Chapter 20 Starting a Business
Things to consider when deciding business forms
 Liability protection
 Tax treatment
 Ease of formation/maintenance
 Ability to raise capital
 Making a positive impact on society and the environment-for those of you interested in benefit corporations.
Sole Proprietorship: An unincorporated business owned by one person. It is the most common form of business (72% of
all businesses). It can have employees, but only one owner.
 Pros
o Can run a business without taking any formal steps
o Not required to register with the government
o Not required to file a separate tax return. The business itself does not pay taxes; the owner pays personal
income tax on all business profits.
 Cons
o The owner is responsible for all of the business’s debts. If ExSciTe cannot pay its suppliers or a student is
injured by an exploding cabbage, Linda is personally liable. She may have to sell her house to pay the
debt.
o The owner of a sole proprietorship has limited options for financing the business. Debt is generally her
only source of working capital because she has no stock or memberships to sell.
General Partnership: An unincorporated association of two or more co-owners who operate a business for profit.
 Pros
o Partnerships are flow-through entities: The partnership itself does not pay income tax; instead, the profits
pass through to the partners, who report it on their personal returns.
o Easy to form: Nothing is required in the way of forms or filings or agreements.
 Cons
o A partner is personally liable for the debts of the enterprise and for the acts of the other partners.
*Case: Marsh v. Gentry
Fact: Tom Gentry and John Marsh were partners in a business that bought and sold racehorses. The partnership paid
$155,000 for Champagne Woman, who subsequently had a foal named Excitable Lady. The partners decided to sell
Champagne Woman at Keeneland, the world’s premier thoroughbred horse auction. Gentry personally purchased the two
horses without telling Marsh that he was the buyer.
Issue: Did Gentry violate his fiduciary duty when he bought partnership property without telling his partner?
Decision: Admittedly, at an auction sale, the specific identity of a purchaser cannot be ascertained before the sale, but
[Kentucky partner- ship law] required a full disclosure by Gentry to Marsh that he would be a prospective purchaser. As
to the private sale of Excitable Lady, Marsh consented to a sale from the partnership, at a specified price, to the
prospective purchaser in California. Even though Marsh obtained the stipulated purchase price, a partner has an absolute
right to know when his partner is the purchaser.
Regular Corporations (C corporation): Regular corporations account for about 18% of all businesses.
 Pros
o Limited liability: Protects managers and investors from personal liability for the debts of the corporation
and the actions of others.
o Transferability of interests-easy to do. As we will see, partnership interests are not transferable without
the permission of the other partners, whereas corporate stock can be bought and sold easily.
o Duration: Perpetual existence-can continue without their founders.
 Cons
o Logistics: Corporations involve a lot of expense and effort to create and operate.
o Taxes: Because corporations are taxable entities, they must pay taxes and file returns.
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Corporations are taxed at 21% and then each shareholder is again taxed on dividends at a rate of
15%. With a taxable entity, that dollar is taxed twice before it is deposited by a shareholder.
Limited Liability Companies (LLCS): An LLC offers the limited liability of a corporation and the tax status of a
partnership (very few companies are organized this way)
 Pros
o Limited liability: Members are not personally liable for the debts of the company.
o Tax status: Income flows through the company to the individual members, avoiding double taxation of a
corporation.
o Flexibility: Can have members that are corporations, partnerships, or nonresident aliens.
o Duration: LLC can continue in operation even after a member withdraws (example: death, resignation, or
bankruptcy)
o Ease of formation: Need a charter and operating agreement
 Charter is the certificate of organization, which contains basic information such as name and
address.
 Operating agreement sets out the rights and obligations of the members.
 Cons
o Newer form of business and there are still legal uncertainties as to how corporate law applies.
o Going public: Loses its favorable tax status and is taxed as a corporation, not a partnership.
o Transferability of interests: Members must obtain the unanimous permission of the remaining members
before transferring ownership rights. The unanimous (全体同意) permission of all members is required to
admit a new member or to sell any existing member’s ownership rights.
 Piercing the Company Veil: Limited liability is one of the great advantages of an LLC. However, if members
abuse their rights, a court may remove that protection by piercing the company veil. A court will hold members of
an LLC personally responsible for the debts of the organization if there is:
o Failure to observe formalities: Members must treat the LLC like a separate organization. Thus, if an
LLC enters into an agreement (particularly with a member), a legitimate contract needs to be signed.
o Commingling (混合) assets: This trap is the most dangerous. An LLC and its members must keep their
assets separate. If courts cannot tell who owns what, they are likely to let creditors take assets of both the
organization and its members.
o Failure to provide adequate capital: In extreme cases, if an LLC is established without enough capital
to run its business, then a court may look to the members' assets. An LLC had capital of only about
$20,000 but proceeded to borrow millions of dollars from one of the members. That ratio looked wrong to
the court; not leaving enough capital in the business to pay out its obligations.
o Fraud: Courts will not protect fraudsters who try to use an LLC as a shield against liability for their
wrongdoing.
Case*: BLD Products v. Technical Plastics of Oregon
Fact: Mark Hardie was the sole member of Technical Plastics of Oregon, LLC (TPO). Hardie regularly used TPO’s
accounts to pay such expenses as landscaping and housecleaning. TPO also paid some of Hardie’s personal credit card
bills, loan payments on his Ford truck, the expense of constructing a deck on his house, his stepson’s college bills, and the
cost of family vacations. At the same time, Hardie deposited cash advances from his personal credit cards into the TPO
checking account. Hardie did not draw a salary from TPO. When the company filed for bankruptcy, it owed BLD
Products approximately $120,000 for goods that it had purchased. BLD filed suit asking the court to pierce TPO’s
company veil and hold Hardie personally liable for the organization’s debts.
Issue: Should the court pierce TPO’s company veil? Should Hardie be personally liable for TPO’s debts?
