently, Broz did not
violate any fiduciary duty to CIS and the Delaware Court of Chancery is reversed.
the corporate opportunity doctrine is implicated only in cases where the
fiduciary’s seizure of an opportunity results in a conflict between the
fiduciary’s duties to the corporation and the self-interest of the director as
actualized by the exploitation of the opportunity.
 Court identifies four considerations in evaluating these situations:
1) the corporations’ ability to take up opportunity financially
2) the opportunity is within Corporation’s lines of business
3) the corporation has an interest or expectancy in the opportunity
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4) by embracing the opportunity, the officer or director would create a conflict between
her self-interest and that of the corporation.
here we don’t have perfect disclosure, it’s only information disclosure. Even though this is shaky
he did not keep it private.
Corporate opportunity is nothing more but one aspect of duty of loyalty. It’s another aspect of
that duty.
Loyalty requires disclosure.
In re eBay, Inc. Shareholders Litigation
Rule of Law
Directors of a corporation are not permitted to personally accept private stock allocations
in an initial public offering of the corporation’s stock when the corporation itself could
have purchased said stock.
Goldman Sachs was hired to underwrite the initial public offering of eBay stock. In doing so,
Goldman Sachs allocated shares of the initial eBay stock to eBay “insiders,” including members
of eBay’s board of directors. Shareholders of eBay (plaintiffs) brought suit against the directors
(defendants), alleging that the directors’ acceptance of the private allocations violated their
fiduciary duty to eBay by usurping eBay’s corporate opportunity in that eBay could and would
have purchased the stock that was allocated. It is undisputed that eBay could afford the stock
financially, that it was in the business of investing in securities, and that eBay was never given
an opportunity to turn down the allocations. The directors filed a motion to dismiss the claim.
Are directors of a corporation personally permitted to accept private stock allocations in an initial
public offering of the corporation’s stock when the corporation itself could have purchased said
Holding and Reasoning
No. Directors of a corporation are not permitted to personally accept private stock allocations in
an initial public offering of the corporation’s stock when the corporation itself could have
purchased said stock. There was a clear conflict of interest between the self-interest of the
defendants in acquiring the valuable eBay stock and the interest of eBay, Inc., which could have
acquired the stock for itself. The acceptance by the eBay directors in this case is a violation of
the corporate opportunity doctrine. eBay could afford the stock financially, eBay was in the
business of investing in securities, and eBay would have surely been interested in purchasing the
stock had it been given the opportunity. Further, even if it is assumed in this case that the
allocations in question do not constitute a “corporate opportunity” under the doctrine, it might
still be a breach of the directors’ fiduciary duty of loyalty as it is likely that Goldman Sachs
intended the allocations to be bribes designed to induce the eBay directors to hire Goldman
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Sachs for future business. As a result of the foregoing, the defendants’ motion to dismiss is
The directors should not have been compensated personally for giving business to Goldman.
Consider Maynard and Salmon because the corporate opportunities are undisclosed profits they
make from doing business. See Reading v. Regem.
Sinclair Oil Corp. v. Levien
Rule of Law
A parent corporation must pass the intrinsic fairness test only when its transactions with its
subsidiary constitute self-dealing.
Sinclair Oil Corp. (Sinclair) (defendant) owned about 97 percent of the stock of its subsidiary,
Sinclair Venezuelan Oil Company (Sinven) (plaintiff). From 1960 to 1966, Sinclair caused
Sinven to pay out $108 million in dividends, which was more than Sinven earned during the time
period. The dividends were made in compliance with law on their face, but Sinven contended
that Sinclair caused the dividends to be paid out simply because Sinclair was in need of cash at
the time. In addition, in 1961 Sinclair caused Sinven to contract with Sinclair International Oil
Company (International), another Sinclair subsidiary created to coordinate Sinclair’s foreign
business. Under the contract, Sinven agreed to sell its crude oil to International. International,
however, consistently made late payments and did not comply with minimum purchase
requirements under the contract. Sinven brought suit against its parent, Sinclair, for the damages
it sustained as a result of the dividends, as well as breach of the contract with International. The
Delaware Court of Chancery applied the intrinsic fairness standard and found in favor of Sinven
on both claims. Sinclair appealed.
Must a parent corporation always pass the intrinsic fairness test when it transacts business that
affects its subsidiary?
Holding and Reasoning
No. A parent corporation must pass the intrinsic fairness test only when its transactions with its
subsidiary constitute self-dealing in that the parent is on both sides of the transaction with its
subsidiary and the parent receives a benefit to the exclusion and at the expense of the subsidiary.
Otherwise, the business judgment rule will apply. Starting with the issue of the dividends in the
present case, the Delaware Court of Chancery improperly applied the intrinsic fairness standard.
The dividend payments were not self-dealing by Sinclair. Although they resulted in a lot of
money changing hands from Sinven to Sinclair, a portion of the money was also received by
Sinven’s minority shareholders. There was no benefit to Sinclair that came at the expense of
Sinven’s minority shareholders and so the payments do not constitute self-dealing. Accordingly,
the business judgment rule applies to the payments and under the business judgment rule, the
court can find no evidence that the decision to cause Sinven to pay dividends was fraudulent or
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made in bad faith. Sinclair, therefore, did not violate its fiduciary duty to Sinven by causing the
dividends to be paid and the Delaware Court of Chancery is reversed on that issue.
On the other hand, in terms of Sinclair inducing the contract between Sinven and International,
Sinclair was engaged in self-dealing, as Sinclair is the parent of both parties to the contract.
Moreover, when the contract was breached by late payment, Sinclair was able to reap the
benefits of the crude oil to the detriment of Sinven’s minority shareholders. As a result, the
Delaware Court of Chancery was correct in applying the intrinsic fairness standard to Sinclair’s
involvement in the contract, and the court determines that the Delaware Court of Chancery was
also correct in finding that Sinclair did not meet its burden of showing objective fairness under
that standard. Clearly Sinclair’s involvement is not objectively fair because International
breached the contract and Sinclair reaped benefits without fully paying for them. Sinclair thus
breached its fiduciary duty to Sinven by its role in the formation and execution of the contract
with International. In accordance with the foregoing, the Delaware Court of Chancery is reversed
in part and affirmed in part.
when the situation involves a parent and a subsidiary, with the parent controlling
the transaction and fixing the terms, the test of intrinsic fairness, with its resulting
shifting of the burden of proof, is applied as opposed to the BJR.
o this standard will be applied only when the fiduciary duty is accompanied
by self-dealing–the situation when a parent is on both sides of a transaction
with its subsidiary. Self-dealing occurs when the parent, by virtue of its
domination of the subsidiary, causes the subsidiary to act in such a way that
the parent receives something from the subsidiary to the exclusion of, and
detriment to, the minority stockholders of the subsidiary.
Absent fraud or overreaching, to achieve expansion through the medium of its
subsidiaries, BJR would be applicable in a parent-subsidiary setting.
Acts of contracting with your dominated subsidiary is self-dealing.
o if you contract with your own subsidiary, you must comply with your
contractual duties.
DE Supreme Court:
a director is a fiduciary . . . So is a dominant or controlling stockholder or group
of stockholders . . . Their powers are in trust . . . Their dealings with the
corporation are subjected to rigorous scrutiny and where any of their contracts or
engagements with the corporation is challenged the burden is on the director or
shareholder not only to prove the good faith of the transaction but also to show its
inherent fairness from the viewpoint of the corporation and those interested
There are circumstances where courts will impose some fiduciary duties on some shareholders.
The courts want to make sure that majority shareholders are fair to minority shareholders. The
court lays down an intrinsic test for fairness here. Shareholder has the burden of proof
transaction was fair to the corporation. but the test only applies when there is potential for selfdealing/self-interest in the deal.
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The majority shareholder might be asked to demonstrate that the proposed transaction in selfdealing question, is not harming the minority shareholders.
Giving out the dividends here was okay because minority shareholders received proportionate
shares. Don’t pass the fairness test because doing its detriment of the minority shareholders,
there are two things that support these conclusions: (1) payments lagged, and (2) minimum
amount of crude oil was not purchased (they secured an advantage over Sinven).
The other way to look at this through the law of agency, the directors of Sinven can be viewed as
agents for Sinclair directors. Through that Sinclair would be responsible.
The court wants to see that control is exercised responsibly.
the concept remained essentially undefined until quite recently. The process of giving content to
good faith began with the Delaware Supreme Court’s decision in Cede & Co. v. Technicolor,
Inc. The obligation of good faith develops in two key areas: executive compensation and
The two principle things that you need to look at in the context of fiduciary duty are:
Duty of care: discharged by the board of directors, ensuring that they get all reasonably available
material to them about the subject of discussion and they have time to deliberate and consider the
matter and they must make an informed judgment.
Duty of loyalty: focuses on whether there is a conflict of interests or not.
Obligation to act in good faith is NOT a third element under the fiduciary duty, unlike how the
next two cases appear. The Good Faith obligation is underlying fore of the two elements of
loyalty and care.
Directors will be only liable when directors have deliberately, intentionally, and consciously
disregarded their directorial responsibilities.
Duty of Care is statutorily protected for directors under § 102b7 in Delaware.
In re the Walt Disney Co. Derivative Litigation
Rule of Law
The concept of intentional dereliction of duty and a conscious disregard for one’s
responsibilities is an appropriate standard for determining whether fiduciaries have acted
in good faith.
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Michael Ovitz was hired as the president of The Walt Disney Company (Disney). Ovitz was a
much respected and well-known executive, and in convincing him to leave his lucrative and
successful job with Creative Artists Agency (CAA), Disney signed Ovitz to a very lucrative
contract. The contract was for five years, but if Ovitz were terminated without cause, he would
be paid the remaining value of his contract as well as a significant severance package in the form
of stock option payouts. The contract was approved by Disney’s compensation committee after
its consideration of term sheets and other documents indicating the total possible payout to Ovitz
if he was fired without cause.
The compensation committee then informed Disney’s board of directors of the provisions of the
contract, including the total possible payout to Ovitz. The board approved the contract and
elected Ovitz as president. After Ovitz’s first year on the job, it was clear that he was not
working out as president and that he was “a poor fit with his fellow executives.” However,
Disney’s CEO and attorneys could not find a way to fire him for any cause, so Disney instead
fired him without cause, triggering the severance package in the contract. Ovitz ended up being
paid $130 million upon his termination. Disney shareholders (plaintiffs) brought derivative suits
against Disney’s directors for failure to exercise due care and good faith in approving the
contract and in hiring Ovitz, and, even if the contract was valid, for breaching their fiduciary
duties by actually making the exorbitant severance payout to Ovitz. The Delaware Court of
Chancery found that although the process of hiring Ovitz and the resulting contract did not
constitute corporate “best practices,” the Disney directors did not breach any fiduciary duty to
the corporation. The Disney shareholders appealed.
Is the concept of intentional dereliction of duty and a conscious disregard for one’s
responsibilities an appropriate standard for determining whether fiduciaries have acted in good
Holding and Reasoning
Yes. As an initial matter, the court determines that the directors did not breach their duty of due
care in approving the contract or hiring Ovitz because the directors were fully informed of all
information available, including the total possible severance payout to Ovitz. In terms of the bad
faith claim, there are at least three categories of fiduciary bad faith. The first two are clearer:
subjective bad faith, meaning intent to harm, and the lack of due care, meaning gross negligence.
However, there is a form of fiduciary bad faith that is not intentional, but “is qualitatively more
culpable than gross negligence.” This category is appropriately captured by the concept of
intentional dereliction of duty and a conscious disregard for one’s responsibilities. Therefore,
although it is not the exclusive definition of fiduciary bad faith, that concept is an appropriate
standard for determining whether fiduciaries have acted in good faith. The court determines that
because the Disney compensation committee and directors were fully informed about the total
potential payout, and because of the well-known skills and qualifications of Ovitz, the Delaware
Court of Chancery properly held that the directors’ actions, although not in line with corporate
best practices, did not violate a duty to act in good faith. Finally, the court finds that the directors
did not violate any fiduciary duties by actually making the severance payout to Ovitz because the
directors were entitled, under the business judgment rule, to rely on advice from Disney’s CEO
and attorneys that there were no grounds for Ovitz to be fired for cause. They were thus entitled
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to fire him without cause. As a result of the foregoing, the court finds in favor of the defendants
and the Delaware Court of Chancery is affirmed.
In making a business decision the directors of a corporation acted in an informed basis, in
good faith, and in the honest belief that the action taken was in the best interests of the
company. Those presumptions can be rebutted if the plaintiff shows that the directors
breaches their (1) fiduciary duty of care, (2) of loyalty or (3) not acted in good faith. If
that is shown, the burden then shifts to the director defendants to demonstrate that the
challenged act or transaction was entirely fair to the corporation and its shareholders.
The fact that there is a lawyer in the hiring process, the fact that there is an executive
compensation expert in the process to give advice on this matter make this whole process
legitimate, making the whole process okay for the good faith obligation of the board members.
Acting in good faith is an integral part of the duty of care and the duty of loyalty.
Bad faith requires that individual directors to act in a deliberately intentional manner that
represents ultimately a reckless and conscious disregard of their responsibilities. In other words,
there has to be clear ill-intent. The corporate equivalent would the wanton disregard of the
corporate interest.
here, the court finds that the board did act in a way that they were doing their duties in an honest,
good faith belief that the practice was in the best interest of the corporation.
Lesson: in making decisions of moment (major decisions that affect the corporate’s interest), you
have to act in the industry-best way. Corporate board members here should have come out with a
better business practice. You have to produce minutes, that the story would tell what the topics
were, and the conclusions were. The court wants to see these things. The most important thing is
rich data that you could analyze the board judgments later.
here, there is no degree of deliberate recklessness, or disregard of Disney’s decision in the whole
Bad Faith requires the subjective motivation to do harm to the corporation, recklessness, and
According to the court:
Attempting to deal with what constitutes bad faith on the part of directors, it gave three
1) acting with a purpose other than advancing the best interests of the corporation
2) acting with intent to violate applicable law
3) intentionally failing to act in the face of a known duty to act
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The exculpation of the duty of good faith is a way for the Delaware legislature to mitigate the
effects of Van Gorkom.
Section 102(b)(7) does not include the conflict of interest situation. It’s specifically excluded.
See page 348.
With regards to the duty of care, the application of the business judgment rule is preoccupied by
the process.
Question 5 on page 349:
(a) Collective, because there is an easier way for the court to assess the response by the
industry as a whole and the minutes, and data, shows how the directors acted when they
did. Webster believes that the decisions of board of directors is usually a team outcome,
because they get to vote and work on the matter together.
(b) Collective
6. Observe the corporate formalities.
Stone v. Ritter
Rule of Law
Directors will be liable for failure to engage in proper corporate oversight where they fail
to implement any reporting or information system, or having implemented such a system,
consciously fail to monitor or oversee its operations.
AmSouth Bancorporation (AmSouth) was forced to pay $50 million in fines and penalties on
account of government investigations about AmSouth employees’ failure to file suspicious
activity reports that were required by the Bank Secrecy Act (BSA) and anti-money-laundering
(AML) regulations. AmSouth’s directors were not penalized. The Federal Reserve and the
Alabama Banking Department issued orders requiring AmSouth to improve its BSA/AML
practices. The orders also required AmSouth to hire an independent consultant to review
AmSouth’s BSA/AML procedures. AmSouth hired KPMG Forensic Services (KPMG) to
conduct the review and KPMG found that the AmSouth directors had established programs and
procedures for BSA/AML compliance, including a BSA officer, a BSA/AML compliance
department, a corporate security department, and a suspicious banking activity oversight
committee. The plaintiffs nonetheless brought suit against AmSouth directors (defendants) for
failure to engage in proper oversight of AmSouth’s BSA/AML policies and procedures. The
Delaware Court of Chancery dismissed the plaintiffs’ complaint. The plaintiffs appealed.
Can hindsight be used to determine whether directors exercised their corporate oversight
responsibilities in good faith?
Holding and Reasoning
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No. Directors will be liable for failure to engage in proper corporate oversight where they fail to
implement any reporting or information system, or having implemented such a system,
consciously fail to monitor or oversee its operations. The standard for such a determination is
whether the directors knew that they were not fulfilling their oversight duties and thus breached
their duty of loyalty to the corporation by failing to act in good faith. This is a forward-looking
standard and hindsight may not be used to determine whether directors exercised their corporate
oversight responsibilities in good faith. In the present case, the KPMG report shows that the
AmSouth directors had substantial BSA/AML policies in place, including a BSA officer, a
BSA/AML compliance department, a corporate security department, and a suspicious banking
activity oversight committee. The implementation of this system discharges the directors’
oversight responsibilities because it is an adequate reporting system and it delegated monitoring
responsibilities to AmSouth employees and departments. Simply because an AmSouth employee
failed to follow the BSA/AML policies and procedures in place does not mean that the directors
did not put the policies and procedures in place in good faith. As a result of the foregoing, the
Delaware Court of Chancery’s dismissal of the plaintiffs’ complaint is affirmed.
a failure to act in good faith requires conduct that is qualitatively different from, and
more culpable than, the conduct giving rise to a violation of the fiduciary duty of care.
imposition of liability requires a showing that the directors knew that they were not
discharging their fiduciary obligations. Where directors fail to act in the face of a known
duty to act, thereby demonstrating a conscious disregard for their responsibilities, they
breach their duty of loyalty by failing to discharge that fiduciary obligation in good faith.
