U.S. Business Organizations | Winter 2021 | Stephen Wilks
Uniform Partnership Act:
https://www.ilga.gov/legislation/ilcs/ilcs5.asp?ActID=2292&ChapterID=65
GENERAL RULES AND REGULATIONS, SECURITIES EXCHANGE ACT OF 1934:
https://www.law.cornell.edu/cfr/text/17/part-240
Course Topics
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Agency
Partnerships
Corporations
Limited Liability Companies
Veil-Piercing
The Firm and the Law of Agency
Agency Law and the Choice of Sole Proprietorship Form
Restatement (Third) of Agency §§ 1.01, 1.02, 1.03
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A firm is created simply by unifying the ownership and control of the team in the hands of
one or more owners (referred to in agency law as the principal), while other team
members agree to serve as employees (referred to as agents)
The principal signals entry into the firm by investing her own money capital to acquire
assts and by agreeing to employee one or more agents – other team members signal
their entry into the firm by agreeing to provide services to the firm subject to the dictates
and control of the owner
o This mutual assent creates the relationship of principal and agent
o Unless otherwise agreed, this relationship may also be terminated at will by
either the principal or agent
o The law of agency imposes a fiduciary duty on agents, and other legal doctrines
impose some limits on the principal’s right to discharge an employee. Thus, the
need to limit contractually the right of action of either the proprietor or her agents
depends, in part, on the extent to which adequate protection will be provided by
ex post judicial enforcement of these state-provided rules.
Restatement (Second) of Agency – Wilks said he prefers this over Restatement (Third)
Fiduciary Limits on Agent’s Right of Action
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Fiduciary duty substitutes for an express contractual specification of exactly what an
agent may or may not do
Fiduciary duty obliges “the fiduciary to act in the best interests of his client or beneficiary
and to refrain from self-interested behavior not specifically allowed by the employment
contract.”
As an alternative to relying solely on fiduciary duty, principals may contract for greater
protection from postemployment competition – Courts will enforce noncompetition
agreements if they are reasonable given the duration, geographical coverage, and the
nature of the employer’s risk from such competition
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Courts will balance the legitimate interest of the employer in protecting her
business against the legitimate interest of the employee seeking to redeploy her
human capital
Agent has fiduciary obligations to the principle
Community Counselling Services, Inc. v. Reilly
CCS is a professional fundraising organization, working primarily for catholic
parishes and institutions. Reilly worked for CCS as a campaign director and
subsequently a sales representative. After being with CCS for several years,
Reilly decided that he wanted to resign for “urgent personal reasons”. He
submitted a resignation on January 4, 1960, and since the employment contract
required 30 days’ notice, CCS and Reilly agreed that the resignation would be
effective as of January 29. After January 4, but prior to January 29, Reilly
engaged in conversations with representative from several different St. Ambrose
Parishes. Since they were already customers of CCS and knew Reilly, they
wanted Reilly to run more fundraising campaigns for them. Reilly had formed the
intention to engage in these fundraising activities post-employment and had
actively sought these out prior to January 29, the intention being to secure a
source of income for himself after his employment with CCS ended. Reilly ended
up running the campaigns for the Parishes from February to April of 1960 and
earned the fees to himself (none flowed to CCS). CCS sued Reilly for the
proceeds and Reilly counterclaimed for recovery of the salary and commission
payments that CCS withheld as a result.
Issue
Did Reilly violate his fiduciary duty to CCS by actively seeking out and securing
business for himself while still employed by CCS?
Holding Yes. Reilly’s conduct was far short of the standards by which he should have
governed himself. The substantial fees which he collected were, in part, the fruit of
his disloyal conduct during his employment in soliciting the valuable contracts for
himself. CCS is entitled to the accounting it sought.
Analysis
- The usual rule is that a former employee, after termination of his
employment, may compete with his former employer, the only restraint
being that he may not use confidential information or trade secrets
obtained from the former employer, appropriating, in effect, to his
competitive advantage what rightfully belongs to the employer.
- There is no suggestion that CCS has any trade secrets which ought not be
utilized by Reilly and since there was no covenant not to compete, Reilly
had a clear and unrestricted right to compete after January 29, 1960.
- HOWEVER, he had NO RIGHT to do this before January 29, since he was
employed by CCS to solicit the business of those parishes for CCS and
not for himself
- During such a period, he cannot solicit for himself future business which
his employment requires him to solicit for his employer. If prospective
customers undertake the opening of negotiations which the
employee could not initiate, he must decline to participate in them.
Above all, he should be candid with his employer and should withhold no
information which would be useful to the employer in the protection and
promotion of his interests
Facts
The principal-agent relationship create a scope of expectations – here, this would
not allow the agent to compete with the principal or diverting to oneself away from
the principal opportunities that should be directed to the principal/employer.