Decision:
We have characterized that formulation [for piercing a company veil] as a three-part test:
1. The defendant controlled the debtor [company]
Yes
2. The defendant engaged in improper conduct, and
Yes. Hardie uses the business account to pay personal expenses.
3. As a result of that improper conduct plaintiff was unable to collect on a debt against the insolvent [company].
I cannot determine as a matter of law that the inability to pay the entire $120,000 debt was due to Hardie’s
improper conduct over the years. Consequently, I grant partial summary judgment that BLD is entitled to pierce
the [company] veil, making Hardie personally liable, but that the amount for which Hardie is personally liable
will have to be determined by the jury.
S Corporations: A type of corporation with a special S designation by the IRS. Shareholders of S corps have both the
limited liability of a corporation and the tax status of a flow-through entity. Congress created S corporations to encourage
entrepreneurship through tax breaks.
 Pros: Shareholders of S corps have:
o The limited liability of a corporation
o The tax status of a partnership
 Cons
o There can only be one class of stock.
o There can be no more than 100 shareholders.
o Shareholders cannot be partnerships or other corporations.
o Shareholders must be U.S. citizens or residents.
o Shareholders must all agree that company should be an S corporation.
Close Corporation: A private company whose stock is not publicly traded and usually has no more than 50 shareholders.
 Common provisions of close corporations:
o Protection of minority shareholders: As there is no public market for the stock of a close corporation, a
minority shareholder who is being mistreated by the majority cannot simply sell his shares and depart.
Therefore, close corporation laws typically protect minority shareholders by providing that majority
shareholders owe them a fiduciary duty. In addition, the charter of a close corporation may require a
unanimous vote of all shareholders to choose officers, set salaries, or pay dividends. It could also grant
each shareholder veto power over all important corporate decisions.
o Transfer restrictions: The shareholders of a close corporation often need to work closely together in the
management of the company. Therefore, the charter may require that a shareholder first offer shares to the
other owners before selling them to an outsider. In that way, the remaining shareholders have some
control over who their new co-owners will be.
o Usually are family owned and operated
Social Enterprises: A new business form created under state law, very few states allow for this. Social enterprises pledge
to behave in a socially responsible manner, even as they pursue profits. (Thus, they are not nonprofits.) Their focus is on
the triple bottom line: “people, planet, and profits.” The goal of the business is to make a profit + social mission.
 Social Mission is part of the Articles of Organization
o Legal duty to pursue that social mission
o Board of Directors must include Benefits Director
 Benefits directors are professionals who plan and direct the overall design, implementation, and
administration of an organization's health and welfare benefits programs.
 Different duty to shareholders
o Such companies are not required to maximize shareholder returns but may instead trade off profitability
for social responsibility, in the process benefiting their stakeholders (investors, employees, suppliers,
customers, creditors), the community, and/or the environment.
Chapter 21 Corporations
The Incorporation Process
 Where to incorporate? Companies generally incorporate either in:
o The state where they conduct most of their business or if they want to operate in multiple states, they
incorporate in Delaware. Delaware offers several advantages:
 Laws that favor management
 An efficient court system: Delaware has a special court (called "Chancery Court") that hears
nothing but business cases and has judges who are experts in corporate law.
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An established body of law: Because so many businesses incorporate in the state, its courts hear
many corporate cases, thus creating a large body of precedent that makes the law more
predictable.
Neutral ground: Because few businesses are actually based in Delaware, it is a neutral place in
which to do battle.
*You can incorporate your business anywhere you want but you must abide by the laws of the
different states in which your business operates and register your business there.

The Charter, also referred to as Articles of Incorporation or Articles of Organization.
o It defines the corporation, including:
 Name of corporation: Need Corporation, Incorporated, Company or Limited after the name.
 Address and registered agent: A company must have an official address in the state in which it
is incorporated so that the secretary of state knows where to contact it and so that anyone who
wants to sue the corporation can serve the complaint in-state. Because most companies
incorporated in Delaware do not actually have an office there, they hire a registered agent to serve
as their official presence in the state.
 Incorporator: Person who signs the charter and delivers it to the Secretary of State.
 Directors and officers
 Purpose
 Stock (Type and amount)

Issuing Stock
o Preferred stock: The owners have preference on dividends and in liquidation.
o Common stock: Preferred stock owners receive dividend and liquidation payments before common
shareholders, but the common stockholders have more voting rights.
o Stock can contain virtually any combination of the following features (established in the charter):
 Dividend rights: The charter establishes whether and when the shareholder is entitled to
dividends.
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Liquidation (清算) rights: The charter specifies the order in which classes of stockholders will
be paid upon dissolution (解散) of the company.
Conversion rights: Some classes of stock may have the right to convert into shares of a different
class. Many companies issue preferred shares to early investors that can convert into common
stock.
Voting rights: These rights can vary among different classes of stock.
After Incorporation: Electing Officers and Directors
 To elect directors, the shareholders can hold a meeting or elect directors by written consent.
 Once the directors are elected, the directors can elect/appoint the officers of the corporation by meeting or written
consent.
 Officers include, CEO/President, CFO or Treasurer, VP, Secretary and Chairperson of the Board.
 Corporate Documents
o Minute book: A book that contains the official record of a corporation’s actions.
o Bylaws: A document that specifies the organizational rules of a corporation or other organization such as
when shareholder meetings are held and what constitutes a quorum.
 Quorum: The percentage of voters who must be present for a meeting to count.
 Written consent: A signed document that takes the place of a shareholder’s or director’s
meeting.
Death of a Corporation
 Voluntary: Shareholders elect (选择) to terminate the corporation
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Forced: By court order; a court may also dissolve a corporation or order that it be sold, if it is insolvent (破产) or
if its directors and shareholders cannot resolve conflict over how the corporation should be managed.