In the absence of red flags, good faith in the context of oversight must be measured by
the directors’ actions “to assure a reasonable information and reporting system exists”
and not by second-guessing after the occurrence of employee conduct that results in an
unintended adverse outcome.
We need to look at industry specific reports and the culture in that sub-industry. In the example
of Countrywide insurance case, there was a sign that the court wanted to bite Countrywide.
Stone: duty of good faith acting is not a separate and independent duty. It is considered to be an
ingredient of the duty of loyalty.
Duty of care and duty of loyalty: for directors
Duty of care is subject to the business judgment
Two ways to violate the good faith duty is to be in conscious disregard or reckless. Webster
believes this case and the Disney case are very kind to directors.
We have two duties
- (1) Duty of Care is the duty that ultimately concerns the business judgment rule. If
there is a challenge to a decision made by the board of directors who buggered something
up, then derivative litigation permits the shareholders to challenge it. The court will under
duty of care approach it with this point of view (a) did you do your HW – i.e. make an
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informed decision, did you go out and commission reports, did you get material that was
reasonably available to you, did you consider, deliberate after listening and hearing those
reports and then make a decision? If YES, then you have properly discharged your duty
of care because the BJR protects for informed decisions made with reasonable expert
- (2) Duty of Loyalty is not protected by the business judgement rule because the duty
of loyalty simply compels directors to ensure that they don’t behave or interact with the
shareholders, etc. where there is a conflict of interest.
- Two things happen in the wake of Van Gorkom which causes confusion:
o Delaware courts are cheesed off
o So they want to protect stupidity on the basis of where there has been a
violation of the duty of care, they can exculpate it. “Absolution” is granted only if
you discharge your duty of care in good faith.
- The Disney court- Find circumstances where people have acted in BAD FAITH.
o Conclusion: Disney will not absolve you of your sins if you acted in
circumstances intentionally or consciously disregarded your duties.
- Duty of loyalty is excluded from Delaware Absolution and Exculpation
o What court does in Stone v. Ritter: It is more critical about what it is going to
do with directors.
 Resurrects good faith and is more - punchy than Disney. What Stone
does now is bring up Caremark case where it is decided to make a
monitoring program mandatory for directors to introduce. Caremark was
decided on basis of duty of care.
 Stone v. Ritter is the progeny, development of Caremark. The duty of
loyalty is a conflict avoidance notion. This court perversely says, we want
to make sure that we toughen up the Caremark decision by making it
absolutely essential that we impose on board of directors having a
mandatory MONITORING programs. They move this from under the duty
of care, to duty of loyalty, because there is no way to get absolution if you
violate your duty of loyalty. If you haven’t discharged your duty of loyalty
properly, you have not acted in good faith.
 This why good faith is considered an ingredient of duty of loyalty. That
is what is Stone vs. Ritter Decides.
This is a duty of loyalty case, because it’s a duty of oversight subcategory.
Caremark was based on a duty of care, and it may be ironic that the court approaches this case
using Caremark.
The Duty of care simply requires that the directors make informed decisions based on material
that is reasonably available to them. If they violate the duty of care, then they have committed
the same fault as in Van Gorkom, so they haven’t been following the proper procedure. Had they
done what the Disney directors did, then the business judgment would protect them.
But . . .
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the duty of loyalty is not protected by the business judgment rule. Duty of loyalty is violated
when there is a conflict of interest.
Duty of care is protected by the statute in Delaware, and the BJR protects it.
There are two conditions that must be met for director oversight liability:
1. directors completely failed to implement ANY reporting or information system or controls, or
2. having implemented such a system or controls, consciously failed to monitor or oversee its
operation this disabling themselves from being informed of risks or problems requiring their
This second element contains a knowledge element, which raises the bar.
Q5. on page 358:
What the court says in Stone: Caremark is the law, that there is an obligation to install these
oversight programs.
The answer: a form of misconduct that came into the attention of the director. Or a failure to
resolve misconduct cases that comes within the attention of the directors would lead to a viable
cause of action. Or failing to improve the system by introducing measures that would improve
the previous failures.
Probably less.
Summary: what are some of the protections for a corporate officer?
1) When in doubt, disclose.
2) You have two duties: care and loyalty. But you are likely protected by the business
judgment rule in particular circumstances.
3) Observe corporate formalities
4) Make sure there is a procedure for you to obtain information necessary to decide, i.e.
make informed decisions. We need process and you need to be involved.
5) Demonstrating good faith in the context of duty of loyalty.
6) Existence of the Exculpation of Section 102b7 in DE, shielding the directors from
personal liability: violation of duty of care but that it is in good faith and honest belief is
protected via exculpation of personal liability.
7) You get indemnification, so there is no personal cost to the director.
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In re Medtronic, Inc. Shareholder Litigation very important
When shareholders are injured only indirectly, the action is derivative. When shareholders show
an injury that is not shared with the corporation, the action is direct. The gist of the inquiry is
who has been harmed.
Medtronic acquired Covidien through a new holding company . . . incorporated in Ireland, with
Medtronic and Covidien then becoming wholly-owned subsidiaries of the Irish holding
company. Shareholders of Medtronic had their stock converted into shares in new Medtronic on
a one-for-one basis, while shareholders of Covidien received $35.19 and 0.956 shares of new
Medtronic for every share of Covidien stock held. Ultimately, former Medtronic shareholders
collectively owned approximately 70 percent of new Medtronic and former Covidien
shareholders collectively owned approximately 30 percent of new Medtronic. Steiner and other
former shareholders allege that Medtronic reduced the interests of its shareholders to 70 percent
of new Medtronic in order to secure and protect the tax benefits it sought in this transaction. In
addition, because the IRS treats an inversion as a taxable transaction, shareholders incurred
capital gain held in taxable accounts but received no compensation from the company for this tax
liability. Complaint alleges the following injuries to Medtronic shareholders: (1) disparate
treatment of Medtronic, as compared to Covidien, shareholders, (2) disparate treatment with
respect to tax liability incurred by Medtronic shareholders and the lack of compensation for that
liability as compared to the reimbursement paid to Medtronic’s officers and directors for their
excise-tax liability, and (3) dilution.
When a derivative claim is brought, the complaining shareholder must allege with particularity
the efforts made to obtain the desired action from the directors of the corporation and the failure
of the corporation to take such action.
You may get voting power and economic benefit as a result of holding shares. Tax benefit and
burdens: company avoided a tax, and a tax on shareholders, and the shareholder dilution. The
issue is whether any of these gives rise to a direct or derivative action?
Inversion is a taxable event: shareholders are not subject to capital gains tax, because of the
issuance of new shares. (policy, the IRS wants to keep companies in the country). So, the
company would be subject to lower tax rates, but that puts the shareholders under a capital gain
The reimbursement of the funds to the corporate directors is a way that corporate funds have
been taken away from the capital gain of the corporate. So, this is a derivate action.
Question: should directors take into account the tax liability of their shareholders when they
make their tax strategy? not necessarily, because a strategy that benefits the corporation in the
long run, it would necessarily benefit the shareholder in the long run. In addition, you wouldn’t
be able to adjust your strategy to the individual shareholders’ situation.
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What about dilution? In the event that complaint is considered meritorious at trial then it’s the
shareholder who recovers.
The latter two, share dilution and shareholder tax payments are direct actions. Direct action gets
pursued like regular trial process, and there is nothing special about it, it will be a civil action. Cf.
with the derivate action, which considers how the voices of the disincentive shareholders get
In the event that a challenge is derivative, the shareholders need to get the approval of the Board
before any action is initiated. If a challenge is direct, then no such approval is necessary. Giving
Boards the right to decide whether to file lawsuits which are classified as “derivate” is designed
to minimize distract baseless litigation.
Most derivative actions don’t go far at all. In derivative actions, shareholders must put up money
to make sure if they fail, there is enough money to compensate the cost to the corporation.
General rule: in the absence of conflict of interest and self-interest, the Board will say that it’s
not in the best interest of the corporation to pursue the shareholder’s claim for derivative action.
If it can be established that the directors breached their duty of loyalty or at least appearing to
there is a question of their impartiality and objectivity, and whether they are acting in a selfinterested manner.
The court would want to know if this is a situation that demand is required or futile.
Demand will be excused if the plaintiff can allege with particularity why the transaction isn’t
protected by the BJR.
Whether demand is excused or not excused? shareholders may be able to substantiate whether
they can move into litigation by demonstrating that they are following the recommendations of a
special litigation committee.
Making an informed decision by the Board needs to be shown that was done by a thorough
process, by consulting people, etc. The board of directors has the option to respond to concerns
by appointing the special litigation committee. Special litigation committees are the process
required to show that everything is fine.
Grimes v. Donald
Rule of Law
When a board of directors reaches a disinterested decision on corporate governance, the
board’s reasoned business judgment will be given great deference by the courts.
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The board of directors of DSC Communications (DSC) (defendant) approved a compensation
agreement for DSC’s CEO, James Donald (defendant), that promised him employment until his
seventy-fifth birthday, and provided that if he lost his job without cause, he would be entitled to
the same salary he would have earned until the contract would otherwise have expired. The
contract also included further incentive bonuses, lifetime medical coverage for Donald and his
family, and other benefits. Grimes (plaintiff), made a demand to the board that it abrogate the
contract with Donald. The board refused. Grimes filed a derivative suit alleging that the board
abdicated its responsibility to oversee the management of the company. Grimes alleged that by
granting Donald a contract that allowed him to collect compensation even if the board chose to
reject the course of action he chooses as CEO, the board had given up its responsibility to
oversee the future of DSC. In his derivative action, Grimes alleged that he never had to make a
demand of the board, because the demand would have been futile in the first place. The chancery
court dismissed Grimes’ case, and Grimes appealed.
Should the courts, faced with a lawsuit, second guess the decisions of the board of directors
regarding a CEO’s contract?
Holding and Reasoning
No. Generally, the courts will grant great deference to the valid exercise of business judgment of
a board of directors. This deference will sometimes mean that board decisions about executive
compensation in a competitive market for executive expertise receive deference from the courts.
The courts’ deference will mean that a board’s decisions about how to respond to requests from
concerned shareholders will be given similar deference. Additionally, the courts are required to
take the demand requirement in a derivative case very seriously. The demand requirement can
only be excused if a plaintiff can show that any demand would have been futile. In this case, not
only did the board of directors have discretion to find a CEO and induce him to take the job with
DSC, it was the board’s responsibility to do so. The fact is that any contract will require the
board to give up some of its future ability to make decisions about how the company should be
run, but the choice to pay Donald to make some decisions for the board is itself a business
judgment. Because the contract was a valid exercise of business judgment, Grimes’ abdication
claim was rightfully dismissed. Grimes argues, with regard to his derivative claim, that he was
excused from making any demand on the board at all. However, the fact that he did make a
formal demand that the board reconsider Donald’s contract bars him from pleading that his
demand would have been futile. As far as the rejection of the claim Grimes did make, once the
board considered his demand, its judgment was entitled to business judgment deference. The
Chancery Court’s dismissal is affirmed in full.
when a stockholder demands that the board of directors act on a claim allegedly
belonging to the corporation and demand is refused, the stockholder may not thereafter
assert that demand is excused with respect to other legal theories in support of the same
a stockholder filing a derivative suit must allege either that the board rejected his pre-suit
demand that the board assert the corporation’s claim or allege with particularity why the
stockholder was justified in not having made the effort to obtain board action.
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One ground for alleging with particularity that demand would be futile is that a
“reasonable doubt” exists that the board is capable of making an independent decision to
assert the claim if demand were made.
(1) a majority of the board has a material financial or familial interest, (2) a majority of
the board is incapable of acting independently for some other reason such as domination
or control, or (3) the underlying transaction is not the product of valid exercise of
business judgement.
If a demand is made and rejected, the board rejecting the demand is entitled to the
presumption of the business judgment rule unless the stockholder can allege facts with
particularity creating a reasonable doubt that the board is entitled to the benefit of the
the court splits the baby.
Marx v. Akers
Rule of Law
In New York, the demand requirement will be excused only when a complaint alleges that
the majority of the board has an interest in the transaction, that it failed to inform itself
before making a decision, or that the decision challenged is so egregious that it could not
have been the product of reasoned business judgment.
New York law stated that in a shareholder derivative action, a complaint must state what steps
the plaintiff took to get the board of directors to take the plaintiff’s preferred course of action.
The board of directors of International Business Machines (IBM) (defendant) voted for
compensation for three members of the board who were also IBM executives, including Akers
(defendant), a former CEO. The board also voted for compensation for directors who were not
executives. Marx (plaintiff) was displeased with this course of action, and filed a derivative
action, without first making a demand of the board of directors. The trial court dismissed for
failure to make a demand, and Marx appealed.
Does New York’s law stating that a complaint in a derivative case must detail a plaintiff’s efforts
to change board policy mean that New York has a universal demand requirement?
Holding and Reasoning
No. While legal theorists have commented on the virtues of a universal demand requirement, the
legislature has not adopted it. The demand requirement exists to ensure that the courts are not
flooded by unnecessary litigation, to protect the board’s ability to make decisions, and to
discourage shareholders from bringing suits merely for personal gain. New York has chosen not
to have a universal demand requirement, and has excused demand in the past when a plaintiff
could show that the board of directors had a direct financial interest in the challenged board
decisions. However, the complaint cannot simply name directors and allege improper motives;
the allegations must be particularized. In this case, Marx alleges that IBM’s executives were
overcompensated. However, only three directors benefited from the allegedly improper executive
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compensation scheme. While there are sometimes “back-scratching” schemes where directors
will vote for compensation for each other, in this case, not enough members of the board
benefited for the board as a whole to be implicated. The trial court was thus correct to dismiss
those parts of the complaint dealing with executive compensation only. On the other hand, the
entire board benefited from the proposal to increase director’s compensation, and because of
that, Marx’s demand was excused with regard to that claim. However, because Marx failed to
properly plead that the compensation to directors was wasteful, that portion of his complaint was
rightfully dismissed. The trial court’s dismissal is thus affirmed.
a complaint challenging the excessiveness of director compensation must –to survive a
dismissal motion– allege compensation rates excessive on their face or other facts which
call into questions whether the compensation was fair to the corporation when approved,
the good faith of the directors setting those rates, or that the decision to set the
compensation could not have been a product of valid business judgment.
The whole point of derivative action is that it represents harm to the corporation.
All these issues arise from the issue of making demand. This is all about direct
and derivative actions. Direct Actions – are not particular problematic. If you
have an issue that hurts the shareholder, low and behold, she can take care of that
and sue the corporation in her own name. And the Litigation pursues the path that
regular law suits would pursue. Derivative actions result in some hurt or harm to
the corporation that the board of directors has chosen to do nothing about. Bearing
in mind that these allegations may be absolutely mythical and lack substance
completely. If shareholders have recognized that the corporation itself has
suffered harm, the whole point of derivative actions is that it represents harm to
the corporation. How do shareholders go about having their grievances redressed.
In cases that there is merit to a shareholder’s concern, the board may grant the concern and allow
Is it always necessary to proceed to the board? Not if the board members are interested and
partial. In Delaware, for example, sensibly advised shareholders usually don’t go to the Board.
Shareholder always lose as far as the Board is concerned, so there is no point, in Delaware, to go
to the Board.
Two situations:
(1) The board may refuse the demand. What to do next?
Webster Rule: unless a shareholder(s) can point to significant directorial misconduct and backing
it up with detailed information/data and substantial evidence, shareholders are not going to win.
Marks: just because the plaintiff has named all the board members on the complaint does not
mean that you have exhausted your obligation to go to the Board first.
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Section 220 of the DE allows shareholders to go in and inspect the books. But inherently in such
cases, there is a scarcity of information.
New York Court: identifies three bases upon which demand may be excused under NY law:
1) Complaint alleges that a majority of board is interested in challenged transaction.
2) Complaint alleges Board failed to properly inform themselves about the transactions.
3) Transaction so egregious that it simply couldn’t have been the product of business
judgment rule.
Takeaway: whatever type of case you get, whether NY or DE, or wherever, there are three
factors to explore:
1) Prejudice
2) Lack of information
3) Business judgment rule simply cannot apply to this type of transaction:
a. lack of independence
b. financial stake
c. family relationship
Note: lack of good faith must be considered in light of context.
Webster: The Special Committee is the Board’s special weapon to deal with the plaintiffs.
Analysis Question: 1. Pg. 379 --- Damage to the corporation, a lost opportunity to the company,
and the director’s duty runs to the corporation not to herself. So, this example would be a
derivative action.
Problems 1. Pg. 379 --- Webster thinks the demand here would be excused because they have a
direct financial interest. The flavor of the scene, the visibility of the conflict is so glaring that it
has to be excused.
Problems 3. Pg. 379 – It would be excused if you can assess with particularity if the members of
the board are beholden to Alice Adams. She may be controlling or domineering and always gets
her way… In those circumstances, it has to be excused. Also, is there a majority of the directors
interested in this transaction? The Directors failed to inform themselves to a degree reasonably
necessary about the transaction.
Auerbach v. Bennett
Rule of Law
When a board of directors delegates its authority to a committee of disinterested members,
the official determination of those members will be accorded due deference under the
business judgment rule.
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The board of directors of General Telephone & Electronics Corporation (defendant) investigated
and found that General Telephone and its officers had made bribe payments, and that some of the
directors had been directly involved in those payments. Auerbach (plaintiff), a shareholder, in
connection with other shareholders including Wallenstein, brought a derivative action against the
board, General Telephone, and Arthur Anderson & Co., General Telephone’s outside auditor.