Ratio
Facts
Issue
Holding
It was irrelevant that the three parishes may not have been in a position to actually
commence their campaigns before the effective date of Reilly’s resignation with
CCS. The substantial fees which he collected from the conduct of the three
campaigns were not solely the fruit of his efforts in aid of the campaign
commenced, but also the fruit of his disloyal conduct in soliciting the contracts for
himself when he owed an unequivocal duty to solicit those contracts for his
employer.
- Essentially, timing is not the issue here. The obligation is for you to
recognize that there is a fiduciary duty that is owed to the principal as the
agent, and the duty obligates you to put your principal’s interest ahead of
your own, when you are supposed to be representing that principal in your
dealings with outside third parties.
Employment as a sales representative demands of the employee the highest
duty of loyalty.
- It is not without its difficulties when the employment continues after the
employee has arrived at a fixed determination to leave his employment, for
then his interests and those of his employer have lost their identity and
may have become conflicting.
Until the employment relationship is finally severed, the employee must
prefer the interests of his employer to his own.
Hamburger v. Hamburger
David Hamburger (defendant) began working full-time at Ace Wire and Burlap,
Inc. (Ace), his family’s business, in 1984. Ace was controlled by David’s father,
Joseph Hamburger (defendant), and David’s uncle, Jacob Hamburger (Ted)
(plaintiff). Joseph and Ted had a strained relationship. David gained more and
more responsibility at the company, ultimately becoming sales manager and
general manager. With his help, Ace’s customer base and total sales doubled.
Ted was resentful of David’s rise at the company and made several attempts to
remove him, which failed due to Joseph’s intervention. Ted made it clear that if
Joseph died before he did, David would be fired. Unhappy and unsure of his
future, David met with one of Ace’s suppliers and discussed starting his own
business to compete with Ace. The supplier loaned David $50,000 in early May
1993, and David promptly leased space for his new company. On May 13, 1993,
David resigned from Ace without notice. He then incorporated his new business,
hired Ace’s bookkeeper, and began calling Ace’s customers, a large number of
whom followed David to the new company. Ted sued David and Joseph, alleging
that David’s financing and lease agreements were made during David’s
employment with Ace, in violation of his duty of loyalty. He also alleged that David
obtained and used Ace’s customer list with Joseph’s assistance, in violation of
their duty of loyalty to Ace.
Whether David violated his duty of loyalty to Ace when he acquired many of Ace’s
customers after resigning.
No.
- David’s having arranged financing and leased space for NEBW (his new
company) while he was still an Ace employee was not illegal, as an
employee is free to make such logistical arrangements while still an
employee.
- There was also no evidence that David had solicited any of Ace’s
customers in any significant way before his resignation. As Ace’s sales
manager, he had been intimately familiar with its customers and pricing, so
that he was familiar with such information when he left Ace’s employ. He
was entitled to use his general knowledge, experience, memory and
skill in establishing NEBW, including “remembered information”
Analysis While David may have made some use of personal notes relating to Ace
customers, customer lists are not considered trade secrets if the information is
readily available from published sources, such as business directories.
- The customer information could have been found in business directories
and white pages, which is public information
Ratio
An employer who wishes to restrict the post-employment competitive
activities of a key employee, where the activities do not entail misuse of
proprietary information, must protect that goal through a non-competition
agreement.
Distinction between CCS v. Reilly and Hamburger v. Hamburger =
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CCS – have to be candid and open with employer
o Can’t negotiate for personal interests that would compete with principal’s interest
while still employed
Hamburger – internal pressure to leave = motivated him to seek out another option
o It’s fine to make logistical arrangements while still employed
o “remembered information”/public knowledge (not trade secrets)
Limits on the Firm’s Right to Discharge an Employee at Will
Employer’s fiduciary obligations to an employee
Exceptions to the at-will doctrine
Facts
Foley v. Interactive Data Corp.
Interactive Data Corporation (IDC) hired Daniel Foley in 1976. Foley worked for
IDC for almost seven years, during which time he received consistently good
evaluations, numerous bonuses, salary increases, and ultimately a promotion to
branch manager. IDC maintained a set of termination guidelines which provided
grounds for discharging employees and mandated a seven-step pre-termination
procedure. In January 1983, Foley learned that his new supervisor, Robert Kuhne,
was being investigated by the FBI for embezzling from a previous employer. He
informed IDC’s vice president Richard Earnest of the investigation, allegedly for
the benefit of IDC. According to Foley, Earnest dismissed the story as a rumor
and told Foley to forget it. In March, Kuhne informed Foley that Foley was being
replaced for performance reasons. Foley was initially given a choice to transfer,
but eventually was simply asked to resign or be fired. Foley sued IDC for wrongful
discharge on several grounds. He argued he had been tortiously discharged in
violation of public policy, in retaliation for reporting Kuhne’s suspected wrongdoing
to IDC officials. Second, Foley alleged that the termination without cause was a
breach of an implied contract. Finally, he argued that IDC breached the implied
covenant of good faith and fair dealing. IDC moved to dismiss each of Foley’s
causes of action for failure to state a claim. The trial court granted the motion to
dismiss, and the appellate court affirmed. Foley successfully brought the case to
the California Supreme Court.