Piercing the corporate veil: A court holds shareholders personally liable for debt of a corporations under four
circumstances:
o
o
o
o
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Failure by the shareholders to observe corporate formalities, such as paying fees or making required
filings
Commingling of personal and corporate assets
Capitalization so inadequate that the organization cannot pay its reasonable debts, or
Fraud
Terminating a corporation is a three-step process:
o Vote: The directors recommend to the shareholders that the corporation be dissolved and a majority of
shareholders agree.
o Filing: The corporation can file “Articles of Dissolution” with the Secretary of State.
o Winding up (清算): The officers of the corporation pay its debts and distribute the remaining property to
shareholders. When winding up ceases, so does the corporation.
Management Duties
 First and foremost, officers and directors have a fiduciary duty to act in the best interests of the shareholders.
However, there are other/competing interests as well.
 Stakeholders: Anyone who is affected by the activities of a corporation, such as shareholders, employees,
customers, creditors, suppliers
 The Business Judgment Rule (BJR)
o A judicially created presumption that officers, and directors make informed decisions in good faith and in
the honest belief that their conduct was in the best interests of the company. If managers comply with the
business judgment rule, a court will not hold them personally liable for any harm their decisions cause the
company or rescind their decisions.
o Accomplishes three goals:
 Permits directors to do their job: If directors were afraid they would be liable for every decision
that led to a loss, they would never make a decision, or at least not a risky one.
 Keeps judges out of corporate management: Shareholders would generally prefer that their
investments be overseen by experienced corporate managers, not judges. Without the business
judgment rule, judges would be tempted, if not required, to second-guess managers' decisions.
 Encourages directors to serve: No one in their right mind would serve as a director if they knew
that every decision was open to attack in the courtroom.
o Duty of Loyalty
 To act in good faith (good intention for the corporation)
 For a lawful purpose
 To act without a conflict of interest
 To advance the best interests of the corporation
o Duty of Care
 To act with the care that an ordinarily prudent person would take in a similar situation
o Corporate opportunity: Prohibits officers, directors, and controlling shareholders from excluding their
company from favorable deals. Managers are in violation of the corporate opportunity doctrine if they
compete against the corporation without its consent. To avoid liability, a manager must first offer an
opportunity to disinterested directors and shareholders, and only if they turn it down does the manager
have the right to take advantage of the opportunity himself.
o Self-dealing: The self-dealing rules prevent managers from forcing their companies into unfair deals. A
manager makes a decision benefiting either himself or another company with which he has a relationship.
When a manager engages in self-dealing, the Business Judgment Rule no longer applies.
Case*: In re Dole Food Co.
Fact: Dole Food Co. was one of the world’s largest producers of fresh fruit and vegetables. David Murdock originally
owned all of Dole but, after encountering financial difficulties, he sold 60 percent of the company to the public in an IPO.
After the sale, he was a controlling shareholder, chairman, CEO, and comptroller. Michael Carter served as president,
COO, and general counsel. Almost immediately after the IPO, Murdock began plotting to buy out the public
shareholders—as cheaply as possible. Four years after the public offering, he offered to purchase the public shares for
$12.00 each (a 50¢ discount from the IPO price). Under Delaware law, a purchase offer from a controlling shareholder
had to be approved by a committee of the independent members of the company’s board (the Committee) and also by the
other shareholders. Murdock and Carter immediately began efforts to make the purchase offer look good by driving down
Dole’s share price with false information about the company. To the public, Carter announced substantially worse cost
estimates than the two men truly expected. To the Committee, he presented low-ball, five-year financial projections that
he had manipulated to look worse than they were. The false predictions did, indeed, cause Dole’s stock price to fall. At the
same time, other companies were interested in buying Dole stock. But Murdock refused to consider outside offers,
regardless of what was best for the other shareholders. He did, however, raise his offer to $13.50. The Committee, the
board, and 50.9 percent of the other shareholders voted in favor of the sale. But some Dole shareholders sued Murdock
and Carter, alleg- ing that they had violated the business judgment rule and were, therefore, personally liable for the
difference between the price Murdock paid for Dole stock and a “fair” price. Dole’s charter had an exculpatory clause
providing that: “no director of the Corporation shall be personally liable to the Corporation or its stockholders for
monetary damages for breach of fiduciary duty as a director.”
Issue: Did Murdock pay a fair price for the Dole stock? Were Murdock and Carter liable under the business judgment
rule?
Decision: The concept of fairness has two basic aspects: fair dealing and fair price. A calculated effort to depress the
market price of a stock until the minority stockholders are eliminated constitutes unfair dealing. Not a fair price as well
because by engaging in fraud, Carter deprived the Committee of its ability to obtain a better result on behalf of the
stockholders, prevented the Committee from having the knowledge it needed to potentially say “no,” and foreclosed the
ability of the stockholders to protect themselves by voting down the deal. As Dole’s controlling stockholder, Murdock
breached his duty of loyalty to the plaintiff shareholder class. For that breach of duty Murdock is liable. Murdock is also
liable in his capacity as a director. He breached his duty of loyalty by orchestrating an unfair, self-interested transaction.
Carter is personally liable both as a director and as an officer. Carter is not entitled to exculpation in his capac- ity as a
director because he breached his duty of loyalty to the corporation and its stockholders and his acts and omissions were
not in good faith.
Case*: Marchand v. Barnhill
Fact: Blue Bell Creameries manufactured ice cream. Paul Kruse was Blue Bell’s president, CEO, and chairman of the
board. His cousin Greg Bridges was the vice president of operations. The federal Food and Drug Administration (FDA)
and state governments regulate food safety. For four years, these regulators found a series of troubling compliance failures
in Blue Bell’s factories. The board of directors had no procedures for monitoring food safety issues because Kruse and
Bridges reported to it only the positive safety findings from regulators. That fictional world survived until Texas health
inspectors found listeria in Blue Bell ice cream and ordered a partial recall. The board was informed of the recall but was
told, “More information is developing and should be known within the next days or weeks.” Instead of calling for more
frequent emergency board meetings to receive constant updates about the life-threatening products, Blue Bell's board took
no action. Two months later, Blue Bell was forced to recall all of its products. Eight customers became sick from listeria;
three of them died. Shareholders sued Kruse, Bridges, and the board of directors for breaching their duties of care and
loyalty. The lower court dismissed their claim on the grounds that these officers and directors had fulfilled their required
duties by undertaking some monitoring and reporting. The shareholders appealed.