Auerbach’s complaint alleged that the board members involved in the transactions and Arthur
Anderson were both liable to General Telephone for the money lost through those improper
transactions. The board of directors formed a special litigation committee, composed of directors
who joined the board after the questionable transactions took place, and asked them to evaluate
what General Telephone should do about the litigation Auerbach initiated. The special
committee found that the directors had not violated their fiduciary duties, and that the claims
were without merit, and that the lawsuit should be dismissed. After this finding, the trial court
dismissed the action, and Wallenstein (but not Auerbach) appealed.
When a special litigation committee composed of disinterested members decides that continuing
a shareholder derivative litigation will not be in the corporation’s best interest, are the courts
bound to dismiss that litigation?
Holding and Reasoning
Yes. The business judgment rule exists because the board of directors is better situated than the
courts to make decisions about what is in the best interests of the company. As long as the
decisions of the board are being made by disinterested decision makers, those decisions deserve
the business judgment protection. Here, the special litigation committee, exercising the power
that the full board delegated to it, made the disinterested, informed decision that the shareholder
litigation would be bad for General Telephone. Wallenstein contends that the special litigation
committee was not truly independent, because it derived its authority from the board, whose
members had a direct interest in the transactions at issue. However, by delegating authority to the
special committee, the board was following a prudent policy of ensuring that interested board
members had no direct role in the decision-making process. There is nothing to suggest that the
investigation the special litigation committee conducted was so limited that its decision could not
be considered fully informed. Accordingly, the trial court properly dismissed the case once the
special litigation committee decided that this litigation is not in the company’s best interests, and
the decision of the trial court is affirmed.
Wallenstein is calling into question the motives of the members of the special litigation
committee. It is inappropriate to dismiss his case before he has had a chance to seek disclosures
on the challenged matters.
The question here is whether the special litigation committee is sufficiently independent. You
must, therefore, make sure that your approach is proper and looks independent. So, you must put
someone in the position that no one could challenge their independence.
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The importance about this case is the fact that the special litigation committee here gets the
procedure perfectly right. So, the judges don’t know the business, but they know the procedure
well, and this case presents an opportunity for the court to take the burden off of itself.
Analysis Question 1 -- Pg. 385 By way of review, note that in Auerbach v. Bennet there is no
mention of the demand issue. Presumably the parties assumed that demand was excused… were
they right about that?
- In Delaware, a majority of the board has not been involved in the issue here... Webster
doesn’t think demand should be excused. Bribery is ugly but if you look at the particular
facts here, you have less than a majority involved. Those who were involved in the
bribery scandal did not receive any personal benefits themselves.
- Webster doesn’t think demand here is excused….
- Alex thinks that’s demand should be excused here, because you can argue fraud even by
a few or less than a majority is pretty egregious… Also, argue that they weren’t
Zapata Corp. v. Maldonado
Rule of Law
A corporate board of directors cannot dismiss a derivative lawsuit based solely on the fact
that a committee composed of disinterested members found that the litigation is not in the
corporation’s best interest.
William Maldonado (plaintiff) brought a derivative action on behalf of Zapata Corp. (defendant)
against Zapata’s board of directors, alleging breach of fiduciary duty. Maldonado had not made a
prior demand on the board and instead argued that demand was futile, because all of the board
members were alleged to have taken part in the challenged transactions. After two new outside
directors were added to the board, the board as a whole appointed those two members to an
investigation committee charged with investigating Maldonado’s claims. The committee found
that it was in Zapata’s best interest that the derivative suit be dismissed. The chancery court ruled
that the board could not dismiss the case on its own determination, and Zapata appealed.
Can a corporate board of directors dismiss a shareholder’s derivative lawsuit based on the vote of
a subcommittee without a showing of the subcommittee’s methods for investigating the
shareholder’s claims?
Holding and Reasoning
No. Many states, relying on Delaware law, have held that the business judgment rule allows a
board of directors to terminate a derivative suit based on a vote by a disinterested committee.
However, the business judgment rule requires far more than that, notably a showing that the
decision was well informed and reached through proper procedures. While the powers of a
shareholder to allege a breach of fiduciary duty are not limitless, they certainly cannot be
extinguished by the board without any examination by the courts. However, when the court
examines the facts of a derivative case, it must engage in a balancing act. On the one hand are
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the interests of the individual shareholder, for whom the derivative suit is an important tool for
guaranteeing good corporate governance.
On the other hand, there are the interests of the corporation and its body of shareholders, for
whom derivative suits are a hassle and a needless expense. In this case, there is no serious
allegation that the members of the committee were disinterested. While the board as a whole had
an interest, as it was a named defendant in the case, the board does not transfer its members’
interest in the litigation to the committee when it empowers the committee to make decisions
about the litigation. However, mere disinterest is not enough to dismiss the suit. The committee
must show, in a detailed manner, how it reached its conclusion that the suit is not in the best
interest of the corporation. Further, the committee must give Maldonado the opportunity to
dispute its findings. If the trial court is convinced that the committee’s findings are both fair and
reasonably arrived at, then the trial court, taking the committee’s findings into account, should
decide whether the litigation truly should be dismissed. The trial court’s order is reversed, and
the case is remanded for a full hearing on dismissal.
BJR is not relevant in corporate decision making until after a decision is made. It is
generally used as a defense to an attack on the decision’s soundness.
A stockholder may sue in equity in his derivative right to assert a cause of action in
behalf of the corporation, without prior demand upon the directors to sue, when it is
apparent that a demand would be futile, that the officers are under an influence that
sterilizes discretion and could not be proper persons to conduct the litigation.
A committee with properly delegated authority under § 141(c), would have the power to
move for dismissal or summary judgment if the entire board did.
The interest taint of the board majority is not a per se legal bar to the delegation of the
board’s power to an independent committee composed of disinterested board members.
the final substantive judgment whether a particular lawsuit should be maintained requires
a balance of many factors – ethical, commercial, promotional, public relations, employee
relations, fiscal as well as legal.
Procedural Analysis
 after an objective and thorough investigation of a derivative suit, an independent
committee may cause its corporation to file a pretrial motion to dismiss.
 the basis of the motion is the best interests of the corporation, as determined by the
 the motion should include a thorough written record of the investigation and its findings
and recommendations.
 The court should apply a two-step test to the motion:
First Step
1) the court should inquire into the independence and good faith of the committee and the
bases supporting its conclusions.
2) the corporation should have the burden of proving independence, good faith, and a
reasonable investigation, no assumption of their existence should be made.
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3) if any of these three standards are not found by the court, the court shall deny the
corporation’s motion.
4) If the court finds them satisfied under the standards of FRCP 56, then step 2 
Second Step
1) the court should determine, applying its own independent business judgment, whether the
motion should be granted.
 this balances the legitimate corporate claims and interests with the ones alleged by the
derivate stockholder suit.
Demand Required and Demand Excused: is trying to balance the interest of the shareholders
against the responsibilities of the directors in running the show. When Demand is Required,
shareholders must take the matter to the board, if shareholders demand, they are invariably by
the BJR going to lose. When the rules say that the Demand is Excused, the shareholders will be
challenged if the Board pursues the claim in the case that the shareholder decides to pursue
Zapata is a case where the demand is not made, because of the alleged problems with the
directors and officers.
All that matters here is the fact that the Board must produce that they did the proper procedure.
Missed Class
Whatever test you apply, the NY or the Delaware tests, the result will more than likely come out
the same way.
- New York does not like the reasonable doubt standard that is supplied by Delaware.
- What NY looks at ultimately is really the same as the Delaware test.
- Webster thinks Shareholders in NY have a marginal but better chance than in Delaware.
- Delaware Courts like to make sure that the power is vested in the board room.
o It is the business-friendly state.
- New York’s demand requirement is codified in Business Corporation Law §626(c) , a
universal demand may only be adopted by the legislature.
- In New York, a demand would be futile if a complaint alleges with particularity that
 a majority of the directors are interested in the transaction,
 or (2) directors failed to inform themselves to a degree reasonably necessary
about the transaction, or
 the directors failed to exercise their business judgment in approving the
2 step determination required: Court should ask:
1. (a) Whether IC acted independently
(b) In good faith
(c) With reasonable investigation
(burden of proof on Z)
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2. And undertake, itself (the court) and independent inquiry into whether the suit should be
 Step 1 includes:
o Inquiry into the bases supporting the committee's recommendations
o Court decides whether there was a reasonable basis for the decision
 Step 2:
o Court may go on to apply its own business judgement as to whether the case is
to be dismissed.
o Function of this step?
 Allow meritorious..
 (see slide)
o Purpose of 2 steps: attempt to balance…
 See slide
 See slide
 Where demand is required, the decision whether to proceed with a derivative action is
protected by BJR.
 If demand is excused then court can decide using 2 step rule.
The question whether corporate directors and officers are “independent and disinterested” arises
in a variety of contexts, such as in determining:
the applicability of the business judgment rule;
whether demand is excused as futile, as illustrated by Grimes;
whether courts should defer to the recommendation of a special litigation committee to
dismiss a derivative lawsuit;
which standard of review to apply to various duty-of-loyalty cases; and
the lawfulness of defenses against hostile takeover bids by the target company’s board of
Aronson v. Lewis, 473 A. 2d 805 (Del. 1984) :
Facts: chief wrongdoer owned 47% of the corporation’s stock and allegedly had personally
selected each board member.
Del.: in order to show that the directors were not independent of the controlling shareholder, the
plaintiff must “demonstrate that through personal or other relationships the directors are
beholden to the controlling person.”
This showing requires “a careful analysis of why the directors, on an individual basis, might
need to curry favor with the majority shareholder is necessary. The court must consider what
material benefits the majority shareholder can bestow upon each of the directors, other than, as a
general matter, the majority shareholder’s capacity to deny them their continuing status as
Delaware County Employees Retirement Fund v. Sanchez
Rule of Law
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To survive a motion to dismiss a shareholder derivative claim in which the plaintiff is
asserting that demand is excused due to lack of director independence, the plaintiff must
plead particularized facts that create a reasonable doubt about the directors’
Sanchez Resources, LLC, a private company, entered into a transaction with a public company in
which the Sanchez family owned the most stock (Sanchez Public Company). There was no
dispute that two of the five directors of the Sanchez Public Company were interested directors
for purposes of the transaction. The Delaware County Employees Retirement Fund and other
shareholders (plaintiffs) of the Sanchez Public Company brought a shareholder derivative suit
against that company’s directors (defendants), challenging the transaction. The plaintiffs claimed
that demand on the Sanchez Public Company board of directors was excused because at least
three of the five directors were interested directors. Specifically, the plaintiffs’ complaint
asserted that Alan Jackson was not a disinterested director. First, the complaint asserted that
Jackson had been close friends with A.R. Sanchez, Jr., the chairman of the board, for over 50
years. Second, the complaint asserted that Jackson’s employment and long-term personal wealth
was wholly dependent on Sanchez. Accordingly, the plaintiffs stated that Jackson was not an
independent director. The Delaware Court of Chancery found that the plaintiffs had not pled
sufficient facts to infer that Jackson was an interested director. Accordingly, the chancery court
found that demand on the board was not excused and dismissed the complaint for the plaintiffs’
failure to meet the demand requirement. The plaintiffs appealed.
To survive a motion to dismiss a shareholder derivative claim in which the plaintiff is asserting
that demand is excused due to lack of director independence, must the plaintiff plead
particularized facts that create a reasonable doubt about the directors’ independence?
Holding and Reasoning
Yes. To survive a motion to dismiss a shareholder derivative claim in which the plaintiff is
asserting that demand is excused due to lack of director independence, the plaintiff must plead
particularized facts, that when considered in a light most favorable to the plaintiff, create a
reasonable doubt about the directors’ independence. The court must analyze the facts that the
plaintiff pleads with respect to the directors’ lack of independence in their totality and not
independent of one another. Analyzing such facts in isolation is not considering them in a light
most favorable to the plaintiff. In this case, the chancery court erred in determining that the
plaintiffs had not pled sufficient facts to infer that Jackson was an interested director. The
chancery court seemingly analyzed the business and personal facts about Jackson’s ties to
Sanchez independently of one another and determined that each fact, alone, was not sufficient.
This analysis was improper. At the dismissal stage, the court must evaluate the facts in a light
most favorable to the plaintiffs. In analyzing the business and personal facts about Jackson in
isolation, the chancery court failed to do so. When viewed together, the totality of the facts about
Jackson’s relationship with and financial dependence on Sanchez leads to an inference that
Jackson could not act independently of Sanchez. Accordingly, the plaintiffs have pled sufficient
facts to withstand the motion to dismiss. The judgment is reversed, and the motion to dismiss is
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Missed Class
Takeaway: This case highlights the difficulty that arises to determine independence in particular
Pg. 398 Question 2: Try to attenuate the “Deep friendship” that was presented by the Plaintiff
between Sanchez and Jackson. Show that Sanchez might just be a terribly friendly person…
which doesn’t mean he has a true friendship with Jackson. They just appear friendly.
Question: Do you think the bar should be higher for independence…. Yes! Because, hence the
importance of the retinue that surrounds the special litigation committee.
In re China Agritech, Inc. Shareholder Derivative Litigation
Rule of Law
Under Delaware law, a sustained or systematic failure of a board of directors to exercise
oversight establishes the lack of good faith that is a necessary condition to board liability.
China Agritech, Inc. (Agritech) was a fertilizer manufacturer headquartered in China. Albert
Rish (plaintiff), a shareholder, filed a derivative suit in the Delaware Court of Chancery against
Agritech’s board of directors (defendants), which included Agritech’s two co-founders. Among
other claims, Rish asserted that the defendants breached their obligation of good faith due to a
systematic lack of oversight at Agritech. In 2008, Agritech established an Audit Committee
comprised of directors. In 2009 and 2010, Agritech engaged in a series of major transactions,
including acquiring additional interest in a company Agritech’s co-founders owned. At the time,
Agritech had five directors including the co-founders. The three other directors sat on the Audit
Committee. Despite this and other major transactions, there is no evidence that the Audit
Committee met in 2009 or 2010. In August 2010, Agritech disclosed in its Securities and
Exchange Commission (SEC) 10-Q filing that material weaknesses had undermined its controls
and procedures. In its following 10-Q, Agritech claimed that the weaknesses were fixed and,
days later, fired its outside auditor. The Audit Committee approved the firing, but there is no
record of the Audit Committee meeting during this time. In addition, Rish alleged that in four of
five years, Agritech reported significant profits to the SEC, but reported losses to the parallel
regulatory agency in China. Rish argued that making a litigation demand on the defendants
would have been futile. The defendants moved to dismiss Rish’s claims on the ground that Rish
did not successfully plead demand futility.
Does a sustained or systematic failure of the board of directors to exercise oversight establish the
lack of good faith that is a necessary condition to board liability?
Holding and Reasoning
Yes. In a derivative suit that involves something other than a business decision of the board—
e.g., failure to exercise oversight—a litigation demand is futile when the director(s) would face a
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“substantial likelihood” of liability if the suit were filed. This rule is in place for the commonsense reason that a board facing liability likely would not admit any wrongdoing or change its
course of action upon receiving such a demand. A board of directors has a fiduciary duty of good
faith to establish internal controls that provide the board with information “to reach informed
judgments concerning both the corporation’s compliance with law and its business
performance.” Generally, a sustained or systematic failure of the board to exercise oversight will
establish the lack of good faith that is a necessary condition to director liability. In this case, Rish
established that there is a substantial likelihood that the defendants will face liability for lack of
oversight if the suit is allowed to move forward. Thus, Rish has sufficiently pleaded that making
a litigation demand on the defendants would have been futile. In 2009 and 2010, Agritech
underwent a series of major transactions that appreciably modified its structure and outlook.
Despite this, however, there is no evidence that the Audit Committee met during this time to put
itself in a position to provide the board with information to help it reach an informed judgment.
Additionally, Agritech filed reports with various governmental agencies that were at best
conflicting, and there is no evidence that the Audit Committee raised this issue. The facts that
Rish alleges support a reasonable inference that the directors on the Audit Committee
“consciously disregarded their duties” and acted in bad faith, and thus face a substantial
likelihood of liability. A litigation demand on the board would have been futile. The defendants’
motion to dismiss is denied.
Aronson: when a derivative plaintiff challenges an earlier board decision made by the
same directors who remain in office at the time suit is filed. (1) the first test examines the
independence and disinterestedness of the directors who remain in office at the time suit
is filed. (2) whether there would be a reasonable doubt that the challenged transaction
was the product of a valid exercise of business judgment.
 Rales: the Delaware Supreme Court framed a demand futility standard that asks “whether
or not the particularized factual allegations of a derivative stockholder complaint create a
reasonable doubt that, as of the time the complaint is filed, the board of directors could
have probably exercised its independent and disinterested business judgment in
responding to a demand.
1. where a business decision was made by the board of a company, but a majority of the
directors making the decision have been replaced,
2. where the subject of the derivative suit is not a business decision of the board, and
3. where the decision being challenged was made by the board of a different corporation.
 to show that a director faces a “substantial risk of liability” a plaintiff does not have to
demonstrate a reasonable probability on the claim . . . the plaintiff need only “make a
threshold showing, through the allegation of particularized facts, that their claims have
some merit.”
 close family relationship, like the parent-child relationship, create a reasonable doubt as
to the independence of a director.
 a failure to act in good faith may be shown, for instance, (1) where the fiduciary
intentionally acts with a purpose other than that of advancing the best interests of the
corporation, (2) where the fiduciary acts with the intent to violate applicable positive law,
and (3) where the fiduciary intentionally fails to act in the face of a known duty to act,
demonstrating a conscious disregard for his duties.