Issue
Holding
Tortious Discharge in Contravention of Public Policy – When the duty of an
employee to disclose information to his employer serves only the private interest
of the employer, the public policy rationale does not apply
Breach of Employment Contract – plaintiff has plead facts which, if proved, may
be sufficient for a jury to find an implied-in-fact contract limiting defendant’s right to
discharge him arbitrarily (facts sufficient to overcome the presumption of “at will”)
“At-will” employment contracts and other employment contracts are not mutually
exclusive concepts, and both can co-exist.
Breach of the Implied Covenant of Good Faith and Fair Dealing – the employment
relationship is not sufficiently similar to that of insurer and insured to warrant
judicial extension of the proposed additional tort remedies in view of the
countervailing concerns about economic policy and stability, the traditional
separation of tort and contract law, and finally, the numerous protections against
improper terminations already afforded employees
Analysis Tortious Discharge in Contravention of public policy
- Absent a contract, employment is “at will,” and the employee can be fired
with or without good cause – but the employer’s right to discharge an “at
will” employee is still subject to limits imposed by public policy
- Past decisions recognizing a tort action for discharge in violation of public
policy seek to protect the public, by protecting the employee who refuses
to commit a crime, who reports criminal activity to proper authorities, or
who discloses other illegal, unethical, or unsafe practices.
- However, no equivalent public interest bars the discharge of an employee
who discloses information to his employer, where the disclosure serves
only the private interest of the employer (as is the case here)
Breach of Employment Contract
- Regarding the alleged implied contract not to terminate the plaintiff without
good cause: The absence of an express written or oral contract term
concerning termination of employment does not necessarily indicate that
the employment is actually intended by the parties to be “at will,” because
the presumption of “at will” employment may be overcome by evidence of
contrary intent
- In the employment context, factors apart from consideration and express
terms may be used to ascertain the existence and content of an
employment agreement, including “the personnel policies or practices of
the employer, the employee’s longevity of service, actions or
communications by the employer reflecting assurances of continued
employment, and the practices of the industry in which the employee is
engaged.”
- “oblique language will not, standing alone, be sufficient to establish
agreement” instead, the totality of the circumstances determines the
nature of the contract.
o Plaintiff alleged repeated oral assurances of job security and
consistent promotions, salary increases and bonuses during the
Ratio
term of his employment contributing to his reasonable expectation
that he would not be discharged except for good cause
Breach of the Implied Covenant of Good Faith and Fair Dealing
- “Every contract imposes upon each party a duty of good faith and fair
dealing in its performance and its enforcement”
- An allegation of breach of the implied covenant of good faith and fair
dealing is an allegation of breach of an “ex contractu” obligation, namely
one arising out of the contract itself.
- The covenant of good faith is read into contracts in order to protect the
express covenants or promises of the contract, not to protect some
general public policy interest not directly tied to the contract’s purpose
(Court indicated that this is a different rationale from that relied on in the
Insurance-based cases that Plaintiff relied on to try and justify tort action
based on good faith requirement in contracts)
- The court was not convinced that a “special relationship” analogous to that
between insurer and insured should be deemed to exist in the usual
employment relationship which would warrant recognition of a tort action
for breach of implied covenant
Absent a contract, employment is “at will,” and the employee can be fired
with or without good cause – but the employer’s right to discharge an “at
will” employee is still subject to limits imposed by public policy
(presumption of “at-will” employment contract)
- In the employment context, factors apart from consideration and express
terms may be used to ascertain the existence and content of an
employment agreement, including “the personnel policies or practices of
the employer, the employee’s longevity of service, actions or
communications by the employer reflecting assurances of continued
employment, and the practices of the industry in which the employee is
engaged.”
Agency Law and Relations with Creditors
Restatement (Third) of Agency §§2.01-2.06, 3.01, 3.03
The law of agency provides standard form rules on which creditors may rely
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Traditional common law rules are designed to protect a principal’s property interests
A third party who deals with an agent does so at his peril
The agent’s actions will bind the principal only if the principal has manifested his or its
assent to such actions
o Manifestations of consent can take two forms:
o Actual authority
o Apparent authority (a.k.a. ostensible authority)
Actual Authority – occurs when the principal manifests his consent directly to the agent. If
actual authority exists, the principal is bound by the agent’s authorized actions, even if the party
with whom the agent deals is unaware that the agent has actual authority and even if it would be
unusual for an agent to have such authority.