Issue: Did the officers and directors violate their duties of loyalty and care?
Decision: We are focusing on whether the board [undertook] good faith efforts to put a board-level system of monitoring
and reporting in place. Where, as here, no reasonable compliance system and protocols were established as to the
obviously most central consumer safety and legal compliance issue facing the company, the board’s lack of efforts
resulted in it not receiving official notices of food safety deficiencies for several years, and that, as a failure to take
remedial action, the company exposed consumers to listeria-infected ice cream, resulting in the death and injury of
company customers, the plaintiff has [made a reasonable] claim.
Shareholder Rights
 Right to information: Shareholders with a proper purpose have the right to inspect and copy corporation’s
financial statements, accounting records, minutes of board meetings and shareholder lists.
 Right to vote: Corporation must have at least one class of stock with voting rights. Shareholders can vote
themselves or by proxy (委托人).
 Appraisal rights: If undertakes a fundamental change lie the sale of assets or a merger, the company must buy
back the shares at a fair value to shareholders (unlike what happened in Dole).
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A company must seek shareholder approval in the following circumstances: Dissolution, amendments (修改) to
the charter, amendments to the bylaws, mergers, sale of assets
Election & Removal of Directors
o The election process begins with the nominating committee of the board presenting a slate of directors to
the shareholders. Shareholders can either vote in favor or withhold their vote. Directors are voted in by
plurality voting—at least one vote.
o Recently many large companies are now requiring majority voting, so directors would have to resign if
more than half of the shareholders withhold their vote.
Independent Directors
o Independent directors are members of the board who are not employed by the company and do not have
close ties to the CEO. For publicly traded companies, independent directors must comprise:
 The majority of the board
 The entire audit committee (and at least three members must be financially literate: the ability to
understand and effectively use various financial skills); and
 The entire compensation, corporate governance, and nominating committees.
Executive Compensation
o Why are corporate executives allowed to be paid so much?
 Other people’s money: The company is paying for the compensation.
 Benchmarking: You want to pay your CEO the same rate as other companies in the industry
because you want to incentivize them to stay.
 Competitive Market: Pay is set by the market
 Cooperative Culture: When they are up for re-election, shareholders are unlikely to withhold their
vote and, should that happen, fellow board members may well let them stay on anyway.
 Data manipulation: Seek the advice of a compensation consultant. These advisors have no
incentive to skimp: if the CEO likes their recommendations, they may be hired to advise on the
firm’s pension or healthcare plan.
 Rationalization: If a company's stock price is doing well, then, by all means, the executives must
be rewarded to keep them from jumping ship. But, if the company is performing poorly, the
officers also need to be rewarded-you guessed it-to keep them from jumping ship.
 Judicial Deference: Courts are highly reluctant to overrule a board in compensation cases.
Solutions to Excessive Pay
o Independent lead director: Independent members of the board must meet regularly without management
presence.
o Clawbacks: The SEC has a right to clawback some CEO and CFO compensation if misconduct on the
part of any employee causes the company to restate its financials (if the CEO is cooking the book, very
rare).
o Disclosure: Public companies must now disclose the compensation of their executives and board
members as part of their annual reports.
o Say-on-pay: At least once every three years, companies must take a non-binding shareholder vote on the
compensation of the five highest-paid executives.
Case*: Raul v. Rynd
Fact: Hercules Offshore, Inc., provided drilling services to the oil and natural gas industry. After a year in which its
financial results and stock price had declined substantially, the Hercules board unanimously approved a compensation
plan that raised executive pay by between 40 and 190 percent. In the required say-on-pay vote, Hercules shareholders
were not feeling too aligned: 59 percent of them voted against the plan. The board ignored the vote and went ahead with
the plan anyway. A Hercules shareholder brought suit alleging that the board had breached its fiduciary duty. He also
alleged that the compensation plan violated the company’s pay-for-performance philosophy as outlined in the proxy
statement. Hercules filed a motion to dismiss.
Issue: Did the Hercules board violate its fiduciary duty when it implemented the compensation plan?
Decision: Plaintiff relies heavily on the fact that the Hercules shareholders voted against the executive compensation plan
yet the Board thereafter did nothing to rescind or modify that plan in response. However, [the Dodd-Frank statute]
explicitly states that say-on-pay votes “shall not be binding” on a company or its board of directors. Dodd-Frank also
explicitly states that the results of say-on-pay votes may not be construed in any of the following ways: (1) as overruling a
decision by a company or its board of directors; [or] (2) to create or imply any change to the fiduciary duties of a company
or its board of directors. Plaintiff’s allegations and arguments fail to recognize these realities of Dodd-Frank.
Plaintiff also relies heavily on his view that Hercules has adopted a strict pay-for-performance policy. It is true that
Hercules’s Proxy Statement explains that pay for performance is part of the philosophy and objectives of the Company’s
compensation programs. However, the same statement also identifies other goals. One of these goals merits particular
discussion in light of Plaintiff’s allegations. This is the Company’s goal of retaining its executive officers, a goal that may
have taken on increased importance precisely because of the difficult financial circumstances in which the Company
found itself.
In addition, Plaintiff’s allegations incorrectly presume that executive compensation is solely awarded retrospectively. As
is common practice in executive compensation, the Proxy Statement makes clear that much of the Company’s executive
compensation is prospective. Hence, Plaintiff’s characterization of the Hercules executive compensation policy as
essentially mandating a strong correlation between certain financial aspects of the Company’s performance and the
compensation of the Company’s executives is incorrect.
The Hercules Motion to Dismiss is GRANTED.