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a red flag here for a court in the US would be the existence of a family member, like the facts
Concerns here:
1. it does not look like a legitimate program. Look at slide 3, both Chang and Teng stand at the
opposite side of the deal with Yinlong Industrial Co., which frustrates the shareholder to believe
that the whole transaction is a sham.
2. lack of proper procedure to comply with regulation. The second reason is probably the lack of
oversight. There must be proper procedure for how stuff is done. You need programs that as
board of directors, you are aware of what happens on the ground (like HR). Your program must
be in place and effective.
3. Section 102(b)(7) is only designed for violations of duty of care, not loyalty.
The directors maintain that they are exculpated because of Section 102(b)(7) (see Van Gorkom).
They argue that they should not be liable. The court says no, the section does not cover bad faith
 a violation of the duty of loyalty is an automatic showing of bad faith and is not
exculpated by Section 102(b)(7).
Note: this case ties together a lot of concepts in a great way, as it shows how they could fit
together. This case brings Van Gorkom and Stone v. Ritter  the DE legislature says we are
going to give you exculpation of violation of duty of care under section 102(b)(7) certificates. In
the 102(b)(7) there is a good faith requirement with regards to the mistake you make (i.e. you
have an honest mistake).
Aronson applies when a director makes a decision and the question is whether that director is
interested (there is an interest conflict) that would implicate the business decision that director
made. So, a decision is made already, and you come and ask whether there is a conflict of
interest with the decision-maker. (challenged transaction).
Cf. Rales, where you are faced with a shareholder presenting a demand and the court asks
whether there is a reasonable doubt as to the director faced with a demand. (i.e. a decision on
demand is not yet made, but it’s before the director, and you ask if that director can be
reasonably doubted.
Analysis on Page 408:
Question 4 on 410:
If the directors are aware of fundamental issues and consciously disregard, then it’s a violation of
the duty of loyalty. If there is a deliberate or intentional harm done to the corporation, then
you’re in violation of the duty of loyalty.
Side Note Case: Rich v. Chong, 66 A.3d 963 (Del. Ch. 2013) :
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if the directors have implemented a system of controls, a finding of liability is
predicated on the directors’ having “consciously failed to monitor or oversee the
system’s operations thus disabling themselves from being informed of risks or
problems requiring their attention.”
One way that the plaintiff may plead such a conscious failure to monitor is to
identify “red flags,” obvious and problematic occurrences, that support an
inference that the directors knew that there were material weaknesses in internal
controls and failed to correct such weaknesses.
Stone v. Ritter is the progeny of Caremark. Caremark involved a failure on part of the
corporation to have an effective oversight program that monitors the way in which they
did business, particularly as far as accounting is concerned. A collision between the
federal government and private industry. Caremark had no sufficient oversight of
basically what is going on in the corporation. Caremark is decided as a duty of care case.
Along comes Stones v. Ritter, which too is an oversight case. The court chooses to
resolve Stone which is like Caremark by deciding this oversight case as if it’s a duty of
loyalty case/bad faith. They wanted to send a message to the business community. Why
the difference?
The simple answer is that the court decided to make this oversight case a duty of loyalty
because Section 102(b)(7) does not absolve you of your sins for a breach of duty of
loyalty, only for breaches of the duty of care.
All oversight cases are a duty of loyalty question.
Beam ex rel. Martha Stewart Living Omnimedia, Inc. v. Stewart
Rule of Law
To bring a shareholder derivative suit without first demanding that the board of directors
file the lawsuit, a shareholder must assert particularized facts creating reasonable doubt
about the board’s independence.
Monica Beam (plaintiff) was a shareholder of Martha Stewart Living Omnimedia, Inc. (MSO)
(plaintiff). Beam filed a derivative action on behalf of MSO against Martha Stewart (defendant),
alleging breaches of Stewart’s fiduciary duties of loyalty and care for illegally selling ImClone
stock and mishandling the media attention that followed. In violation of Delaware Chancery Rule
23.1, Beam did not demand that MSO’s board of directors file the lawsuit prior to filing the
lawsuit herself. However, Beam alleged that any presuit demand would have been futile because
a majority of the board members were not disinterested in the litigation. Specifically, Beam
alleged that five of MSO’s six board members were personally interested in the litigation against
Stewart: Stewart, Sharon Patrick, Arthur Martinez, Darla Moore, and Naomi Seligman. Patrick
was an inside director and MSO officer, and she received significant compensation from MSO.
Martinez and Moore were longstanding friends of Stewart. Seligman had called a publishing
house to try to stop a book that was critical of Stewart. MSO moved to dismiss based on Beam’s
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failure to make a presuit demand on MSO’s board of directors. The Court of Chancery
determined that Beam had not shown that a presuit demand would have been futile and
dismissed the claim. Beam appealed to the Delaware Supreme Court.
To bring a shareholder derivative suit without first demanding that the board of directors file the
lawsuit, must a shareholder assert particularized facts creating reasonable doubt about the
board’s independence?
Holding and Reasoning
Yes. To bring a shareholder derivative suit without first making a presuit demand on the board of
directors, a shareholder must assert particularized facts creating reasonable doubt about the
board’s independence. A shareholder may not pursue a derivative suit to assert a claim that
belongs to the corporation unless either: (1) the plaintiff first demanded that the board of
directors pursue the claim, and the board refused; or (2) a presuit demand is futile because the
directors are incapable of making an independent, impartial decision regarding the litigation.
Directors are presumed to be independent and faithful to their fiduciary duties. To overcome this
presumption and excuse the need to make a presuit demand, a shareholder plaintiff must plead
particularized facts creating reasonable doubt about the board’s independence. A director is not
independent, and is therefore interested, if there is a potential personal benefit or detriment to the
director as a result of the decision. In that case, the director’s business judgment might be
influenced by the personal consequences of the decision. In this case, Stewart is interested based
on the potential criminal implications of the illegal stock transactions. Patrick is also interested
based on her position with MSO and compensation received from MSO. However, by itself,
Stewart’s friendship with Martinez and Moore does not make those directors interested. There
must be additional circumstances indicating that the directors would put their friendship ahead of
their reputations. Finally, Seligman’s call to the publishing house does not create reasonable
doubt about her independence. That call protected MSO and its reputation in addition to
Stewart’s personal reputation. Therefore, Beam has not carried her burden of showing that a
majority of MSO’s directors were not independent and, therefore, that a presuit demand on the
directors would have been futile. The dismissal is affirmed.
Corporate opportunity, the definition varies from state to state. Webster believes that courts take
the following into account:
 Are the circumstances of which the corporate officer became aware of the opportunities?
 Did the corporate office learn about it while in her work capacity?
 Was the opportunity that came up led the officer to believe that the opportunity was
something that was for the corporation but not for the officer and that officer knowingly
(from the perspective of a reasonable person in your position with the same
circumstances) took advantage? See Cardozo’s opinion in the Meinhard case, he wanted
to stress on disclosure.
 Rule of Thumb: does your mother approve of this?
Obligation on the corporate officer:
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Rejection (you must disclose immediately), reject the awareness, i.e. it’s not for me.
Before exploiting the opportunity: ask about the information and disclosure.
Another related issue that must be considered:
 If you disclose, and you have information that should go to a full board, then disclose in a
full board presentation. You would cover your ass with this.
 Rejection must be made on the basis of fairness to the corporation. Rejection must be
made on the notion that it’s fair for the corporation to reject it. This can be problematic,
as shareholders may not be happy if they find out.
 Rejection must be abundantly fair.
Question 319:
1. Not necessarily. Adeline: it would be a matter of timing issue. He wouldn’t necessarily know
if they would buy.
Questions on 324:
1. in relation to their general line of business, this is a different business activity.
2. traditional approach tells us that if you’re approached in corporate setting you have to say
sorry I can’t.
3. it wouldn’t matter, there would still be a duty to disclose. You’re still the company’s
“servant,” i.e. in the service of the company.
4. important: it’s disclosure, he’s fine. It need not be a formal corporate process.
5. the only way that George and the board would be vulnerable would a challenge/ derivative
action against the board. Ultimately, the business judgment would protect.
The goal that investment opportunities are provided to everybody at an equal footing.
SEC v. Texas Gulf Sulphur Co.
Rule of Law
Individuals with knowledge of material inside information must either disclose it to the
public, or abstain from trading in or recommending the securities concerned while such
inside information remains undisclosed.
Texas Gulf Sulphur Co. (TGS) began drilling on a site in Canada and found high mineral
content. To keep the purchase price of the site low, TGS kept the results of the drilling quiet.
When word of the high mineral content of the site started to get out, TGS released a statement
saying that the reports were exaggerated and that reports of the content of the site were
inconclusive. Between that statement and TGS’s official announcement of the discovered copper
ore four days later, the TGS secretary, a TGS director, and a TGS engineer (defendants) all
bought TGS stock. The SEC started an investigation and eventually brought suit. The trial court
found in favor of the defendants. The SEC appealed.
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Is not-yet-publicly-disclosed information about the success of a drilling discovery material inside
information invoking the insider trading responsibilities of Rule 10b-5?
Holding and Reasoning
Yes. Individuals with knowledge of material inside information must either disclose it to the
public or abstain from trading in the securities concerned while such inside information remains
undisclosed. The materiality of a statement depends on the significance that a reasonable investor
would place on the withheld or misrepresented information. In the present case, the inside
information about the specifics of the drilling site discovery that the defendants withheld from
the public was material because the high mineral content of the site is information a reasonable
investor would have liked to have known and, if known, would certainly have affected the price
of the stock. This is evidenced by the importance placed on the drilling site by those individuals
who knew about it, including the defendants. Because the information was material, the
defendants were not entitled to acquire TGS stock until public disclosure of the high mineral
content was made. Their doing so before public disclosure constitutes insider trading in violation
of Rule 10b-5. The trial court is therefore reversed. In addition, the court determines that the case
will be remanded for a determination of whether the TGS press release saying that reports of the
discovery were exaggerated was misleading and/or deceptive.
It contains that there must be equal opportunity.
Texas Gulf Rules:
(1) disclose or abstain (equal access theory)
(2) materiality: probability/magnitude test: the materiality would be what the reasonable investor
would consider as would alter the total mix of available information.
insiders need to wait until such time that the information (material) is effectively disclosed.
Insiders can’t wait until the information is effectively disseminated.
The court says that keeping the information is not illegal, but once the information leaks out you
must disclose.
The fact that investors rely on your misleading statement makes it necessary that you should
The court says that “in connection” does not matter if the company did not trade itself, because
the information that was going to be passed on to the public.
Current Law – Chiarella
The duty to abstain arises from the relationship of trust between a corporation’s shareholders and
its employees. Since there was no relationship of trust, there was no duty to disclose.
Dirks v. SEC
Rule of Law
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A breach of an insider’s fiduciary duty must occur before a tippee inherits the duty to
disclose inside information.
Ronald Secrist, a former officer of Equity Funding of America (Equity Funding), told Raymond
Dirks (defendant) that Equity Funding’s assets were exaggerated due to fraudulent corporate
practices. Secrist told Dirks to verify the fraud and publicly disclose it. Dirks investigated Equity
Funding and over the course of his investigation, he discussed his findings with various
investors, including some investors who had stock in Equity Funding and who sold the stock
after they spoke with Dirks. Dirks went to WSJ to publish his findings, and they did not care.
Thereafter, he passed the information and told people about it. As a result of the stock sales,
Equity Funding’s stock fell abruptly, and the SEC opened an investigation. The SEC found that
Dirks aided and abetted insider trading in violation of SEC Rule 10b-5. The court of appeals
affirmed. Dirks appealed.
Does a tippee violate a fiduciary duty to the shareholders of the corporation on which he received
a tip if the insider from whom he received the tip did not receive a benefit of any kind from
giving the tip?
Holding and Reasoning (Powell, J.)
No. A tippee assumes a fiduciary duty to the shareholders of the corporation not to trade on the
material nonpublic information only when the insider giving the tip has breached his fiduciary
duty to the shareholders by disclosing the information to the tippee, and the tippee knows or
should know that there has been a breach. An insider breaches that duty only if he gives the
information to the tippee in order to personally benefit, directly or indirectly, from his disclosure.
Where the insider does not violate any fiduciary duty, the tippee cannot be deemed to violate a
fiduciary duty either. In the instant case, Secrist’s motivation in telling Dirks about the fraud
within Equity Funding was for the purpose of exposing the fraud, not to benefit personally in any
way. Therefore, because Secrist in fact did not benefit either directly or indirectly from telling
Dirks, he did not violate a fiduciary duty to the Equity Funding shareholders. Consequently,
Dirks did not violate any resulting fiduciary duty to the Equity Funding shareholders. The court
of appeals is reversed.
The duty to disclose arises from the relationship between the parties and not merely from
one’s liability to acquire information because of his position in the market.
In determining whether a tippee is under an obligation to disclose or abstain, it is
necessary to determine whether the insider’s tip constituted a breach of the insider’s
fiduciary duty.
The test is whether the insider personally will benefit, directly or indirectly, from his
disclosure. Absent some personal gain, there has been no breach of duty to stockholders.
And absent a breach by the insider, there is no derivative breach.
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Dirks did not want to engage in fraud but wanted to get the fraud out. It does not mean that the
automatically has to disclose or abstain from trading.
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Tipper breaches her fiduciary duty if she discloses the material information, for which she had a
fiduciary duty to the corporation not to disclose. The tippee/recipient of the information would
be liable only if the tippee knew or should have known that the tipper was acting in breach of
his/her fiduciary duty.
The tipper must receive a benefit.
The tippee would be liable if she knows or has reason to know that the tipper had violated a
fiduciary duty when she provided that information to the tippee.
The tipee’s liability arises out of the tipper’s liability.
Salman v. US
Rule of Law
A tippee is liable for securities fraud if the tipper breaches a fiduciary duty by making a
gift of confidential information to a trading relative or friend.
Maher Kara (Maher) was an investment banker for Citigroup. Maher gave inside information to
his brother, Michael Kara (Michael). Maher knew that Michael would trade on the information.
Maher loved his brother and testified at trial that he gave Michael the information to help him. In
addition to trading on this information himself, Michael gave the information to his friend
Bassam Salman (defendant), who also traded on the inside information. At trial, Michael testified
that Salman knew the inside information was coming from Maher. Salman made over $1.5
million in profits using the inside information. A jury in the United States District Court for the
Northern District of California convicted Salman of securities fraud. The United States Court of
Appeals for the Ninth Circuit affirmed. The United States Supreme Court granted certiorari.
Is a tippee liable for securities fraud if the tipper breaches a fiduciary duty by making a gift of
confidential information to a trading relative or friend?
Holding and Reasoning (Alito, J.)
Yes. A tippee is liable for securities fraud if the tipper breaches a fiduciary duty by making a gift
of confidential information to a trading relative or friend. Generally, a tippee is liable for
securities fraud based on insider trading if the tipper personally benefits from the disclosure of
the inside information. A tipper personally benefits from a gift of the inside information if the
gift is made to a trading relative or friend because, absent the gift of information, the tipper could
simply use the information to trade for himself or herself and then pass the profits on to the
tippee. This practice would clearly be securities fraud, and if the information is given to and
traded on by a friend or relative, the result of the practice is the same. Thus, in a securities fraud
case under these circumstances, the jury can infer that the tipper intended the information to be
the same as a cash gift. Here, the lower courts properly found Salman liable for securities fraud.
Maher gifted inside information to Michael, a close relative. The jury was entitled to infer that
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Maher intended the information to be the equivalent of a monetary gift to Michael, and that
Maher thus personally benefitted from disclosing the information. Salman knew Maher had
gifted the information to Michael, and, as a tippee, Salman is also liable for securities fraud. The
conviction is affirmed.
According to Dirk, the tipper must have received a benefit, but Salman says that the tipper need
not receive a tangible benefit himself. The benefit that the tipper receives need not be tangible or
significant. The family relationship and the fact that the circumstances between these two cases
are differs matter too.
United States v. O’Hagan
Rule of Law
(1) A person is guilty of securities fraud when he misappropriates confidential information
for securities trading purposes, in breach of a duty to the source of that information.
(2) SEC Rule 14e-3 is a proper use of the SEC’s rulemaking authority and should be given
James O’Hagan (defendant) was a partner in the law firm that represented Grand Metropolitan
PLC in its tender offer of Pillsbury Company (Pillsbury) common stock. The possibility of the
tender offer was confidential and not public until the offer was formally made by Grand Met.
However, during the time when the potential tender offer was still confidential and nonpublic,
O’Hagan used the inside information he received through his firm to purchase call options and
general stock in Pillsbury. Subsequently, after the information of the tender offer became public,
Pillsbury stock skyrocketed, and O’Hagan sold his shares, making a profit of over $4 million.
The Securities and Exchange Commission (SEC) initiated an investigation into O’Hagan’s
transactions and brought charges against O’Hagan for violating § 10(b) and § 14(e) of the
Securities Exchange Act. The trial jury convicted O’Hagan, but the United States Court of
Appeals for the Eighth Circuit reversed on the grounds that violation of SEC Rule 10b-5 cannot
be grounded in the misappropriation theory of insider trading. The United States Supreme Court
granted certiorari.