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Consent may be expressly manifested (e.g., when the principal instructs the agent in
writing or orally as to the scope of the agent’s authority)
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Consent may also be implied from the conduct of the principal (e.g., principal’s conduct
of authorizing certain conduct repeatedly in the past through silent acquiescence)
If actual authority exists, the principal is bound by the agent’s authorized actions, even if the
party with whom the agent deals is unaware that the agent has actual authority.
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Restatement (Third) of Agency §2.01 explicitly mentions actual authority, providing a
definition
o §2.02 – adds additional context, providing the scope of authority
o The scope of authority constrains the behavior of the agent
Apparent Authority – arises when an agent is without actual authority, but the principal
manifests his consent directly to the third party who is dealing with the agent
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Apparent authority may be created expressly or impliedly, as with actual authority
A third party will be able to bind the principal on the basis of apparent authority
only if the third party reasonably believed that the agent was authorized (i.e., if the
third party knows that an agent is without actual authority, or if the manifestations made
by the principal constitute an insufficient foundation for forming a reasonable belief that
the agent is authorized, then the agent’s unauthorized actions will not bind the principal)
Example: a door-to-door salesman who wears a nametag with the company logo and
their name on it
Restatement (Third) of Agency §2.03 – definition of apparent authority
The common law developed from traditional common law to add greater protection for the
expectations of third parties, even when the principal’s manifestations were illusory at best. This
led to the development of a third category of authority: inherent authority
Inherent Authority – does not arise from manifestations of consent of the type contemplated by
traditional common law authority rules, but rather springs from a desire to protect the
reasonable expectations of outsiders who deal with an agent.
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Facts
View as an implied term in a contract between principal and all who deal with its agents
A gap-filling device used by courts to achieve a fair and efficient allocation of losses from
an agent’s unauthorized actions
Partners in a partnership have inherent authority (each partner is an agent of the
partnership)
Blackburn v. Witter
Blackburn (P) was a widow with no business experience and no family to advise
her. She selected Long to become her trusted investment advisor on behalf of
Walston & Company and later Dean Witter (Defendants). During his tenure with
Defendants, Long convinced P to invest in a nonexistent company he called
American Commercial Investment Company. Long claimed that it was willing to
pay 10% interest. P sold some of her stocks and invested her money in the
fictitious company. P got rediform receipts from Long for her investments, but
nothing appeared on her statements with Ds regarding this new investment, and
the receipts and note she got were not written on company stationery. When she
inquired about this, Long claimed that the company was so new that stationery
was being printed. P testified at trial that she trusted Long and that he had
represented he was working for Ds and had no reason to doubt his statements
even though the statements were different and Long was taking the money as
trustee of the nonexistent company. Ds presented testimony at trial concerning
the limitations that they placed on their agents but presented no evidence that P
was ever told of those limitations. On the theory of ostensible authority, the trial
court entered judgment in favor of P.
Issue
Whether Long had apparent authority to act on both Defendant brokerages behalf.
Holding Yes. Affirmed judgment of trial court (in favor of plaintiff on theory of ostensible
authority). There is an agency relationship between the brokerages and Long.
Analysis Long had no authority as an employee of either company to borrow money for his
personal use, or to take money from a client and give his personal note rather
than security for it.
Ostensible authority, as defined in the (California) Civil Code: Ostensible
authority is such as a principal, intentionally or by want of ordinary care,
causes or allows a third person to believe the agent to possess. (thus, it’s not
merely that a third party’s belief is traceable to a principal’s manifestations –
rather, the principal is obligated to protect the authorized expressions of their
agents in the market place; e.g., the brokerages had some obligation to notify their
customers that Long no longer worked for them or wasn’t acting on their behalf)
- Further, a principal is bound by acts of his agent, under a merely
ostensible authority, to those persons only who have in good faith, and
without want of ordinary care, incurred a liability or parted with value, upon
the faith thereof
Appellants attempted to argue that Respondent, as a reasonable and prudent
person should have known that Long was misleading her and was acting for
himself, not either brokerage, when he took her money for investment
- The record showed that the research services which the appellants used
to induce customers to rely upon them for advice contributed to the fraud
- It is also difficult to see how the brokerages can accept the benefits of the
sale of the stock by Long as their agent and then deny liability for the
fraudulent misuses of the money obtained by the sale of the stock
Plaintiff is trying to hold defendants accountable on the basis that Long worked on
behalf of both.
Potential argument that Defendants could have made: Long was the middle
person between both parties, and he was lying to both sides. Thus, they shouldn’t
be held responsible for his post-termination activities, especially considering that
Blackburn had her suspicions and questioned Long.