Enforcing Shareholder Rights
o Derivative lawsuits (on behalf of all shareholders and target management)
 Brought by shareholders to remedy a wrong that the board of directors has committed against the
corporation (ask permission of the directors to file a lawsuit).
 First, shareholders must make a demand on the directors in order to file a derivative lawsuit. The
only way to overcome this requirement is to show that demand is futile (it is not useful because
the directors themselves are responsible for the wrongdoing) because directors violated duty of
care, duty of loyalty as required by business judgment rule.
o Direct lawsuits (individual shareholder has an issue with the company)
 Shareholders are permitted to sue the corporation directly only if their own rights have been
harmed.
Chapter 22 Securities Regulation
Securities and Exchange Commission (SEC)
 SEC was created in 1934 to regulate the securities industry.
 What is a security? Any transaction in which the buyer invests money in a common enterprise and expects to earn
a profit predominately from the efforts of others.

What are common types of securities? Stock, bonds, notes, debentures, evidence of indebtedness (债务),
certificates of interest or participation in any profit-sharing agreement, and 18 other equivalents.
o
Debentures (公司债券): In corporate finance, a debenture is a medium- to long-term debt instrument used
by large companies to borrow money, at a fixed rate of interest.
Securities Act of 1933
 Requires that before offering or selling securities, the issuer must register the securities with the SEC unless the
securities qualify for an exemption.
 Issuer: A company that sells its own stock.
 When an issuer registers securities, the SEC does not investigate the quality of the offering. It simply ascertains
that, on the surface, the company has disclosed all required information about itself and the security it is selling.
The guiding principle of the federal securities laws is that investors can make a reasoned decision on whether to
buy or sell securities if they have full and accurate information about a company and the security it is selling.
 Exemptions
o Exemptions from registration – Issuer must determine whether they are exempt from the registration
under the 1933 Act.
o Based on two factors: Type of security and type of transaction
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Exempt Securities: Government securities, bank securities, non-profit issues (religious,
charitable organizations), and insurance policies and annuity contracts (governed by insurance
laws).
 Exempt Transactions
 Section 4(2) of the 1933 Act exempts from registration transactions by an issuer not
involving any public offerings.
 Private offerings: A sale of securities in which the issuer provides less disclosure in
return for selling less stock, to fewer (often wealthier) investors, than in a public offering.
 The most popular private placement is Regulation D. There are three different types of
private offerings under Reg. D-Rule 504, 505 or 506.
o Generally speaking, companies can raise money through Regulation D without a
public offering subject to these limitations:
 The offering must be to accredited, sophisticated investors—institutions
or wealthy individuals who can assess the risks of the offering.
 The securities must be purchased for investment purposes and cannot be
sold for one year.
Public Offerings
o Initial public offering (IPO): A company’s first public sale of securities.
o Secondary offering: Any public sale of securities by a company after the initial public offering.
 Firm commitment underwriting: The underwriter (Investment Bank) buys stock from the issuer
and sells it to the public.
 Best efforts underwriting: The underwriter does not buy the stock from the issuer but instead
acts as the issuer’s agent in selling the securities.
Registration statement (form S-1)
o Two purposes of the registration statement: (1) Notify the SEC that a sale of securities is pending (2)
Disclose information to prospective purchasers
 Prospectus: what the buyers of securities receive
 Sales effort: investment bank can solicit offers (advertise for the company, create buzz)
 Going effective: once SEC reviews the preliminary registration statement, the issuer and
underwriter agree on a price of the stock and sale begins.
o Registration Statement contains the prospectus, which must be delivered to anyone who buys the
securities. It also contains the following information:
 Description of company’s business, properties, and competition
 Description of risks of investing
 Discussion and analysis of financial condition
 Identity of officers and directors and compensation
 Description of material transactions involving officers, directors and shareholders
 Description of material legal proceedings
 Description of plan and use of the proceeds of the offering
Liability Under the 1933 Act
o Issuers can violate the 1933 Act in three ways:
 Selling securities that are neither registered nor exempt.
 Fraud-lying about the securities.
 Errors in the registration statement. Material means important enough to affect an investor’s
decision. If these errors are material, the purchase can recover against anyone who signed the
registration statement. This list includes the issuer, its directors and chief officers, experts (such
as auditors, engineers, or lawyers), and the underwriters.
Securities Exchange Act of 1934
 Registration requirements – An issuer must register with the SEC if:
o It completes a public offering under the 1933 Act.
o Its securities are traded on a national exchange like the NYSE and NASDAQ.
o The 1934 Act also mandates periodic disclosures.
 Disclosure requirements—Section 13 Requires companies to file the following documents:
o An initial, detailed information statement when the company first registers: S-1
o Annual reports on Form 10-K
Quarterly reports on Form 10-Q, which are less detailed than 10-Ks
Form 8-K to report any significant developments
 This statute requires a company’s CEO and CFO to certify that:
 The information in the quarterly and annual reports are true;
 The company has effective internal controls; and
 The officers have informed the company’s audit committee and external auditors about
concerns of internal controls.
Short-swing trading—Section 16
o Prevents corporate managers and insiders who own more than 10% of the company from taking unfair
advantage of privileged information to manipulate the market:
 Insiders must report their trades within 2 business days to the SEC and the company.
 Insiders have to return any profits from a purchase and sale that is in a 6-month period.
Liability Under the 1934 Act
o Section 18 (filings)
 Anyone who makes a false or misleading statement in a filing under the 1934 Act is liable to
buyers and sellers who:
 Acted in reliance on the statement
 Can prove that the price at which they bought or sold was affected by the false filing
o Section 10 (b)
 Prohibits fraud in connection with the purchase and sale of any security whether or not it is
registered under the 1934 Act. It is a catchall provision.
o
o
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
Case*: In Re HP Securities Litigation
Fact: Shortly after Léo Apotheker became CEO of HP, he decided to acquire Autonomy Corporation for over $11 billion.