(1) Is a person guilty of securities fraud when he misappropriates confidential information for
securities trading purposes, in breach of a duty to the source of said information?
(2) Is SEC Rule 14e–3, creating a duty to disclose or abstain from trading on information that is
obtained from an insider, a proper use of the SEC’s rulemaking authority that should be given
Holding and Reasoning (Ginsburg, J.)
(1) Yes. A person is guilty of securities fraud when he misappropriates confidential information
for securities trading purposes, in breach of a duty to the source of the information. Under the
misappropriation theory of insider trading, an individual misappropriates material nonpublic
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information for the purposes of trading, in breach of a fiduciary duty to the source of the
information. This is in contrast to the classical theory of insider trading where a corporate insider
misappropriates material nonpublic information for the purposes of trading, in breach of a
fiduciary duty to the shareholders of the corporation itself. Insider trading under the
misappropriation theory satisfies SEC Rule 10b–5’s requirements of fraudulent practices because
individuals who engage in such misappropriation clearly use deceptive practices in connection
with the purchase of securities. Such individuals “deal in deception” by feigning loyalty to the
principal while using confidential information to purchase stocks—a clear violation of Rule 10b5. In this case, the misappropriation theory applies because O’Hagan violated a fiduciary duty to
his law firm and Grand Met (i.e. the sources of the information), not Pillsbury, the trading party
in which he bought the stock. This deceptive misuse of confidential information in order to
purchase stocks constitutes a violation of Rule 10b–5. Therefore, O’Hagan breached his duty,
and his conviction should be upheld. The judgment of the court of appeals is reversed.
(2) Yes. SEC Rule 14e–3, which creates a duty to disclose or abstain from trading on information
that is obtained from an insider, is a proper use of the SEC’s rulemaking authority and should be
given deference. O’Hagan’s conviction based on violation of Rule 14e–3 should not have been
vacated because the SEC’s creation of this rule was proper. The SEC is permitted to prohibit acts
if the intent is to prevent fraudulent acts, and if the prohibition is reasonably designed to prevent
these acts. The SEC will be granted deference in its prohibition of certain acts as long as the
prohibition is not arbitrary, capricious, or contrary to statute. In regard to Rule 14e–3, the SEC
has created a reasonable rule in which fraud is prevented by prohibiting trades based on the
acquisition of inside information. The SEC is well within its authority to prohibit trades that may
be fraudulent. Since the rule is proper, O’Hagan may be found guilty of violating the rule. The
judgment of the court of appeals is reversed.
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O’Hagan took the confidential information that belonged to the law firm and the client.
The deception is what brings insider trading under the Rule 10b–5. SEC would argue that taking
the confidential information is an act of deception, hence the violation of 10b–5.
if the fiduciary discloses to the source that he plans to trade on the
nonpublic information, there is no “deceptive device” and thus no § 10(b)
violation– although the fiduciary turned trader may remain liable under
state law for breach of duty of loyalty.
With the classical theory, we have insiders/temporary insiders and tippers/tippees.
Misappropriation may happen from printers, lawyers, etc.
Consider several points before analyzing the indemnification statutes, which cover the authority
or obligation of a corporation to indemnify officers and directors for any damages they might
incur in connection with their corporate activities.
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First, there are several different situations that might give rise to liability. Suits may arise by
employees, customers, competitors, or the government. Delaware’s protective provision, §
102(b)(7) applies only to “liability of a director to the corporation or its stockholders for
monetary damages for breach of fiduciary duty as a director.”
Second, the risk of liability may be remote, but the amount of the damages can be large in
relation to the individual wealth of the officers and directors and there may be forms of relief
other than money damages.
Third, corporations may be able to buy insurance to cover damages and expenses of defense, but
if they are allowed to do that, why not allow them to become self-insurers? It would be stupid.
Waltuch v. Conticommodity Services, Inc.
Rule of Law
For purposes of indemnification, a defendant is “successful” in defense of the claim against
him if he assumes no liability and does not have to pay the settlement.
Norton Waltuch (plaintiff) was a silver trader for Conticommodity Services, Inc. (Conti)
(defendant). When the silver market crashed, silver speculators brought multiple lawsuits against
Waltuch and Conti. All of the suits settled with Conti paying the settlements. As a result of
Conti’s payments, Waltuch was dismissed from the suits with no settlement contribution.
However, in defending himself in the suits, Waltuch spent approximately $1.2 million out of his
own pocket. In addition to the civil suits, the Commodity Futures Trading Commission (CFTC)
brought an enforcement proceeding against Waltuch. That proceeding settled as well, with
Waltuch agreeing to a fine and a six-month ban on trading. Waltuch spent an additional $1
million in defending himself in the CFTC proceeding.
Waltuch brought suit against Conti, seeking indemnification of his various legal expenses.
Waltuch first claimed that a provision in Conti’s articles of incorporation categorically required
Conti to indemnify him. Conti claimed that a Delaware law barred the claim by allowing
indemnification only if the corporate officer acted in good faith, which Waltuch did not establish.
Waltuch’s second claim was that a different provision of that Delaware law required Conti to
indemnify him because he was “successful on the merits or otherwise” in the civil suits (this
statute did not apply to the CFTC proceeding). Conti responded that its settlement payments
were partially on Waltuch’s behalf so he was not actually successful in the suits. The United
States District Court for the Southern District of New York agreed with Conti on both claims.
Waltuch appealed.
For purposes of indemnification, is a defendant “successful” in defense of the claim against him
if he assumes no liability and does not have to pay the settlement because his employer paid the
whole settlement payment?
Holding and Reasoning
Yes. For purposes of indemnification, a defendant is “successful” in defense of the claim against
him if he assumes no liability and does not have to pay the settlement because his employer paid
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the whole settlement payment. A court will not go “behind the result” and inquire as to why a
defendant assumes no liability or payment in a claim against him. The fact that the defendant is
dismissed from the case, even if his employer paid the settlement, is sufficient to warrant
indemnification of his legal expenses because he is “successful on the merits or otherwise.”
Therefore, in this case, Waltuch is entitled to indemnification from Conti for legal expenses for
the civil claims because he was dismissed from the suits and thus “successful.” The United States
District Court for the Southern District of New York is reversed on that issue, Waltuch’s second
claim. However, the United States District Court for the Southern District of New York is
affirmed on Waltuch’s first claim that Conti’s articles of incorporation categorically provide for
his indemnification, specifically on the CFTC proceeding. Although articles of incorporation
may broaden indemnification rights beyond what the Delaware statute provides, the
indemnification rights granted may not be inconsistent with the scope of a corporation’s
indemnification powers as provided by the statute. The court determines that requiring
indemnification without a finding of good faith on the part of the corporate officer is inconsistent
with the Delaware statute because requirement of such a finding is “explicitly imposed” in the
statute. Accordingly, that indemnification provision of Conti’s articles of incorporation is invalid
and Waltuch is not entitled to indemnification for legal expenses related to his defense in the
CFTC proceeding. As a result of the foregoing, the United States District Court for the Southern
District of New York is reversed in part and affirmed in part.
 Under § 145(f), a corporation may provide indemnification rights that go beyond the
rights provided by § 145(a) and the other substantive subsections of § 145.
 Indemnification rights may be broader than those set out in the statute, but they cannot be
inconsistent with the scope of the corporation’s power to indemnify, as delineated in the
statue’s substantive provisions.
145(a) requires good faith, but 145(c) does not require a good faith requirement. The court says
they are not going to ask questions about the merits underlying the decision. They believe the
success is measured by claims going away not being won on trial. The point is no liability.
Webster believes that 145(a) and (c) are badly drafted, because it there is some overlap between
situations covered in each section. You could be indemnified under (a) if you act in good faith,
but in (c) you need to be paid out if the process is successful.
One of the things that should attract directors is the fact that they will be indemnified by their
corporations if they are subject to liability.
Citadel Holding Corporation v. Roven,
Rule of Law
A director may be entitled to advance payment from a corporation for his legal fees even if
he is eventually not entitled to indemnification for those fees.
Alfred Roven (plaintiff) was a director of Citadel Holding Corporation (Citadel) (defendant).
Roven and Citadel entered into an Indemnity Agreement that had a specific indemnity provision.
The Indemnity Agreement also contained a provision granting Roven a right to advance payment
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from Citadel of costs and expenses Roven incurred as a result of defending himself against
claims arising from his business with Citadel. Citadel brought suit against Roven for violating
Section 16(b) of the Securities Exchange Act of 1934. To defend himself in that suit, Roven
asked for an advance payment for legal fees from Citadel pursuant to his Indemnification
Agreement. When Citadel refused to pay, Roven brought suit for breach of contract. The lower
court ruled in favor of Roven, holding that he was entitled to the advances. Citadel appealed on
the grounds that if Roven was not going to be entitled to indemnification in the suit against him,
he should not be awarded advance payment for his defense either.
May a director be entitled to advance payment from a corporation for his legal fees even if he is
eventually not entitled to indemnification for those fees?
Holding and Reasoning
Yes. A director may be entitled to advance payment from a corporation for his legal fees even if
he is eventually not entitled to indemnification for those fees. The case at bar is a suit for
advances under an Indemnification Agreement, not a suit for indemnification. The advances
provision in the agreement has nothing to do with the indemnification provision. The fact that
Roven may not be entitled to indemnification of his legal fees is immaterial to his claim for
advances. Consequently, according to the terms of the Indemnification Agreement, Roven is
entitled to his advance and the lower court is affirmed.
They contracted above the statutory provision requirements.
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Chapter 6 – Problems of Control
Because few shareholders of public corporations attend the annual meeting, the outcome will
generally depend on which group has collected the most “proxies.”
Under corporate law, shareholders may appoint an agent to attend the meeting and vote on their
behalf. That agent is the shareholder’s “proxyholder,” sometimes simply called the shareholder’s
“proxy:” the document by which the shareholder appoints the agent is also called the “proxy.”
See page 528 for the discussion on naming (street name v. beneficial ownership).
Levin v. Metro-Goldwyn-Mayer, Inc.
Rule of Law
Using corporate funds to hire attorneys or a proxy soliciting organization in a proxy
solicitation contest is not illegal or unfair if the amounts paid by the corporation are not
The stockholder annual meeting for Metro-Goldwyn-Mayer, Inc. (MGM) was coming up and
two different groups of stockholders wanted to nominate two different slates of directors for
MGM’s board. Both groups solicited proxies for the meeting. MGM’s proxy statement stated
that MGM would “bear all cost in connection with the management solicitation of proxies.” One
group, the O’Brien group (defendants), used MGM funds in its solicitation of proxies, including
use of MGM funds to retain attorneys, hire a public relations firm, and hire proxy soliciting
organizations. The other group, consisting of Philip Levin and other stockholders (plaintiffs),
brought suit against MGM and the O’Brien group, seeking injunctive relief against the O’Brien
group’s continued solicitation of proxies in that manner.
Is using corporate funds to hire attorneys or a proxy soliciting organization in a proxy solicitation
contest illegal or unfair?
Holding and Reasoning
No. Using corporate funds to hire attorneys or a proxy soliciting organization in a proxy
solicitation contest is not illegal or unfair if the amounts paid by the corporation are not
excessive. This method does not violate any federal statute or SEC regulation and it is in line
with MGM’s proxy statement filed with the SEC. In addition, the court determines that the
amounts paid by the O’Brien group in its solicitation of proxies are not excessive. Accordingly,
the plaintiffs’ motion for injunctive relief is denied.
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Rosenfield v. Fairchild Engine & Airplane Corp.
Rule of Law
In a proxy contest over policy, corporate directors have the right to make reasonable and
proper expenditures from the corporate treasury for the purpose of persuading the
stockholders of the correctness of their position and soliciting their support for policies
which the directors believe are in the best interests of the corporation.
In a policy-related proxy contest (as opposed to a personal contest for power) for a board of
directors election in Fairchild Engine & Airplane Corp. (Fairchild) (defendant), Fairchild’s
treasury paid $106,000 in defense of the old board of director’s position; $28,000 to the old
board by the new board after the change to compensate the old board for their failed campaign;
and $127,000 reimbursing expenses that the new board members incurred in their campaign.
That reimbursement was ratified by a majority vote of the stockholders. The policy question
behind the proxy contest was the long-term and very expensive pension contract of a former
director, Carlton Ward. Rosenfeld (plaintiff), brought suit to compel the return of the above
payments to the Fairchild treasury. The lower court dismissed Rosenfeld’s complaint. He
In a proxy contest over policy, may directors make expenditures from the corporate treasury in
order to solicit stockholders’ support?
Holding and Reasoning
Yes. In a proxy contest over policy, corporate directors have the right to make reasonable and
proper expenditures from the corporate treasury for the purpose of persuading the stockholders
of the correctness of their position and soliciting their support for policies which the directors
believe are in the best interests of the corporation. The stockholders may also reimburse new
directors for costs that the new directors incur in their policy campaign. Because corporations
have so many stockholders, if directors were not able to use corporate funds for solicitation of
proxies, it is very possible that corporate business would be “seriously interfered with.” There
are so many stockholders that each individual stockholder cannot make much of a difference in a
vote. Use of proxies is a way to pool stockholders’ votes, making corporate business conductible.
And proxies would likely not be used as much as they are if the directors had to pay for their
solicitation out of their own pockets. Consequently, directors, if acting in good faith, may incur
reasonable expenses in the solicitation of proxies in a policy-related proxy contest. Because this
is exactly what had occurred in the case at bar, the lower court’s dismissal of Rosenfeld’s
complaint is affirmed.
when the directors act in good faith in a contest over policy, they have the right to incur
reasonable and proper expenses for solicitation of proxies and in defense of their
corporate policies and are not obliged to sit idly by.
Reimbursement happens only when there is a dispute over policy.
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It is very difficult in general to make a strict distinction between policy and personal contests, as
changes in management often have elements of each. In addition, in this case, personal power
factors are “deeply rooted” in Fairchild’s proxy contest, as the main impetus for the change in
management was the Ward contract which is clearly an issue personal in nature.
Regulation of Proxy Fights
1) The Regulatory Scheme:
a. Section 14(a) of the 34 Act prohibits people from soliciting proxies in violation of
SEC rules.
i. Rule 14a–2: shareholder does not fall under the SEC filing requirements if
it does not solicit proxies for itself.
b. the rules require people who solicit proxies to furnish each shareholder with a
“proxy statement.” In it, they must disclose information that may be relevant to
the decision the shareholder must make.
c. when an insurgent group wants to contest management and solicit proxies, Rule
14a–7 gives management a choice: it can either mail the insurgent group’s
material to the shareholders directly and charge the group for the cost, or it can
give the group a copy of the shareholder list and let it distribute its own material.
2) The economics of proxy fights:
a. if an insurgent group organized a proxy fight and lost, it bore the entire cost of
soliciting the proxies; if it won and made the firm more profitable, it gained only a
fraction of that increased profitability.
b. investors who expect to incur large financial risks in rehabilitating a badly
managed firm will prefer to keep for themselves any increased value they create.
With a tender offer, they can buy all the corporate stock and do so. With a proxy
fight, they must share value with the other shareholders.
3) Statutory in Delaware re expenses:
(a) The bylaws may provide for the reimbursement by the corporation of expenses incurred
by a stockholder in soliciting proxies in connection with an election of directors, subject to
such procedures or conditions as the bylaws may prescribe, including:
(1) Conditioning eligibility for reimbursement upon the number or proportion of
persons nominated by the stockholder seeking reimbursement or whether such
stockholder previously sought reimbursement for similar expenses;
(2) Limitations on the amount of reimbursement based upon the proportion of votes
cast in favor of 1 or more of the persons nominated by the stockholder seeking
reimbursement, or upon the amount spent by the corporation in soliciting proxies in
connection with the election;
(3) Limitations concerning elections of directors by cumulative voting pursuant to §
214 of this title; or
(4) Any other lawful condition.
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(b) No bylaw so adopted shall apply to elections for which any record date precedes its
Trinity Wall Street v. Wal-Mart Stores, Inc.
Rule of Law
A company cannot exclude from a proxy statement a shareholder proposal that focuses on
a matter of significant social policy related to the company’s day-to-day business
operations if the policy issue transcends those operations.
Trinity Wall Street (Trinity) (plaintiff) owned shares of Wal-Mart Stores, Inc. (Walmart)
(defendant). Trinity filed a shareholder proposal with Walmart, proposing that Walmart adopt a
policy to not sell guns with high-capacity magazines. Walmart declined to include the proposal
in its 2014 proxy statement. Trinity brought suit arguing that Walmart’s exclusion of its proposal
violated the Securities Exchange Act of 1934. Trinity claimed that the proposal related to
Walmart’s corporate governance rather than being a good corporate citizen. Trinity argued that
selling guns with high-capacity magazines would hurt Walmart’s reputation and brand. The
district court found in favor of Trinity. Walmart appealed.
Can a company exclude from a proxy statement a shareholder proposal that focuses on a matter
of significant social policy related to the company’s day-to-day business operations if the policy
issue transcends those operations?