Facts
Sennott v. Rodman & Renshaw
Jordan Rothbart was a securities dealer and prior to 1958 was an employee of
Rodman & Renshaw (Rodman) (defendant), a securities trading firm. Jordan was
reprimanded by the SEC in 1962 for violating certain anti-fraud provisions of the
Securities Act. He also had his registration other issues, including revocation of
his registration with NASD. The Sennott’s were unaware of any of this for the
majority of their relationship. Jordan’s father, William Rothbart, was a partner in
Rodman throughout the period at issue here. Around 1960, Jordan began trading
on his own account. He befriended a fellow trader, Richard Sennott (plaintiff), and
passed along numerous investment recommendations to Sennott which he got
from his father. Jordan offered to have an account opened for Sennott and his
wife at Rodman. Sennott accepted, and Jordan placed orders through Rodman on
Sennott’s behalf. Between 1964 and 1966, Sennott purchased around $2 million
in securities in this manner, mostly through Jordan and on the investment
recommendations of his father. In February 1964, Jordan offered Sennott stock
options in a company called Skyline Homes, which was about to be listed on the
NYSE. Sennott agreed to purchase $142,000 worth of these options. Jordan told
Sennott that the options were highly confidential and that he could not discuss
them with anyone, even William. Sennott complied. He did not meet William until
after making the order. The stock options did not exist. Jordan actually deposited
the checks in a personal account. In late 1964, Rodman’s managing partner,
Vernon Carroll, uncovered evidence of the fraud, and attempted to ask Sennott
about it. On William and Jordan’s advice, Sennott refused to discuss the matter
with Carroll. When Sennott finally learned that he had been defrauded, he sued
Rodman, along with Jordan and William Rothbart. The trial court found against the
Rothbarts and against Rodman in the amount of $99,600. Rodman appealed.
Issue
Did Sennott rely upon Jordan Rothbart’s apparent agency with Rodman in respect
to the fraudulent Skyline options transaction?
Holding No. The damage Jordan Rothbart inflicted upon the plaintiff was a result of
Sennott’s misplaced reliance upon Jordan Rothbart and not upon Rodman &
Renshaw.
Analysis With respect to agency – it is clear that Rodman must be deemed to have had
knowledge of all of the securities transactions which Jordan solicited for his father
prior to the inception of the fraudulent stock option scheme (under general
principles of agency, the knowledge of William Rothbart in this situation is imputed
to the partnership). However, these transactions do not form the substance of this
lawsuit (the fraudulent stock options do).
- The record is silent on whether William Rothbart had knowledge of the
fraudulent transactions. There’s no evidence to indicate that he did have
the knowledge or did anything to induce the Sennott’s into the transcations
- Further, there’s no evidence to suggest that Sennott considered William
Rothbart to be any part of the transaction other than he had been the
original offeree of the mythical options (also evidenced by the fact that
Sennott’s conversation with Jordan to keep the transactions secret, even
from William)
Sennott put forward a theory of apparent authority, which would require him to
prove that he was relying upon Jordan’s apparent authority (and hence on
Rodman), when he decided to purchase the Skyline options
- Reliance is not demonstrated – the opposite is. Both Sennott and Jordan
actively sought to prevent Rodman from discovering the option plan and
tried to keep it secret
- Sennott also refused to cooperate with Carroll’s inquiry into the check
indorsement issue
Plaintiff also tried to rely on Blackburn v. Dean Witter
- Factually similar, but major distinction = the plaintiff in Blackburn was a
customer of the brokerage and believed that she was purchasing stock
through the brokerage in the same manner that she had done previously,
relying on the expertise of the brokerage
- Here, there was no reliance upon this agency in the transactions in
question
Sennott knew that he was participating in a fraudulent scheme, so wasn’t coming
to the court with clean hands.
If William Rothbart had had knowledge of the fraudulent transaction, would this have been a
different outcome?
Difference between Blackburn & Sennott:
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Sennott knew that he was participating in a fraudulent scheme (i.e., inference from
Sennott’s refusal to discuss the transactions with Carroll = Sennott, as the plaintiff,
roadblocked the company from being able to rectify the issue)
PARTNERSHIPS
Traditional Noncorporate Business Associations
The General Partnership
Every state except Louisiana bases its partnership law on the Uniform Partnership Act (“UPA
(1914)”) or the Uniform Partnership Act (1997) (“UPA (1997)”). See UPA (1997), §202.
Uniform Partnership Act (1997), Section 202
SECTION 202. FORMATION OF PARTNERSHIP.
(a) Except as otherwise provided in subsection (b), the association of two or more persons to
carry on as co-owners a business for profit forms a partnership, whether or not the persons
intend to form a partnership.
(b) An association formed under a statute other than this [act], a predecessor statute, or a
comparable statute of another jurisdiction is not a partnership under this [act].