His decision was strongly resisted by HP executives, including CFO Catherine Lesjak (lisjek). But he went ahead anyway.
The day after HP announced the acquisition, its stock price dropped by 20 percent. A week before the Autonomy deal was
to close, the board of directors replaced Apotheker as CEO with Meg Whitman. She wanted to terminate the Autonomy
acquisition but was told that it was impossible due to the United Kingdom’s takeover rules. Over the next few months, HP
learned that Autonomy’s earnings and growth numbers were inaccurate. On May 23, HP hired Pricewaterhouse- Coopers
to investigate it. Meanwhile, HP executives insisted that Autonomy is a terrific product. On November 20, the
investigation was complete. HP announced that Autonomy had been a fraud. It wrote down the investment by $8.8 billion.
HP’s stock dropped another 12 percent. Shareholders filed lawsuit alleging that Whitman, Lesjak, and HP had committed
fraud under §10(b). The defendants filed a motion to dismiss, arguing that they did not have scienter.
Scienter (明知，故意) is a legal term meaning that someone has acted with the intent to deceive or with deliberate
recklessness as to the possibility of misleading investors. Negligence is not enough to create liability.
Issue: Did the defendants have scienter? Did they act either intentionally or with deliberate recklessness?
Decision:
Arguments for Shareholders: Even before the deal closed, executives at HP knew that it was a mistake. Yet still, it went
forward. Then HP discovered that Autonomy’s numbers were inaccurate. Later, Whistleblower No. 4 came forward. (It is
always a bad sign when there are so many whistleblowers, they have to take a number). For eight months, HP executives
made filings with the SEC and statements to investors that did not give any hint of trouble. Whitman even made up a
whole story about how Autonomy was going through growing pains. HP said in a filing that, at the time of the Autonomy
acquisition in October, its fair value approximated the carrying value. The senior executives could not possibly have
believed that statement to be true. In short, they deliberately duped and defrauded investors.
Arguments for the Company: Admittedly, there were rumors and allegations about Autonomy, but not until November
20, when the Pricewaterhouse investigation finished, did the defendants know for sure that the deal had been a fraud. As
soon as the company knew, it made a public announcement. It is reasonable to investigate a situation before making
disclosures. Moreover, many of the defendants’ statements were nothing more than puffery. Even if some of their
statements were untrue, HP executives are not liable if they acted carelessly, or even recklessly. Under the scienter
requirement, shareholders must show that the defendants acted with intent or deliberate recklessness. Autonomy was a
bad deal, but no one intentionally engaged in wrongdoing. HP was the one who was duped.
Case*: Stonebridge Investment Partners v. Scientific-Atlanta, Inc.
Fact: Charter Communications, Inc., was a cable operator that engaged in a variety of fraudulent practices to pump up its
financial statements. When it still failed to meet Wall Street expectations, Charter approached two of its suppliers—
Scientific-Atlanta and Motorola—for help in furthering the fraud. These two companies sold Charter the set-top boxes
that Charter furnished its customers. Charter arranged to overpay the suppliers $20 for each set-top box it purchased, with
the understanding that they would return the overpayment by purchasing advertising from Charter. These transactions
inflate Charter’s revenue and operating cash flow numbers. They also violated generally accepted accounting principles.
The inflated numbers were included in financial statements filed with the SEC and reported to the public. Purchasers of
Charter stock sued the two suppliers, alleging that they had violated §10(b). The District Court granted defendants’
motion to dismiss. The U.S. Court of Appeals for the Eighth Circuit affirmed. The Supreme Court granted certiorari.
Issue: Did the purchasers of Charter stock rely on statements by the suppliers?
Decision: Reliance by the plaintiff upon the defendant’s deceptive acts is an essential element of the §10(b) cause of
action. [In this case, no] member of the investing public had knowledge of [defendants’] deceptive acts during the relevant
times. Petitioner, as a result, cannot show reliance upon any of [defendants’] actions except in an indirect chain that the
court find too remote for liability. Here respondents were acting in concert with Charter in the ordinary course as
suppliers, not in the investment sphere. Charter was free to do as it chose in preparing its books, conferring with its
auditor, and preparing and then issuing its financial statements. In these circumstances, the investors cannot be said to
have relied upon any of [defendants’] deceptive acts in the decision to purchase or sell securities; therefore, [the
defendants] have no liability to [plaintiffs].
Insider Trading* (Focus on this part for the test)
 Insider trading: A crime punishable by fines, imprisonment, and disgorgement of profits.
 Fiduciary duty: Any corporate insider who trades while in possession of nonpublic, material information in
violation of his fiduciary duty to his company is liable under Rule 10b-5. The fiduciary’s spouse, child, parent and
sibling also have duty not to trade (strangers usually do not have a fiduciary duty to a company so they will not be
liable).
 Corporate insider includes officers, directors and anyone else who works for the company. This includes
employees and constructive insiders, such as lawyers and auditors who have an indirect employment relationship.
 Tippers – Anyone who reveals material nonpublic information in violation of his fiduciary duty is liable if he:
o Knows the information is confidential
o Expected some personal gain
 Tippees - Those who receive tips are liable for trading on inside information, even if they do not have a fiduciary
relationship to the company, as long as:
o They know the information is confidential
o They know it came from an insider who was violating his fiduciary duty
o The insider expected some personal gain
 Misappropriation: Anyone with (1) material, non-public information, (2) who breaches a fiduciary duty to the
source of that information, (3) by revealing or trading on it, is also guilty of insider trading.
o Examples: lawyers, accountants, family members.