Holding and Reasoning
No. A company cannot exclude from a proxy statement a shareholder proposal that focuses on a
matter of significant social policy related to the company’s day-to-day business operations if the
policy issue transcends those operations. Generally, a company can exclude a shareholder
proposal from a proxy statement if the proposal relates to the company’s ordinary business
operations. To make such a determination, courts consider the subject matter of the proposal and
whether that subject matter relates to the company’s ordinary business operations. However,
even if a proposal involves the company’s ordinary business operations, the company cannot
exclude the proposal if its focus is a matter of significant social policy that goes beyond the
company’s day-to-day business operations. In this case, the sale of guns with high-capacity
magazines is an issue of significant social policy. But the social policy does not transcend
Walmart’s day-to-day business operations. The subject matter of Trinity’s proposal is the
products that Walmart sells, which is a matter of Walmart’s day-to-day business operations. And
while the sale of high-capacity guns is a significant social matter, the social policy matter does
not transcend Walmart’s ordinary business operations. The heart of a retailer’s business is the
decisions as to which products the retailer sells. It is rare that a social policy matter will
transcend something so inherent to retail operations as product choices, and it does not do so
here. A retailer’s weighing of consumer and community safety in deciding which products to sell
is inextricably intertwined with the retailer’s ordinary business operations. Accordingly, Walmart
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was entitled to exclude Trinity’s shareholder proposal from its proxy statement. The judgment of
the district court is reversed.
There exists a two-part analysis to determine whether shareholders’ proposal “deals with
a matter relating to the company’s ordinary business operations.”
1) whether the subject matter of the proposal is legitimate?
2) whether that subject matter relates to the corporation’s ordinary business transactions?
a. if yes, then the corporation must convince the court that the shareholders’
proposal does not raise a significant policy issue that transcends the nuts and
bolts of the corporation’s business.
b. the inquiry would be the following:
i. whether the proposal focuses on a significant policy (be it social or
1. If it does not, the proposal fails to fit within the social-policy
exception to Rule 14a–8(i)(7)’s exclusion.
2. If it does, then the second step:
ii. whether the significant policy issue transcends the company’s ordinary
business operations.
This case creates a sort of buffer for the corporate directors to be able to insulate from the
shareholder crowds (freely exercising business judgments).
Proposals need to attract attention.
Shareholder voting is corporate democracy. However, it’s important to consider the following:
 this democracy is not genuinely true, you may prevent the shareholders to participate in
 shareholder proposals are pretty cosmetic.
Under Rule 14a–8 adopted by the SEC under Rule 14(a) of the Securities and Exchange Act
1934, a company must generally include a shareholder proposal its proxy materials unless the
proposal meets one of the specified exceptions set forth in the rule. Rule 14a–8(i)(7) permits a
company to exclude a proposal if it simply relates to the ordinary business operations of the
company– its day-to-day operations.
In determining these issues - while the Court states it was employing a two-part analysis, its test
seems to have 3 prongs:
1) What’s the subject matter of the proposal?
 here it’s managerial discretion and freedom
2) Does the identified subject matter “relate” to [touches upon] the company’s ordinary
business operations?
 relate means day to day matter. Relate to is broad and to the extent whether it
touches/there is some connection between, here, shelf stocking and managerial
activity? i.e. your bread and butter issue.
3) If so,
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a. Does the proposal implicate a significant social issue or public policy; and
o significant is from a subjective stand-point. You know it when you see it.
b. Does the proposal’s subject matter “transcend” the company’s ordinary business?
SEC issued administrative guidance in the wake of this decision:
According to the SEC - a proposal may transcend a company’s ordinary business operations even
if the significant policy issue relates to the “nitty gritty” of its core business.
Webster: the court agrees with the SEC.
Analysis on page 565:
Q1. what’s the effect/history.
Q3. It should not be excludable. This is different, it depends on a corporation’s assets and
shareholders’ property.
Q4. it’s very hard to come up with a significant policy determinant.
Q6. it’s a matter of how important that product is to the operation of the business. Coke, e.g.
Q8. yes, checks and balances.
Lovenheim v. Iroquois Brands, Ltd.
Rule of Law
The meaning of “significantly related” in the SEC rule for omissions in proxy statements is
not limited to economic significance.
Peter Lovenheim (plaintiff) was a shareholder in Iroquois Brands, Ltd. (Iroquois) (defendant).
Iroquois was preparing to send proxy materials to its shareholders containing information about a
shareholders meeting. Lovenheim sought to include in the proxy materials a proposed resolution
that he planned to offer at the meeting. The resolution pertained to the allegedly inhumane
procedures used to force-feed geese for production of pate de foie gras in France, which was a
type of pate imported by Iroquois. Iroquois refused to include information on Lovenheim’s
resolution in the proxy materials. Iroquois defended its refusal based on the SEC rule that a
corporation may omit a proposal from its proxy statement “if the proposal relates to operations
which account for less than 5 percent of [Iroquois’s] total assets at the end of its most recent
fiscal year . . . and is not otherwise significantly related to [Iroquois’s] business.” Pate accounted
for well less than 5 percent of Iroquois’s business. However, Lovenheim maintained that his
proposal could not be excluded because of the second part of the rule in that it cannot be said that
the proposal is not otherwise significantly related to Iroquois’s business. Lovenheim argued that
the proposal had ethical or social significance.
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Is the meaning of “significantly related” in the SEC rule for omissions in proxy statements
limited to economic significance?
Holding and Reasoning
No. The meaning of “significantly related” in the SEC rule for omissions in proxy statements is
not limited to economic significance. Therefore, because of the ethical and social significance of
Lovenheim’s proposed resolution, Lovenheim has shown a likelihood of prevailing on the merits
in that his proposal is “otherwise significantly related” to Iroquois business. The proposal
therefore may not be excluded from the proxy statement being distributed.
Footnote 3 highlights the fact that we treat animals with some degree of humanity. “significantly
related is not limited to economic significance.”
Shareholder proposal should be drafted as recommendations, not directives.
Analysis on Page 569:
Q. you can’t direct the corporation to do anything, that’s the business of the directors.
Shareholders only vote.
Webster: the only difference between Trinity and Lovenheim, that the latter considers a
construction and the first is under an ordinary business exception.
So, if it’s ordinary business matter, then Lovenheim,
if you get a fact like Trinity, follow Trinity.
Rule of Law
A shareholder proposal does not “relate to an election” under the SEC’s rules for exclusion
from a proxy statement if it seeks to amend the corporate bylaws to establish a procedure
by which certain shareholders are entitled to include in the proxy materials their nominees
for the board of directors.
The American Federation of State, County & Municipal Employees (AFSCME) (plaintiff) is a
shareholder of American International Group (AIG) (defendant). AFSCME submitted a proposal
to AIG that AFSCME wanted to be included in AIG’s proxy materials. The proposal was to
amend AIG’s bylaws to establish a procedure by which certain shareholders are entitled to
include in the proxy materials their nominees for the board of directors. Under SEC rules, subject
to certain exceptions, shareholder proposals must be included in a corporation’s proxy statement.
However, one of those exceptions is if the proposal “relates to an election for membership” on
the corporation’s board. Based on that exception, AIG refused to include the proposal in its
proxy materials. AFSCME claimed that because of the article “an,” before the word election, the
exception applies only to proposals that address single elections. AFSCME brought suit in the
United States District Court for the Southern District of New York, seeking a court order to
include the proposal. The claim was denied and dismissed. AFSCME appealed.
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Does a shareholder proposal “relate to an election” under the SEC’s rules for exclusion from a
proxy statement if it seeks to amend the corporate bylaws to establish a procedure by which
certain shareholders are entitled to include in the proxy materials their nominees for the board of
Holding and Reasoning
No. A shareholder proposal does not “relate to an election” under the SEC’s rules for exclusion
from a proxy statement if it seeks to amend the corporate bylaws to establish a procedure by
which certain shareholders are entitled to include in the proxy materials their nominees for the
board of directors. The language in the rule is ambiguous as to whether it refers to a single
election or all elections generally and the SEC has actually provided two different
interpretations. Originally, the SEC interpreted its exception to mean relating to a particular
election, which would support AFSCME’s claim that its proposal relating to all future elections
should not be excluded; however, recently the SEC has interpreted the rule to apply to all
elections generally, which would support AIG’s interpretation. Although the SEC has leeway to
change its interpretation of its own rule, under administrative law, it has a duty to explain “its
departure from prior norms” and it has not done so in this case. Accordingly, the SEC’s prior,
original interpretation of the rule controls and the exception does not apply to proposals
involving elections generally. AFSCME’s proposal regarding all future elections must therefore
be included in AIG’s proxy statement. The United States District Court for the Southern District
of New York is reversed.
The court says that the interpretation of the SEC rules is ambiguous. And the court says that the
SEC can better interpret its own rules.
Shareholder proposals battered away the presumption of excludability. The interpretation is up to
the SEC, however. The SEC wants to see transparency, effectiveness, and procedural soundness.
Analysis on Page 577:
Q1. Research says that unions exert control over the boards and this a way for them to make
corporations more union friendly. The question is whether what is good for a trade union is also
good for the shareholders? Not necessarily. In light of Dodge v. Ford, corporations are for the
maximization of corporate profits.
CA, Inc. v. AFSCME Employees Pension Plan
Rule of Law
(1) A bylaw is permissible if it defines the process and procedure by which a board of
directors makes business decisions.
(2) A corporation’s board may not enter a contract that requires it to act in a manner that
would violate its fiduciary duties.
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CA, Inc. (plaintiff) is a Delaware corporation, in which AFSCME Employees Pension Plan
(defendant) is a shareholder. AFSCME proposed a bylaw that would require CA to reimburse its
shareholders for the costs associated with holding a contested election of its board of directors.
CA requested a no-action letter from the Securities and Exchange Commission on the matter,
with AFSCME responding in opposition. The SEC then certified the matter for a decision by the
Delaware Supreme Court to determine whether: (1) the by-law is appropriate for stockholder
action without agreement by the board, and (2) whether the by-law would be violative of
Delaware law.
(1) Is a bylaw permissible if it defines the process and procedure by which a board of directors
makes business decisions?
(2) May a corporation’s board enter a contract that requires it to act in a manner that would
violate its fiduciary duties?
Holding and Reasoning
(1) Yes. The bylaw in question falls within the scope of permissible bylaws because it regulates
the process through which directors are selected. A bylaw is permissible if it defines the process
and procedure through which a board of directors makes business decisions. This is explicitly
stated in Delaware statutes. These statutes specifically authorize bylaws regulating the number of
directors on a board, as well as other bylaws relating to boards of directors. In this case, the
bylaw in question is in regards to the process by which CA’s directors are elected. The election
of directors affects the process and procedure through which business decisions are made for a
corporation, as it is the directors who make such decisions. Thus, the bylaw in question is
permissible. However, the bylaw as it is currently written could violate other areas of Delaware
law, and is thus impermissible on those grounds.
 whether or not a bylaw is process-related must necessarily be determined in light of its
context and purpose.
(2) No. Delaware General Corporation Law § 109(a) vests the power to adopt, amend, or repeal a
corporation’s by-laws concurrently in a corporation’s directors and its stockholders. Section
141(a) provides that a corporation is to be managed and directed by the corporation’s board.
Reading these two provisions together, it is apparent that a stockholder’s statutory power to
amend, adopt, or repeal a by-law is subject to a board’s duty to manage the corporation. The first
issue here is whether the AFSCME’s proposed by-law can be the proper subject of the upcoming
stockholder’s meeting without intruding on the board’s management powers. Under Delaware
law, a by-law is not intended to dictate how a board should decide substantive matters, but rather
the procedures by which substantive decisions are made. The by-law at issue here governs the
procedure for electing directors. The effect of the by-law would be to encourage non-board
sponsored nominees to seek election, thereby furthering the right of shareholders to participate in
the election of directors. Consequently, this court finds the by-law to be a proper subject for a
stockholder vote. Nevertheless, directors may not enter contracts that require the board to act in a
manner that would breach their fiduciary duties. Here, it is possible that a proxy contest could be
motivated by pettiness, in which case the board’s fiduciary duties might require it to deny
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reimbursement. Because the by-law does not allow for a board to deny reimbursement in such
situations, this court finds the by-law is violative of Delaware law.
The court is basically separating the procedural from substantive matters. This case is delicate on
separation/tension of what shareholders can do against the background of potency of the BoD. It
can be seen from how §109 operates in light of §141.
that a shareholder bylaw concerning the reimbursement of expenses in a proxy contest was a
proper subject for stockholder action, but that in the case of this specific bylaw, the bylaw could
not (1) mandate a board of directors to reimburse expenses in all cases, or (2) prevent the
directors from fulfilling their fiduciary duties. The Court also confirmed that “a proper function
of bylaws is not to mandate how the board should decide specific substantive business
The Court also confirmed that “a proper function of bylaws is not to mandate how the board
should decide specific substantive business decisions.” The Court’s decision addressed a
proposed stockholder bylaw that would have required the Board of Directors of CA, Inc. ("CA")
to reimburse the reasonable expenses incurred by stockholders in conducting successful “shortslate” proxy contests (i.e., where a slate of candidates runs for fewer than half the seats on the
The Court held that, while the proposed bylaw related to director elections and was a proper
subject for stockholder action under Delaware law, the proposed bylaw “mandates
reimbursement of election expenses in circumstances that a proper application of fiduciary
principles could preclude” and so – if adopted - could cause CA to violate Delaware law.
You will want to have the “shareholder list.” Precisely because information about shareholder
identity is valuable to you, incumbent managers are likely to resist your efforts to obtain it. There
is nothing in the federal proxy rules requiring the corporation to give you the shareholder list, but
the federal rules do not impair any rights you may have under state law. Thus, battles for the
shareholder list are fought under state laws.
Crane Co. v. Anaconda Co.
Rule of Law
A stockholder may inspect the corporation’s list of stockholders to ascertain the identity of
fellow stockholders for the purposes of communicating a tender offer.
Crane Co. (plaintiff) announced that it was offering up to $100 million in debentures for up to 5
million shares of Anaconda Co. (defendant)—over one fifth of Anaconda’s outstanding stock.
After Crane obtained some Anaconda stock, it formally asked for a copy of Anaconda’s list of
shareholders. Crane wanted to see the list so it could communicate its tender offer to the
remaining shareholders. Crane’s demand stated that its proposed inspection of the list was solely
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for the purposes of the business of Anaconda, in accordance with the Business Corporations
Law. Anaconda denied Crane access to the list of shareholders, arguing that trying to convince
stockholders to sell their stock does not involve the business of the corporation. Crane brought
suit. The trial court dismissed Crane’s claim, but the appellate court reversed. Anaconda
May a stockholder inspect the corporation’s list of stockholders to ascertain the identity of fellow
stockholders for the purposes of communicating a tender offer?
Holding and Reasoning
Yes. A stockholder may inspect the corporation’s list of stockholders to ascertain the identity of
fellow stockholders for the purposes of communicating a tender offer. Generally, a stockholder
should be granted such access unless the purpose is hostile to the corporation. Anaconda’s
argument that a tender offer to stockholders does not involve the business of the corporation is
misguided. If a corporation is involved in a possible transaction that will potentially affect its
value, the stockholders are affected in their role as stockholders and thus the business of the
corporation is involved. In the present case, a tender offer involving so much of Anaconda’s
stock has a clear effect on the value and future of the corporation and thus involves the business
of the corporation under the Business Corporations Law. Consequently, the appellate court is
affirmed, and Crane is entitled to inspect Anaconda’s stockholder list.
A shareholder desiring to discuss relevant aspects of a tender offer should be granted
access to the shareholder list unless it is sought for a purpose inimical to the corporation
or its stockholders–and the manner of communication selected should be within the
judgment of the shareholder.
The conceptual basis for this right is derived from the shareholder’s beneficial ownership of
corporate assets and the concomitant right to protect his investment.
the difference between Pillsbury and Anaconda:
there is no economic question in Pillsbury, which is different from Anaconda.
State ex rel. Pillsbury v. Honeywell, Inc.
Rule of Law
Shareholders must have a proper purpose germane to their economic interest in the
corporation to inspect corporate records.
Pillsbury (plaintiff) found out that Honeywell, Inc. (defendant) was engaged in the production of
munitions used in the Vietnam War. Pillsbury was against the war and bought 100 shares of
Honeywell with the sole purpose of gaining access to Honeywell’s business affairs so he could
convince the board of directors and fellow shareholders to stop producing the munitions. To that
end, Pillsbury formally demanded from Honeywell access to its original shareholder ledger,
current shareholder ledger, and all corporate records dealing with the manufacture of munitions.
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Honeywell refused to grant Pillsbury access. Pillsbury brought suit, seeking a writ of mandamus
compelling Pillsbury to produce the documents. The district court denied the writ and Pillsbury
May a shareholder inspect corporate records if his sole purpose in doing so is to convince the
corporation to adopt his political concerns, without any regard for his financial interest in the
Holding and Reasoning
No. Shareholders must have a proper purpose germane to their economic interest in the
corporation to inspect corporate records. A shareholder therefore may not inspect corporate
records if his sole purpose in doing so is to convince the corporation to adopt his political
concerns, absent any regard for his financial interest in the corporation. Given the sheer number
of shareholders in modern day corporations, some kind of limit needs to be put on shareholders’
ability to inspect records. Without such a limit, it would be very difficult to efficiently keep
records and generally conduct business. In this case, Pillsbury had no interest in the financial
well-being of Honeywell or even his own stock in Honeywell. His sole purpose in seeking to
inspect the corporate records was to convince the Honeywell board and shareholders that it
should stop manufacturing munitions for use in Vietnam. This social and political purpose,
unrelated to any economic interest, is not sufficiently proper under corporations law. Pillsbury is
thus not entitled to inspect the corporate records and the trial court is affirmed.