(c) In determining whether a partnership is formed, the following rules apply:
(1) Joint tenancy, tenancy in common, tenancy by the entireties, joint property,
common property, or part ownership does not by itself establish a partnership, even if
the coowners share profits made by the use of the property.
(2) The sharing of gross returns does not by itself establish a partnership, even if the
persons sharing them have a joint or common right or interest in property from which
the returns are derived.
(3) A person who receives a share of the profits of a business is presumed to be a
partner in the business, unless the profits were received in payment:
(i) of a debt by installments or otherwise;
(ii) for services as an independent contractor or of wages or other
compensation to an employee;
(iii) of rent;
(iv) of an annuity or other retirement or health benefit to a deceased or retired
partner or a beneficiary, representative, or designee of a deceased or retired
partner;
(v) of interest or other charge on a loan, even if the amount of payment varies
with the profits of the business, including a direct or indirect present or future
ownership of the collateral, or rights to income, proceeds, or increase in value
derived from the collateral; or
(vi) for the sale of the goodwill of a business or other property by installments
or otherwise.
Formation of a general partnership requires no written agreement or governmental action – all
that is required is a statutorily specified mutual manifestation of consent
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Under partnership law norms, the association of two or more persons to carry on as coowners a business for profit creates a partnership
Thus, under U.S. law, it is possible for parties to become de facto partners, even if
they don’t intend to (i.e., UPA §202(a))
The General Partner’s Rights and Duties (See UPA Section 401)
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Partners must share equally in profits and be chargeable with a share of losses in
proportion to their respective share of partnership profits
Partners have equal rights to participate in the management of the firm
A partner, its agents and attorneys shall have access to the partnerships books and
records pertaining to the period of their partnership
While ordinary matters are resolved by majority rule (50% +1), any change in the
partnership agreement or any extraordinary decisions must be made unanimously
No person can become a partner unless all current partners agree (unanimous consent)
Any partner can withdraw, triggering automatic dissolution of the partnership
Each partner owes a fiduciary duty to the firm (§404(a))
Each partner bears unlimited personal liability for the partnership’s losses and
obligations
o Partners joining an existing firm are not liable for obligations incurred prior to their
admission
All partners are jointly and severally liable for the firm’s obligations
The General Partner’s Standards of Conduct: UPA §404
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Among other things, a partner’s duty of loyalty to the partnership includes:
o Accounting to the partnership and hold as trustee for it any property, profit, or
benefit
o Refraining from dealing with the partnership in a position adverse to the
partnership’s interests
o Refraining from competing with the partnership prior to its dissolution
Partners must exercise a duty of care that is limited to refraining from grossly negligent
or reckless conduct, intentional misconduct, or a knowing violation of law
Discharge duties to the partnership and its partners, exercising obligations, consistently
with the obligation of good faith and fair dealing
Defining characteristics of general partnership form:
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Equal sharing of ownership and management functions
o General partnerships distribute the ownership and management functions (in
contrast to a sole proprietorship, which usually performs all of these functions
themselves):
 Residual claimant and risk-bearer
 Partnership law norms also assign to each partner an equal share
of profits and an equal responsibility for losses
 Full and equal right to participate in management of the firm
 Equal right to act as an agent of the partnership
Individual partner’s adaptability to changed circumstances favored over firm’s continuity
and adaptability
o
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In a sole proprietorship, agency and employment law default rules allow the
proprietor to adapt to changed circumstances by hiring and firing agents at will,
changing the course or nature of business at will, etc.
o Under partnership law default rules, if the partnership wishes to terminate its
association with a partner, it may do so only by dissolving the partnership and
paying the expelled partner the value of her interest in cash
 Thus, adaption is characterized by lack of stability and continuity
Unlimited personal liability
o All partners are jointly and severally liable for all obligations of the partnership
and there is no limit on this potential personal liability.
 I.e. misconduct of one partner could result in financial ruin for fellow
partners
Fiduciary duty
o Each partners owes a fiduciary duty to other partners
o Reduces the likelihood that one or more partners will misuse their ownership
powers or rights
Uniform Partnership Act (1997), Section 301
SECTION 301. PARTNER AGENT OF PARTNERSHIP.
Subject to the effect of a statement of partnership authority under Section 303, the following
rules apply:
(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
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.
(2) An act of a partner which is not apparently for carrying on in the ordinary course the
partnership’s business or business of the kind carried on by the partnership binds the
partnership only if the act was actually authorized by all the other partners.
Have to consider what each partner is engaging in, and whether their activities fall under
“partnership” business.