*Case: Salman v. United States
Fact: Maher Kara was an investment banker specializing in the healthcare industry at Citigroup. To understand scientific
aspects of his job, Maher sought help from his older brother Michael, who was a chemist. Later, when their father was ill,
Maher told his brother about companies that were secretly developing innovative treatments. Eventually Maher realized
that Michael was trading on this secret information. Maher implored Michael to stop, even offering him money. But
Michael just wanted information. Although he disapproved of Michael’s trades, Maher continued to provide tips to him,
knowing that he would trade on them. When Maher started dating (and ultimately married) Bassam Salman’s sister,
Michael and Salman became friends. Without telling Maher, Michael began sharing Maher’s tips with Salman, who made
over $1.5 million in profits. Salman knew the information was coming from Maher. All three men were charged with
insider trading. Michael and Maher pleaded guilty and testified against Salman at his trial. Salman was convicted of
insider trading, sentenced to 36 months imprisonment, and ordered to pay over $730,000 in restitution. He appealed,
arguing that he was not guilty of insider trading because the tipper (Maher) had not received a benefit.
Issue: Did the tipper receive a benefit? Did Salman engage in illegal insider trading?
Decision: [A violation also occurs] when an insider makes a gift of confidential information to a trading relative or friend.
Here, by disclosing confidential information as a gift to his brother with the expectation that he would trade on it, Maher
breached his duty of trust and confidence to Citigroup and its clients. And since Salman traded on the information with
full knowledge that it had been improperly disclosed, he has engaged in illegal insider trading.
Chapter 24 Intellectual Property: Patent
Why Do Businesses Need Intellectual Property?
 Differentiate from competitors: being unique is valuable.
 Defend against competitors: successful companies get attacked.
 Prevent creation of competitors: successful companies get copied.
 Raise $: investors want to know their investment is safe.
 Marketing: consumers crave what they consider special products and services.
o Commercials
o Product sheets
o Hiring
Patents
 The importance of granting monopolies for new inventions has been recognized in the United States since the
adoption of the U.S. Constitution. In Article I, section 8, the U.S. Constitution:
o Congress shall have power…to promote the progress of science and useful arts, by securing for limited
times to authors (copyright) and inventors (patents) the exclusive right to their respective writings and
discoveries.
 A patent is a legal right to prevent others from making, using, selling/offering to sell, importing
o Does not give its owner right to make, use, sell, offer to sell, or import
o Does not (directly) protect products or services (it does not directly give you the right to products or
services; it gives you the right to exclude others from trying to profit from your invention)
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
Patentable Subject Matter in the U.S.
o Statutory Basis: 35 U.S.C. § 101
 A patent can be obtained for “any new and useful process, machine, manufacture, or composition
of matter, or any new and useful improvement thereof…” (new things or things that you invented
that are better)
Types of Patents
o Utility Patents
 Machines, Articles of manufacture (things you make), Methods, Compositions of matter
 Utility patents protect the function of the invention and last 20 years from the date of filing. Over
90% of issued patents are utility patents.
 Requirement for a utility patent
 To receive a utility patent, the new invention must be:
o Novel (new): the invention cannot already be patented, in public use or in a
printed publication.
o Nonobvious: not an obvious invention to someone of ordinary skill in the
art/invention.
o Useful: the invention must do something. To the PTO, useful does not mean
socially beneficial; it simply means capable of some use.
o Design Patents: protect ornamental appearance of article
 Design patents protect the appearance, not the function of an item. Last 14 years from the date of
issuance.
 Apple v. Samsung Design Patent Litigation: Apples was awarded $533.3 million for
Samsung’s design patent infringement.
o
Plant Patents: Asexually reproduced plants through grafting (嫁接) rather than by planting its seeds. For
example, one company patented a unique rose whose color combination did not exist in nature.
 Patents on living organisms
 You can patent genetically engineered bacteria or other organisms as long as they are not
otherwise naturally occurring. Diamond v. Chakrabarty (1980): made famous the phrase
that patentable subject matter included “anything under the sun that is made by man.”
 However, in Association for Molecular Pathology v. Myriad Genetics, the Supreme Court
ruled differently. Synthesized DNA could be patented.
*Case: Association for Molecular Pathology v. Myriad Genetics, Inc.
Fact: Mutations in two genes known as BRCA1 and BRCA2 can dramatically increase the risk of breast and ovarian
cancer. Myriad Genetics, Inc. (Myriad) obtained a number of patents on these genes. One patent gave Myriad the
exclusive right to isolate an individual’s naturally occurring BRCA1 and BRCA2 genes. Another patent granted Myriad
the exclusive right to synthetically create variants of BRCA1 and BRCA2 in the laboratory (cDNA). A group of
researchers filed a lawsuit seeking a declaration that Myriad’s patents were invalid. The district court struck down the
patents on the grounds that they covered products of nature. The appeals court reversed, holding that both DNA and
cDNA were patentable. The Supreme Court granted certiorari.
Issue: Is naturally occurring DNA patentable? Is man-made cDNA patentable?
Decision: Myriad did not create anything. To be sure, it found an important and useful gene, but separating that gene from
its surrounding genetic material is not an act of invention. In contrast, creation of a cDNA sequence results in a molecule
that is not naturally occurring. The lab technician unquestionably creates something new when cDNA is made. As a result,
cDNA is not a “product of nature” and is patent eligible under §101. For the foregoing reasons, the judgment of the
Federal Circuit is affirmed in part and reversed in part.
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
Where should you file patent?
o Patents are territorial, meaning that the holder of a U.S. patent can only enforce those rights in the United
States. A U.S. patent does not give its holder the right to sue a counterfeiter who makes, uses, or sells the
invention outside this country.
o Therefore, you need to evaluate your supply chain. Where are the competitors? Where are the markets?
Where are the manufacturers? Foreign filling is expensive, so be strategic.
Patent Process – “Prosecution”
Chapter 24: Copyrights, Trademarks, and Trade Secrets
Copyrights
 The holder of a copyright owns the particular tangible expression of an idea, but not the underlying idea or
method of operation.
 The Copyright Act protects: Literature, music, drama, choreography, pictures, sculpture, movies, recordings,
architectural works, computer databases, and computer programs
 A work is automatically copyrighted once it is in tangible form.
o Registration with the Copyright Office of the Library of Congress is necessary if the holder brings suit to
enforce the copyright.