Del. Code Ann. tit. 8, § 220 :
(b) Any stockholder . . . shall have the right (given proper purpose) inspect for any proper
purpose of the corporation’s stock ledger . . . A proper purpose shall mean a purpose
reasonably related to such person’s interest as a stockholder.
(c) if the corporation . . . refuses to permit an inspection sought by a stockholder . . . the
stockholder may apply to the Court of Chancery for an order to compel such inspection.
o where the stockholder seeks to inspect the corporation’s books and records,
other than its stock ledger or list of stockholders, he shall first establish (1)
that he has complied with the provisions of this section respecting the form
and manner of making demand for inspection of such document; and (2) that
the inspection he seeks is for a proper purpose.
Because the power to inspect may be the power to destroy, it is important that only those
with a bona fide interest in the corporation enjoy that power.
where it is shown that such stockholding is only colorable, or solely for the purpose of
maintaining proceedings of this kind, we fail to see how the petitioner can be said to a
person interested, entitled as of right to inspect.
Webster: this case discloses the danger of outright honesty (the fact that Pillsbury is against the
war and doesn’t want it). He should have said that the Honeywell bomb manufacturing plants its
adversely affecting its economic performance  a political beef is not enough for a proper
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purpose. Trinity was about the subject matter of a proposal, this case is about accessing corporate
Sadler v. NCR Corporation
Rule of Law
Production of an out-of-state corporation’s shareholder and NOBO lists to an in-state
resident is permitted when the corporation is doing business in the shareholder’s state,
even when the shareholder was not able to obtain the lists under the law of the state of
NCR Corporation (NCR) (defendant) was incorporated in Maryland with a principal place of
business in Ohio, but conducted considerable business in its eight New York offices. AT&T was
a New York corporation. The Sadlers (plaintiffs) were New York residents who owned more
than 6,000 shares of NCR. AT&T began a tender offer for shares of NCR. NCR mailed the offer
to all NCR shareholders, but the NCR board rejected the offer. After the rejection, AT&T and
the Sadlers (at AT&T’s request) asked NCR for a list of its stockholders in order to more
effectively communicate with them. The Sadlers also asked for NCR’s non-objecting beneficial
owners (NOBO) list, a list of those individuals owning beneficial interests in shares of NCR.
Under NCR’s corporate charter, the shares of these individuals count as a vote in favor of
management if the shares are not voted at a meeting. The Sadlers were not able to obtain the lists
under Maryland law. NCR denied these requests and the Sadlers brought suit based on a New
York law that allowed New York residents that for more than six months had owned shares in a
foreign corporation doing business in New York to obtain the corporation’s list of stockholders.
AT&T had recently obtained 100 shares of NCR, but had not held the shares for more than six
months. NCR thus argued that the Sadlers did not qualify under the New York law because of
their arrangement with AT&T. The United States District Court for the Southern District of New
York found in favor of the Sadlers on both of their requests. NCR appealed.
Is production of an out-of-state corporation’s shareholder and NOBO lists to an in-state resident
permitted when the shareholder was not able to obtain the lists under the law of the state of
Holding and Reasoning
Yes. Production of an out-of-state corporation’s shareholder and NOBO lists to an in-state
resident is permitted when the corporation is doing business in the shareholder’s state, even
when the shareholder was not able to obtain the lists under the law of the state of incorporation.
In this case, the Sadlers’ arrangement with AT&T does not disqualify them from the New York
law as the law is to be “liberally construed in favor of the stockholder.” In fact, the law actually
allows an agent to act for the qualifying residential shareholder. In addition, because under the
NCR charter the shares of those on the NOBO list count as a vote in favor of management if the
shares are not voted at a meeting, it would be unfair to deny opponents of management a chance
to contact those NOBOs. As a result of the foregoing, the Sadlers are entitled to access to the list
of stockholders and the NOBO list. The United States District Court for the Southern District of
New York is affirmed.
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Webster: believes this case is about communications. Secondly, it’s about the tiered ownership
of shares.
Stroh v. Blackhawk Holding Corp.
Rule of Law
A limitation on a class of stock that prevents the stock from receiving dividends does not
invalidate the stock.
Blackhawk Holding Corp. (Blackhawk) (defendant) designated two classes of stock, Class A and
Class B. Each share of the Class B stock was entitled to a vote in corporate matters, but the
articles of incorporation provided that Class B stock was not entitled to dividends of any kind.
Stroh, et al. (plaintiffs) brought suit as owners of Class B stock, claiming that the provision
effectively invalidated their stock. Illinois law defined “shares” as “the units into which the
proprietary interests in a corporation are divided” and the plaintiffs claimed that the word
“proprietary” connoted some kind of economic interest.
Does a limitation on a class of stock that prevents the stock from receiving dividends invalidate
the stock?
Holding and Reasoning
No. A limitation on a class of stock that prevents the stock from receiving dividends does not
invalidate the stock. The word “proprietary” in the definition of shares does not necessarily mean
some kind of economic interest. In this instance, “proprietary rights” means the ability to
exercise some control over the corporation, i.e. by way of a vote. Corporations are entitled to
issue certain shares of stock that have preference over another class of shares. Although this
creates the possibility for wrongdoing, it is a valid system under the law as long as both classes
carry the same voting power. Accordingly, the plaintiffs’ stock is valid, and the court finds in
favor of Blackhawk.
Removing economic rights from shares effectively removes “the ownership incidents of
ownership.” What is left after such removal no longer constitutes a share of stock.
Stock is not simply limited to economic privileges. Some people may not have significant
monetary investment but wield enormous power.
Espinoza v. Zuckerberg
Rule of Law
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A controlling stockholder(s) of a Delaware corporation cannot ratify an interested board’s
decision without adhering to the corporate formalities for taking stockholder action.
Ernesto Espinoza (plaintiff) brought a shareholder derivative suit challenging the Facebook, Inc.,
board of directors’ (defendants) decision to approve certain compensation to outside directors.
Mark Zuckerberg (defendant) was the controlling stockholder of Facebook, controlling over 61
percent. After Espinoza filed suit, Zuckerberg, in a deposition and affidavit, approved the
contested compensation. Zuckerberg had not received the compensation. The directors moved
for summary judgment on the ground that Zuckerberg’s approval constituted stockholder
ratification of the board’s compensation decision.
Can a controlling stockholder(s) of a Delaware corporation ratify an interested board’s decision
without adhering to the corporate formalities for taking stockholder action?
Holding and Reasoning
No. A controlling stockholder(s) of a Delaware corporation cannot ratify an interested board’s
decision without adhering to the corporate formalities for taking stockholder action. Under
Delaware law, stockholders can assent to a corporate decision by a formal vote or by written
consent. Such written consent of the controlling stockholder(s) does not need prior notice, a vote,
or a meeting to be effective, but it does require prompt notice of such consent to nonconsenting
stockholders. Nonconsenting stockholders are entitled to the transparency and corporate
information that such prompt notice affords. In this case, Zuckerberg, the controlling stockholder
of Facebook, did not adhere to the corporate formalities for taking stockholder action.
Zuckerberg filed an affidavit approving the compensation decision. While the affidavit qualifies
as written consent to the decision, Zuckerberg failed to promptly notify the nonconsenting
shareholders of the approval. As a result, Zuckerberg’s approval of the compensation does not
constitute stockholder ratification of the compensation. The motion for summary judgment is
denied, and the entire fairness standard applies.
where directors make decisions about their own compensation, those decisions
presumptively will be reviewed as self-dealing transactions under the entire fairness
standard rather than under the business judgment rule.
o a decision dominated by interested directors can gain the protection of the
business judgment rule, however, if a fully-informed disinterested majority of
stockholders ratifies the transaction
o that translates into the doctrinal standard of waste: the well-pleaded allegations of
the complaint must support the conclusion that “no person of ordinary, sound
business judgment would say that the consideration received for the options was a
fair exchange for the options granted.”
Under the DGCL, there are two methods by which stockholders can express assent on a
matter concerning the affairs of the corporation:
by voting in person or by proxy at a meeting of stockholders, or
by written consent.
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Although minority stockholders have no power to alter a controlling stockholder’s
binding decisions absent a fiduciary breach, they are entitled to the benefits of the
formalities imposed by the DGCL, including prompt notification under Section 228(e).
This requirement promotes transparency and enables minority stockholders to stay
abreast of corporate decision making and maintain the accountability of boards of
directors and controlling stockholders.
Closely held corporations: corporations with limited number of shareholders. Family businesses
and startups.
In these businesses, family fractions and interested shareholders, seek to exert control.
Shareholders make arrangements about how they will vote–in particular–for whom they will vote
on to the BoD. Courts allow this type of arrangement and the next case–Ringling, is an example.
Ringling Bros.-Barnum & Bailey Combined Shows v. Ringling
Rule of Law
An agreement between two shareholders in a closely held corporation to vote jointly is
binding and enforceable as a contract.
There were 1000 outstanding shares of Ringling Bros.-Barnum & Bailey Combined Shows
(Ringling Bros.). Edith Conway Ringling (Mrs. Ringling) (plaintiff) owned 315; Aubrey
Ringling Haley (Mrs. Haley) (defendant) owned 315; and John Ringling North (Mr. North)
(defendant) owned 370. Mrs. Ringling and Mrs. Haley entered into an agreement which provided
that they would always vote their shares jointly and in the same way. The agreement provided
that if they could not agree on how to vote their shares, the issue would be submitted to binding
arbitration. At a 1946 annual meeting, the women disagreed on whom to elect to one of the
Ringling Bros. director positions. They agreed that Mrs. Ringling would vote for herself and her
son, and that Mrs. Haley would vote for herself and Mr. Haley. However, they could not agree
on a fifth director. The arbitrator directed the women to cast 4/5 of their votes as provided above,
but the final 1/5 of their votes in favor of a Mr. Dunn. Instead of doing this, Mr. Haley (as proxy
for Mrs. Haley) cast all of Mrs. Haley’s votes for himself and Mrs. Haley, omitting Mr. Dunn.
Mr. North, meanwhile, voted for himself, a Mr. Woods, and a Mr. Griffin as he was entitled to
do since he was not a party to the agreement between Mrs. Ringling and Mrs. Haley. The
chairman of the Ringling Bros. board ruled that the following were elected to the seven-member
Ringling Bros. board: Mrs. Ringling, her son, Mrs. Haley, Mr. Haley, Mr. Dunn, Mr. North, and
Mr. Woods. Thus, Mr. Dunn was elected, and not Mr. Griffin, as would have been the case the
way Mrs. Haley voted in violation of the agreement. At the next stockholders’ meeting, Mr.
Griffin attempted to join in the voting despite the arbitrator’s and the chairman’s ruling and Mrs.
Ringling brought suit, seeking declaratory relief. The Delaware Court of Chancery ruled that the
agreement between Mrs. Ringling and Mrs. Haley was valid and binding and ordered a new
election to be held before a master to see that the terms of the agreement were followed.
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Is an agreement between two shareholders in a closely held corporation to vote jointly a binding
and enforceable contract?
Holding and Reasoning
Yes. A shareholder generally has significant freedom in how he or she votes and an agreement
between two shareholders in a closely held corporation to vote jointly is a binding and
enforceable contract. Although the contract in the current case provided that the arbitration was
binding, there was no enforcement instrument in the contract to make it so. However, by not
voting according to the arbitration, Mr. Haley (on behalf of Mrs. Haley) breached the contract
and Mrs. Ringling is therefore entitled to relief. The court determines that the most appropriate
relief is to reject and invalidate the votes of Mr. Haley. Therefore, because Mrs. Ringling voted
in accordance with the valid contract and because Mr. North was not a party to the contract and
his votes were therefore valid, the court determines that the six people for whom those parties
voted (Mrs. Ringling, her son, Mr. Dunn, Mr. North, and Mr. Woods, and Mr. Griffin) are
elected. This leaves one vacancy on the seven-member board, which the court determines should
be filled at the next annual meeting of Ringling Bros. The decision of the Delaware Court of
Chancery is hereby modified.
This is an example of a contractually enforceable agreement with regards to poll sharing in order
to maximize BoD control.
Is this quarrel legitimate? Yes, but the court says they don’t know what to do as remedies.
This case endorses voting arrangements, cf. with the following case (McQuade), where the
principle is that voting arrangements are perfectly fine, but you need to examine and make sure
that it does not restrict the director’s discretion.
McQuade v. Stoneham
Rule of Law
A contract is void if it requires directors of a corporation to refrain from changing officers,
salaries, or policies or retaining individuals in office without consent of the contracting
Stoneham (defendant) was the majority owner of National Exhibition Company (NEC). McGraw
(defendant) and McQuade (plaintiff) each bought 70 shares of Stoneham’s stock. As part of the
purchase, the three entered into a contract that provided that the parties would “use their best
endeavors” to make sure that each would remain directors of NEC. Stoneham became president
of the board, McGraw vice-president, and McQuade treasurer. Stoneham selected and controlled
the other four directors. McQuade and Stoneham began quarreling about the corporate treasury.
At a board meeting at which the position of treasurer was up for election, Stoneham and
McGraw did not vote, McQuade voted for himself, and the four other directors voted for a Leo
Bondy to succeed McQuade; McQuade thus lost his position as treasurer. At the next board
meeting, the board dropped McQuade as a director. McQuade's removal was due to personal
conflict with Stoneham, not for any misconduct by McQuade. McQuade brought suit for breach
of contract, alleging that Stoneham and McGraw did not use their best efforts to keep him on as a
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director. The defendants claimed that the contract was void because the duty to act in the best
interests of the corporation superseded the contract. The lower courts did not reinstate McQuade
as treasurer but did award him damages for the breach.
Is a contract that requires directors of a corporation to refrain from changing officers, salaries, or
policies or retaining individuals in office without consent of the contracting parties void?
Holding and Reasoning
Yes. A contract that requires directors of a corporation to refrain from changing officers, salaries,
or policies or retaining individuals in office without consent of the contracting parties is void. A
director’s primary duty is to the corporation and its shareholders. Shareholders may combine
their votes to elect directors, but they may not extend this power to limit directors' authority to
run the corporation, such as in the selection of officers or fixing salaries. A contract adding a
concurrent duty to other directors brings with it the likelihood that the director will not always
make personnel decisions in the best interests of the corporation. Accordingly, an outright ban of
such contracts is appropriate so as not to put the courts in a position of judging the motives of
directors in individual cases. In addition, McQuade was also ineligible to be a director because
he was a city magistrate at the time and thus prohibited by law from engaging in other business.
The contract in question is therefore void and the lower courts are reversed.
The contract should be void because McQuade was a city magistrate, but it cannot be argued that
shareholders that own a majority of the outstanding stock in a corporation are lawfully precluded
from joining their shares to exercise control of that corporation. Such shareholders still have a
duty to act in the best interests of the corporation, guided by their personal will. There should be
no legal difference between the joint action in those cases and the contract in this case. The
parties to the contract still have a duty to act in the best interests of the corporation as directors.
As a result, the contract is not inherently illegal; it merely results in a small number of majority
shareholders combining to exercise their control over the corporation.
The power to unite is limited to the election of directors and is not extended to contracts
whereby limitations are placed on the power of directors to manage the business of the
corporation by the selection of agents at defined salaries.
The Court says no, that you cannot limit the directors’ powers in this domain, they must be able
to wield their business judgment.
This shareholder agreement binds the hands of the directors, which essentially interferes with
their business judgment, and it interferes with their ultimate responsible exercise of directors’
fiduciary duties in the larger shareholder community.
It’s an agreement between shareholders, in a closely held corporation, which limits the power
and discretion of the BoD.
Clark v. Dodge
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Professor Webster
Rule of Law
If the enforcement of a contract between directors that are the sole stockholders in a
corporation damages no one, not even the public, it is not illegal.
Clark (plaintiff) owned 25 percent of each of two corporations. Dodge (defendant) owned the
other 75 percent of each. Clark was a director and the general manager of Bell & Co., Inc. (Bell),
one of the corporations. The corporations manufactured medicinal preparations by secret
methods and formulas known only to Clark. Dodge and Clark entered into an agreement that
provided that Clark would disclose the secret formula to a son of Dodge and in return, Dodge
would vote his stock so that (1) Clark would continue to be a director of Bell; (2) Clark would
continue to be the general manager of Bell as long as he was “faithful, efficient and competent;”
(3) during his lifetime, Clark would receive ¼ of the net income of the corporations; and (4) no
unreasonable salaries would be paid to other officers of the corporations which would reduce the
net income. Clark brought suit, claiming that Dodge did not use his stock to maintain Clark as
director and general manager and that Dodge hired “incompetent persons at excessive salaries”
so as to reduce the portion of net income paid to Clark. The appellate court dismissed the
complaint. Clark appealed.
Is a contract between directors that are the sole stockholders in a corporation to vote for certain
people as officers illegal?
Holding and Reasoning (Crouch, J.)