Grounds for Dissolution: §801
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The statute prescribes particular circumstances when general partnerships must be
dissolved
o Where a partner gives notice of their intention to withdraw from an at-will
partnership
o A triggering event as agreed to by the partners – such as a particular date or
occurrence
o Circumstances that render all or substantially all of the partnership’s business
unlawful (e.g., Change in market conditions, such as selling something that
becomes illegal)
o Following a partner’s application, a judicial determination that the partnership’s
economic purpose has been unreasonably frustrated; another partner’s conduct
does not make it reasonably practical to carry on the business in partnership with
them; or where it is not reasonably practical to carry on the partnership business
as per the partnership
“Capitalizing” the partnership = funding the partnership (each partner’s capital contribution)
-
Doesn’t have to be in the form of cash, can be chattels, access to facilities, “sweat
equity” (e.g., labor, expertise, etc.), etc.
“Flow through” Partnership = the taxes flow through to each partner, rather than the partnership
(i.e., the partnership is not a taxable entity)
-
Capital contribution difference in partnership vs corporation
o Partnership – each partner offers up funds to capitalize the partnership and is
taxed on their income earned from the partnership (i.e., the partnership raises
capital by selling capital contributions, which are made by individual partners)
o Corporation – each shareholder purchases shares of the corporation, which in
turn capitalizes the business, and the corporation is taxed
Joint Ventures
Distinction between general partnerships (associates carry on a business as co-owners) and
joint ventures (associates join to exploit a particular opportunity)
Joint Venture = a legal relationship between “two or more persons, who, in some specific
venture, seek a profit jointly without the existence between them of any actual partnership,
corporation, or other business entity.” (Florida Tomato Packers, Inc. v. Wilson)
The Limited Liability Partnership
Traditional general partnerships and limited partnerships have a central drawback – general
partners are personally liable for the firm’s obligations.
A new business type formed in the 1990s – the Limited Liability Company (LLC) – where
liability of the company owners is limited, and owners would only lose the capital they had
actually invested in the company if it were unable to satisfy its obligations. Thus, two new
business entities formed:
-
Limited Liability Partnership (LLP)
Limited Liability Limited Partnership (LLLP)
Determining the Legal Nature of the Relationship
Facts
Byker v. Mannes
In 1985, plaintiff was doing accounting work for defendant, which lead to
discussion about going into business together, due to their complementary
business skills. They agreed to start the business where they would buy and
manage properties, sharing equally in the profits, losses and expenses. They
eventually formed several different entities in order to facilitate investment of
limited partners, where again, they shared equally in the commissions and costs,
and even personally guaranteed loans from several financial institutions. The
relationship started to deteriorate after the creation of one of these entities, Pier
1000 Ltd. Pier 1000 Ltd started to encounter financial difficulties, which they had
to take profits from another one of their entities (M & B Ltd) and borrow money to
compensate for the losses. Mannes eventually refused to make any more
monetary contributions, while Byker continued to incur fees and make payments
(including entering into several individual loans for Pier 1000’s benefit, which
Mannes was not aware of). The marina that Pier 1000 owned was eventually
returned to its original owners, who took on the remaining debt. New business
ventures between Byker and Mannes ceased after this, and Byker requested that
Mannes make equalizing payments to him for the extra contributions he had to
pay. Mannes declined and Byker filed suit on the basis that they had entered into
a “general” partnership. Trial court held that they had entered into a general
partnership, Court of Appeal reversed on the basis that they parties did not have
mutual intent to form a partnership.
Issue
Whether the subjective intent of parties to form a legal relationship is relevant to
whether a partnership is formed.
Whether the law governing the financial situation of Pier 1000 is partnership
based, or corporation based.
Whether Byker and Mannes are partners, and partnership law should wash over
all of the other businesses created.
Holding Remand to Court of Appeals with proper test to analyze whether there was a
partnership that existed.
Analysis Plaintiff claims that their original business venture was a general partnership,
whereas defendant was claiming that he merely invested in separate business
ventures with plaintiff, and there was no understanding about a general
partnership between them.
The 1994 UPA amended the definition of a partnership to be defined as “the
association of two or more person to carry on as co-owners a business for profit,
whether or not the persons intend to form a partnership”
- The Michigan equivalent has not adopted this amendment but nonetheless
spells out that a partnership is defined as “an association of 2 or more
persons, which may consist of husband and wife, to carry on as co-owners
a business for profit…”
- That is, the subjective intent to form a legal relationship is not relevant –
stated plainly, the statute does not require “partners” to be aware of
their status as partners in order to have a legal relationship
Common Law – Court draws a distinction between analyzing whether the
parties intentionally acted as co-owners of a business for profit, and
whether they consciously intended to create the legal relationship of
“partnership”, with an emphasis that the focus should be on the former, and not
the latter
Ratio
In ascertaining the existence of a partnership, the proper focus is on
whether the parties intended to, and in fact did, “carry on as co-owners a
business for profit” and not on whether the parties subjectively intended to
form a partnership
Facts
Hynansky v. Vietri
Hynansky and Vietri entered into a business venture in 1988 to purchase and
develop a parcel of land. Because of zoning obstacles, the parcel could not be
rezoned as the parties had intended and they decided to sell it at a substantial
loss. Before they entered into the agreement, both parties executed a document
labelled “Partnership Agreement” that established “JHV Associates”,
Hynansky brought this action to obtain payment by Vietri of his capital
contribution, which Vietri never made, and Vietri’s pro rata share of the business
venture’s losses.