Case*: Bikram’s Yoga College of India, L.P. v. Evolation Yoga, LLC
Fact: Bikram Choudhury was a lifelong student of a type of yoga known as Hatha. In the early 1970s, he developed a
method of practicing yoga, which he called Bikram. It consisted of a sequence of 26 Hatha yoga asanas, arranged
in an order designed to work the muscles optimally (the Sequence). Choudhury’s other innovation was to teach the
Sequence in a room heated to 105 degrees. Choudhury published and copyrighted a book that included descriptions,
photographs, and drawings of the Sequence. Many years later, Mark Drost and Zefea Samson, Choudhury’s former
students, opened Evolation Yoga, a studio offering “hot yoga” classes. Evolation instructors taught the Sequence in a
heated room in a manner and order identical to Bikram Yoga. Choudhury sued Evolation Yoga for copyright
infringement. He claimed that he deserved the exclusive right to perform the Sequence because he developed it over years
of research and had copyrighted the book describing it. The district court granted summary judgment to Evolation,
reasoning that the Sequence was an idea that could not be protected under copyright law.
Issue: Was the Sequence copyrightable?
Decision: The copyright for a book describing how to perform a complicated surgery does not give the holder the
exclusive right to perform the surgery. Like the series of movements a surgeon makes, the Sequence is, as Choudhury tells
readers, a method designed to alleviate physical injuries and illness. Monopoly protection for such a method can only be
secured, if it can be secured at all, by patent. Consumers would have little reason to buy Choudhury’s book if Choudhury
held a monopoly on the practice of the very activity he sought to popularize. Rather than stimulating creativity for the
general public good, copyright protection for the Sequence would prevent the public from engaging with Choudhury’s
idea and building upon it. They do not bring the Sequence into the realm of copyright protection.

Copyright Term
o Currently, copyrights are valid until 70 years after the death of the work’s only or last living author.
o In the case of works owned by a corporation, the copyright lasts:
 95 years from publication or
 120 years from creation, whichever is shorter
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
Copyright Infringement
o To prove a violation, the plaintiff must present evidence that the work was original and that either:
 The infringer actually copied the work, or
 That the infringer had access to the original and the two works are substantially similar (more
than 75%).
o A court may:
 Prohibit the infringer from further violations
 Order destruction of the infringing material, and
 Require the infringer to pay damages, profits earned, and attorney’s fees
Permissible Copying
o Fair use: Permits limited use of copyrighted material without permission of the author for purposes such
as criticism, parody, comment, news reporting, scholarship, research, or education.
o First sale: a person who owns a lawfully made copy of a copyrighted work may sell or otherwise dispose
of the copy.
o Parody–A fair use of copyrighted material so long as the use of original is not excessive (make fun of the
work).
Trademarks
 Any combination of words and symbols that a business uses to distinguish products or services and distinguish
them from others.
 Types of marks
o Trademarks: Affixed to goods in interstate commerce
o Service marks: Identifies services, not products
 Trademarks not limited to words: Can be anything that identifies and distinguishes goods and services of one
seller/manufacturer from those of another. E.g., words, name, logo, slogan, distinctive sound, color, product
shape, scent.
 Trademark Ownership and Registration
o First person to use a mark in trade owns it
o Registration with federal government is not necessary but beneficial for defending the mark.
 PTO will accept trademark application as long as owner has used the mark in interstate commerce
or promises to use it within 6 months after filing.
 Trademark is initially valid for 10 years and can be renewed for additional 10-year terms.
 Valid Trademarks
o To be valid, a trademark must be distinctive.
o Categories
 Fanciful: Made-up words such as Kodak.
 Arbitrary: Use existing words that do not describe the product such as Apple.
 Suggestive: Indirectly describe the product’s function such as Coppertone.
o Trade dress is the image and overall appearance of a product or service and may include color, size,
shape or texture.
 Trademark Selection
o Avoid terms that are generic or descriptive: suggestive and arbitrary or coined terms are better.
Case*: Iancu v. Brunetti
Fact: The Lanham Act prohibits the registration of “immoral or scandalous” marks. To determine whether a proposed
mark fits in this category, the PTO asks whether the general public would find the mark “shocking to the sense of truth,
decency, or propriety,” “offensive,” or “vulgar.” Artist Erik Brunetti founded a clothing line called FUCT. According to
Brunetti, the brand name stands for “Friends U Can’t Trust” and is pronounced as four distinct letters: F-U-C-T. But
because the PTO suspected that many people would read these letters as the past tense of a curse word, it denied
Brunetti’s trademark application. Brunetti argued that the Lanham Act’s prohibition on immoral or scandalous trademarks
violated the First Amendment. The appeals court agreed with Brunetti, and the Supreme Court granted certiorari.
Issue: Is a prohibition on “immoral or scandalous” trademarks unconstitutional?
Decision: The “immoral or scandalous” bar must be invalidated. There are a great many immoral and scandalous ideas in
the world (even more than there are swearwords), and the Lanham Act covers them all. It therefore violates the First
Amendment. We accordingly affirm the judgment of the Court of Appeals.

Infringement
o To win an infringement suit, the trademark owner must show that:
 Defendant’s trademark is likely to deceive customers about who made the product or provided the
service.
o The rightful owner is entitled to:
 An injunction prohibiting further violations
 Destruction of the infringing material
 Up to three times actual damages
 Any profits the infringer earned on the product
 Attorney’s fees
Trade Secrets
 A Trade Secret is a formula, device, process, method or compilation of information that, when used in business,
gives the owner an advantage over competitors who do not know it. Examples include: recipes, customer lists,
business plans and marketing strategies. In determining if information is a trade secret, courts look at:
o How difficult is the information to obtain?
o Does the information create an important competitive advantage?
o Did the company make reasonable efforts to protect it?