No. The court in McQuade v. Stoneham, 189 NE 234 (1934) effectively held that public policy
and possible detriment to the corporation require that there may be no variation, however slight,
from the idea that the board of directors manages the business of the corporation without any
influence other than the best interests of the corporation. However, this court holds
that McQuade should be limited to the facts in that case because if a contract between directors
that are the sole stockholders in a corporation damages no one, not even the public, it should not
be held to be illegal. The McQuade decision is too restrictive as directors in a closely held
corporation should have the freedom to choose the officers they see fit unless their decision
clearly harms the corporation. In this case, the contract between Clark and Dodge harms no one
and does not interfere with the directors’ ability to manage the corporations with their best
interest in mind. Requirement (1) is a “perfectly legal contract” as Dodge, as stockholder, is
entitled to vote for whomever he chooses as director. Requirement (2) certainly keeps Bell’s best
interests in mind by ensuring that Clark is a faithful, efficient, and competent general manager.
Requirement (3) is proper because the net income of the corporations will only be what is left
after the directors in good faith determine dividends, salaries, etc. And requirement (4) to not
overpay any incompetent employees is clearly a reasonable clause that has the corporation’s best
interests in mind. As a result of the foregoing, the contract between Clark and Dodge does not
fall into the category proscribed by McQuade. The court determines that it is valid and
enforceable. The appellate court is reversed.
See §§ 620 (NY Business Corporation Law), 141(a) and 142(b) of the DGCL on pages 628–29.
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Professor Webster
The law:
Under NY GCL §27, “the business of a corporation shall be managed by its board of directors.”
This case is not the same of McQuade, yet it’s a shareholder agreement that on the face.
Clark is naïve by suing Dodge, and usually winning.
This is a valid contract between the two parties, because there is no other party that would be
negatively affected by this contract.
The point is that there is a mutually agreed upon agreement between two parties, and there is
simply no need to worry about other shareholders, whereas in McQuade, we were talking about
many other shareholders, (the exclusion of the other parties that were not in the shareholder
agreement)  so here, we have two shareholders and that’s why an agreement between them is
Analysis on Page 628:
1. what underlies public policy: two factors, (1) shareholders are not informed enough about
business judgement, and (2) leave it to the directors to run the business.
2. not really clear.
3. An agreement that would have preserved his board position on that capacity, you could limit it
in time, and refresh it every once in a while. You can also put it in the bylaws.
4. the law has been amended, and the requirement is that there must be consent by all
5. employing specific performance under their contract, they can employ specific performance
usefully and productively based on the assumption that the business will not suffer if Clark is
7. Just because he’s efficient, faithful, and competent, it doesn’t mean that you can’t find
someone else to do the job better at a cheaper price.
shareholders agreements requiring the appointment of particular individuals as officers or
employees of the corporation is enforceable, at least for closely held corporations, as long as they
are signed by all shareholders. (Galler v. Galler and Zion v. Kurtz).
voting trust: a device specifically authorized by the corporation laws of most states. Here,
shareholders who wish to act in concert turn their shares over to a trustee. The trustee then votes
all the shares, in accordance with instructions in the document establishing the trust. Voting
trusts are generally made public.
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Professor Webster
Many states have special statutory provisions for closely held corporations. Under the DGCL,
close corporation status may be elected by corporations with not more than 30 shareholders. See
the discussion on LLC and differences in management on page 632.
There is nothing exciting about it.
Galler v. Galler
Rule of Law
In a close corporation, an agreement as to the management of the corporation agreed to by
the directors must be valid where there is no complaining minority interest, no fraud or
apparent injury to the public or creditors, and no violation of clearly prohibitory statutory
Benjamin and Isadore Galler were brothers and equal partners in the Galler Drug Company
(GDC). In 1955, they executed an agreement to ensure that after the death of the one of the
brothers, the immediate family of the deceased would maintain equal control of GDC. In 1956,
Benjamin created a trust with his shares of GDC and named his wife, Emma (plaintiff), as
trustee. Benjamin died in December 1957. Prior to Benjamin’s death, Isadore, Isadore’s wife,
Rose, and Isadore’s son, Aaron (defendants) had decided that they were not going to honor the
agreement. When Emma presented Benjamin’s stock certificates to the defendants to transfer the
certificates into her name, the defendants tried to convince Emma to abandon the agreement.
Emma refused, but agreed to let Aaron become the president of GDC for one year without
interference in exchange for Aaron reissuing Benjamin’s stock in Emma’s name. Subsequently,
Emma demanded enforcement of the terms of the agreement guaranteeing her equal control,
dividends each year, and a continuation of Benjamin’s salary. The defendants refused and Emma
brought suit. The lower court ruled that the agreement was void because “the undue duration,
stated purpose and substantial disregard of the provisions of the Corporation Act outweigh any
considerations which might call for divisibility” of the agreement. The court thus ruled that the
public policy implications of the agreement rendered it void. Emma appealed.
Is an agreement between directors in a close corporation valid if it calls for the election of a
certain person to an office, a minimum dividend to an individual each year, and a continuation of
salary to the successor in interest of a deceased director?
Holding and Reasoning
Yes. In a close corporation, an agreement as to the management of the corporation agreed to by
the directors must be valid where there is no complaining minority interest, no fraud or apparent
injury to the public or creditors, and no violation of clearly prohibitory statutory language. For a
number of reasons due to the nature of close corporations, its directors need to be able to exercise
their control and effectively protect their interests and this is usually done by a detailed
shareholder agreement. The court has upheld a number of such agreements that have “technically
violated” the Business Corporation Act and have done so because of the agreements’ important
role in protecting close corporation shareholders. The agreement in this case is not complained of
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Professor Webster
by a minority interest, fraudulent, injurious to the public or creditors, or a violation of “clearly
prohibitory statutory language.” Accordingly, the court determines that it is a valid agreement
and must be enforced. The court rules in favor of Emma and the appellate court is reversed.
The court finds the agreement and enforces it. Webster believes this case is similar to Clark (as
opposed to McQuade), because Rosenberg does not complain. It also matters to the court, the
fact that you have a noncomplaining agreement. In light of no complaint, is there an assumption
of silence is acquiescence.
What would you do as a judge? why not come to a practical solution.
This contract is bad because it did not have an arbitration clause or an exit clause.
Analysis on page 638:
Q4. the lawyer should communicate with their clients and show the court that you are not going
to put that information in the contract.
Webster: in close corporations, you are likely to experience dissent and resentment, and the way
to get out of that would be to draft an arbitration clause or agreement.
Ramos v. Estrada
Rule of Law
Pooling agreements are valid and may be enforced equitably.
Broadcast Group partnered with another group, Ventura 41, to obtain a permit from the FCC to
run a television station. Each group owned 50 percent of the combined entity, Television, Inc.
The Ramoses (plaintiffs) owned 50 percent of Broadcast Group (and thus 25 percent of
Television, Inc.) and Tila Estrada (defendant) owned 10 percent of the Broadcast Group (five
percent of Television, Inc.). The members of Broadcast Group entered into an agreement to vote
all of their shares in Television, Inc. the same way, as determined by a majority of the members.
The agreement provided that if anyone did not vote with the majority, their shares would be sold
to the other members of the Broadcast Group. Mr. Ramos was elected president of Television,
Inc. at the first meeting of the combined entity, but after that, Estrada “defected” from the
Broadcast Group. She voted with the Ventura 41 members of Television, Inc. to remove Ramos
as president and replace him with a member from Ventura 41. The Ramoses sued Estrada for
breach of contract, seeking specific performance of the agreement, causing her shares to be sold.
The trial court found in favor of the Ramoses and Estrada appealed on the grounds that the
agreement constituted a proxy, which expired when Estrada revoked it.
Are pooling agreements valid if one of the parties seeks to get out of the agreement?
Holding and Reasoning
Yes. Pooling agreements are valid and specifically enforceable even if one of the parties seeks to
get out of the agreement. A pooling agreement does not constitute a proxy that may be revoked
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Professor Webster
by a party at any time. California law states that a proxy is a written authorization giving another
shareholder power to vote with the authorizer’s shares. The Broadcast Group agreement in this
case contains no such authorization. It states the members will consult each other, try to obtain a
consensus, and eventually all vote according to the majority of the group. This in no way creates
a proxy. The agreement is valid and should be specifically enforced with the sale of Estrada’s
shares to the other members of the Broadcast Group. The trial court is affirmed.
The vote pooling agreement is perfectly legit, per Clark and Lingling.
These vote pooling arrangements are VALID even if firm is NOT a statutory Close Corporation.
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Professor Webster
Not on the exam, but you have to know for the bar.
Wilkes v. Springside Nursing Home, Inc.
Rule of Law
Majority shareholders in a close corporation owe minority shareholders a strict duty of the
utmost good faith and loyalty, unless a legitimate business purpose can be demonstrated to
justify a breach of that duty.
Wilkes (plaintiff), Riche, Quinn, and Connor were the four directors of the Springside Nursing
Home, Inc. (Springside) (defendant), each owning equal shares and having equal power within
the corporation. Eventually the relationship between Wilkes and the other three directors
(defendants) soured. When Springside became profitable, the defendants voted to pay out
salaries to themselves, but did not include Wilkes in the group to whom salary would be paid.
Then, at an annual meeting, Wilkes was not reelected as director and was informed that he was
no longer wanted in the management group of Springside. Over the course of these events,
Wilkes faithfully and diligently carried on his duties to the corporation. Wilkes brought suit
against the defendants for breach of their fiduciary duty owed to him. The lower court dismissed
Wilkes’s complaint. He appealed.
Are majority shareholders in a close corporation liable for breach of a fiduciary duty to a
minority shareholder if they remove him from office and cut off his salary without any showing
of misconduct?
Holding and Reasoning
Yes. Majority shareholders in a close corporation owe minority shareholders a strict duty of the
utmost good faith and loyalty, unless a legitimate business purpose can be demonstrated to
justify a breach of that duty. Where no legitimate business purpose can be shown, the majority
shareholders are liable for their breach of that duty. In this case, there has been no showing of
misconduct or poor performance in Wilkes’s role as director. It was merely a “personal desire”
of the defendants to remove Wilkes from office and deny him salary. The defendants’ actions
constitute an unlawful corporate freeze out and because they did not show any legitimate
business purpose for the freezing out of Wilkes, they are liable for breach of their fiduciary duty
to him. The lower court is reversed, and the case is remanded for a final determination on
The imposition of the duty of strict good faith upon the majority shareholders for the minority
Takeaway: shareholders in close corporations are somewhat akin to partners.
1. Shareholders in close corporations owe each other a duty of strict good faith.
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Professor Webster
2. if challenged by a minority shareholder, a controlling group of must show a
3. A plaintiff minority shareholder can prevail if she can show that the controlling group
could have accomplished its business objective in a way that harmed her interests less.
Ingle v. Glamore Motor Sales, Inc.
Rule of Law
A minority shareholder in a close corporation, by that status alone, acquires no right from
the corporation or majority shareholders against discharge from his employment in the
Ingle (plaintiff) was one of four directors and shareholders of Glamore Motor Sales, Inc. (GMS)
(defendant); Ingle was also GMS’s sales manager. Ingle did not have an employment contract
that specified any kind of employment duration. The other three directors/shareholders were
James Glamore and his two sons (defendants). The four directors entered into an agreement that
provided that if “any Stockholder cease[d] to be an employee of the Corporation for any reason,”
James Glamore would have the option to purchase all the shares owned by that stockholder.
Subsequently, Ingle was voted out of his director position and fired from his job at GMS. Ingle
brought suit, alleging a breach of fiduciary duty and arguing that as a minority shareholder in a
close corporation his employment rights are attached to the fiduciary duties owed to him. The
lower courts dismissed the complaint and Ingle appealed.
Does a minority shareholder in a close corporation, by that status alone, acquire a right from the
corporation or majority shareholders against discharge from his employment in the corporation?
Holding and Reasoning
No. A minority shareholder in a close corporation, by that status alone, acquires no right from
the corporation or majority shareholders against discharge from his employment in the
corporation. The duty a corporation owes to a shareholder as a shareholder is different from a
duty that the corporation might owe to a shareholder as an employee. Here, Ingle did not present
any evidence of an employment contract setting a definite duration of his employment. As a
result, he was simply an employee at will of GMS and the defendants had a right to terminate his
employment at any time. By doing so, they did not violate any fiduciary duty to Ingle as the
signed shareholder agreement provided that his shares would be eligible to be sold upon
termination of his employment. His employment was not tied to his role as director. The lower
courts are affirmed.
The employment of a minority shareholder in a close corporation is not the same as an ordinary
employer-employee relationship. A person who buys a minority interest in a close corporation
does so as an investment and often with the expectation of continued employment. The
defendants in this case effectively freeze out Ingle and the majority allows them to do so by not
affording him the general protection and fiduciary duties that should be afforded to minority
shareholders in close corporations.
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Professor Webster
One of the things that distinguish a close corporation from others is the fact that there is no
market for close corporations. So, when Ingle received that $100k payment shows that he
received the protection needed, as he argues. Accordingly, the court argues that he was an
employee only.
Brodie v. Jordan
Rule of Law
The proper remedy for a freeze out is to restore to the minority shareholder the benefits
from the corporation that she reasonably expected but did not receive due to the breach of
fiduciary duty.
Walter Brodie (Walter), Barbuto, and Jordan were the three directors of Malden, a Massachusetts
corporation. Each held one-third of the shares of the corporation. As Walter got older and wanted
to be less involved, he requested multiple times that Barbuto and Jordan (defendants) buy out his
shares. They refused. Neither the articles of organization nor corporate bylaws called for a
buyout obligation upon request. Eventually Walter was voted out as president and director of
Malden and died five years later. Walter’s executrix (Brodie) (plaintiff) inherited Walter’s shares
in Malden. Upon her requests, the defendants repeatedly failed to provide her with various
company information. In addition, Brodie nominated herself as director, but was voted down by
the defendants. Brodie also requested that the defendants buy out her shares, but they again
declined. Brodie brought suit for breach of fiduciary duty. The Massachusetts Superior Court
held that the defendants’ actions constituted a “freeze out” and ordered the defendants to buy out
Brodie’s shares. The defendants appealed, but only on the issue of the buyout order.
Should a minority shareholder reasonably expect that the majority shareholders should be forced
to buy out her shares upon request?
Holding and Reasoning
No. Stockholders in a close corporation owe to one another a duty of the utmost good faith and
loyalty. When that duty is breached in the form of a freeze out, the proper remedy is to restore to
the minority shareholder the benefits from the corporation that she reasonably expected but did
not receive due to the breach. Absent applicable language in a corporation’s articles of
organization or bylaws, a forced buyout of the minority shareholder’s shares would exceed the
minority shareholder’s reasonable expectations. There is no applicable law that would indicate
otherwise. Therefore, because there is nothing in Malden’s articles of organization or bylaws that
calls for a forced buyout upon request, the Massachusetts Superior Court’s order exceeds
Brodie’s reasonable expectations and is an overreaching remedy. The Massachusetts Superior
Court effectively created an artificial market for Brodie’s shares when in a close corporation,
there is by definition no such market. As a result of the foregoing, the Massachusetts Superior
Court is reversed, and the case is remanded for a proper determination on damages.
Smith v. Atlantic Properties, Inc.
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Professor Webster
Rule of Law
A minority stockholder in a close corporation that requires a unanimous vote for corporate
action may not repeatedly vote against an action for personal reasons if the action would be
in the best interest of the corporation.
Louis Wolfson (defendant), Paul Smith, Abraham Zimble, and William Burke each owned 25
percent of the outstanding shares of Atlantic Properties, Inc. (Atlantic). Atlantic’s bylaws stated
that no corporate action could be taken without an affirmative vote of 80 percent of the
outstanding stock. This provision effectively meant that any decision could be vetoed by one of
the four partners. When Atlantic began to turn a profit, Smith, Zimble, and Burke (plaintiffs)
wanted to declare dividends. Wolfson, however, repeatedly voted against declaring dividends,
instead wanting to devote the funds to repairs on the property. The plaintiffs agreed to devote a
moderate amount of the funds to repairs but maintained that declaring dividends was the correct
approach. Eventually, Atlantic accumulated so much profit that they were in excess of the IRS
limits, which provided that at a certain point of profit, corporations must declare dividends.
Wolfson still refused to vote in favor of declaring dividends and because of the 80 percent
provision, Atlantic was not able to do so. The IRS accordingly assessed penalties against Atlantic
for seven straight years, with Wolfson still refusing to give in. After about four years of the IRS
penalties, the plaintiffs brought suit, seeking reimbursement to Atlantic from Wolfson for the
IRS penalties. The Massachusetts Superior Court found in favor of the plaintiffs, holding that
Wolfson’s actions were based in part on a desire to avoid tax payments and that Wolfson failed
to present a definite program for repairs that would satisfy an IRS inquiry into the dividend
matter. Wolfson appealed.
May a minority stockholder in a close corporation that requires a unanimous vote for corporate
action repeatedly vote against an action for personal reasons if the action would be in the best
interest of the corporation?
Holding and Reasoning
No. Stockholders in a close corporation owe to one another a duty of the utmost good faith and
loyalty. Because of the nature of close corporations, majority stockholders may actually require
protection from minority stockholders in some cases. In any case, each director in a close
corporation carries the same fiduciary duty. In the present case, the 80 percent provision as it was
carried out made Wolfson the de facto majority stockholder because his became the controlling
interest. By refusing to vote for dividends, the refusal of which resulted in IRS penalties,
Wolfson acted unreasonably and not in the best interest of the corporation. He breached his
fiduciary duty of good faith and loyalty to the plaintiffs and is therefore liable to Atlantic for the
IRS penalties incurred. The Massachusetts Superior Court is affirmed.
Majority shareholders may owe a fiduciary duty to each other to protect their own interest.