Issue
Whether intent to create a partnership is a factor in determining whether the
creation of a partnership was valid.
Holding Vietri proferred evidence that Hynansky treated the assets and the losses of JHV
Associates as his own for tax purposes, and that Hynansky identified JHV
Associates as a corporation on the contract of sale for the Parcel. Because any
conclusion as to the parties’ intent to form a partnership would require a balancing
of the conflicting evidence, summary judgment cannot be granted on the question
of whether JHV Associates is a Delaware general partnership.
Analysis On its face the document looked like a partnership agreement, and additionally,
the documents executed to acquire the parcel of land clearly indicated that the
acquiring entity was a partnership, with Vietri executing the closing documents as
a “Partner”.
- Vietri acknowledged that he signed the documents, but that he did not
read the original Agreement (and he relied upon his attorney).
Hynansky asserts that the business venture was a general partnership known as
JHV Associates, while also seeking dissolution of this partnership, after Vietri pays
his proportionate share of the losses which Hynansky absorbed
- Vietri conceded that executed a partnership agreement, but contends that
his understanding was that it was a limited partnership or corporation and
that he would only be providing his expertise (also that he would not
become an equity partner until the rezoning had been obtained)
- Hynansky also argued that the market conditions had changed, such that
the partnership needed to be dissolved
- Hynansky was also seeking for Vietri to pay his capital contribution
Parol Evidence Rule
- The parol evidence rule is designed to keep out extrinsic evidence that
would vary a fully integrated agreement that the parties have reduced to
writing
- Paragraph 21 of the Agreement explicitly lays out that the Agreement
contained the entire understanding between the two parties (i.e., it was an
integrated agreement). Vietri & Hynansky clearly assented to the
Agreement as their complete understanding when they signed the
document
- Therefore, Vietri’s attempt to introduce evidence that he had a different
understanding will vary the Agreement, and is not valid (despite Vietri’s
contention that this is a condition precedent that would not “vary” the
Agreement – court does not buy this, says it will do the opposite of what
Vietri claims = essentially it will vary the agreement)
- An exception to the Parol Evidence rule is when there is fraud or
misrepresentation or mutual mistake. However, Vietri cannot claim to have
relied on misrepresentation by Hynansky because he saw the agreement
and although he may not have read it, he conceded that realized that he
was signing it as a “Partner”
“the entire agreement and all the attendant circumstances must be taken into
consideration in reaching a determination that a partnership has actually
materialized.”
Ratio
The creation of a partnership is a question of intent. To prove the existence
of a partnership, one must show the intent to divide the profits of the
venture. In demonstrating that a partnership exists, the acts, dealings,
conduct, admissions and declarations of the purported partners, in addition
to other direct evidence, may by utilized. When the controversy is between
two partners, as it is here, stricter proof of the intention to create a
partnership is required.
- Thus, evidence in the forms of a partnership agreement is strong but
not conclusive proof of such an intention
Despite the court’s harsh language towards Vietri’s position, they still recognized that Vietri had
some justiciable claims and thus could not grant summary judgment for Hynansky.
Reconciling Byker and Hynansky:
-
Hynansky adds: have to look at the behavior of the parties in determining whether a
partnership exists (which is separate from subjective intent, and takes on a more
objective analysis)
Notes:
-
In some jurisdictions, most prominently New York, an agreement to share losses
appears indispensable to the existence of a partnership
In many jurisdictions an agreement to share losses also is indispensable to the
existence of a joint venture
UPA (1997) §401(a)(2) provides that, unless otherwise agreed, partners share
partnership losses in the same proportion as they share partnership profits
Problem 2-1
-
-
UPA (1997), s202 (a) & (c)(3)
Hynansky (conduct of parties)
Look at subjective & objective elements
o Subjective: party’s intention to make money together & form some type of entity
to make a profit
o Objective: whether a partnership has been formed, regardless of whether the
parties intended to or not
Conduct of the parties – behavior-based analysis
o Lack of willingness to sign an agreement
Problem 2-2
-
UPA (1997), s.301(2)
Sharing Profits and Losses
The common law and the Uniform Partnership Act each provide default rules governing a
partner’s right to share in profits, to be paid for services, or to receive interest on contributed
capital or money loaned to the firm. Likewise, the common law and the Uniform Partnership Act
provide fallback rules governing a partner’s responsibility to share in any losses experienced by
the partnership.
UPA (1997) §401(h)
Kovacik v. Reed
Plaintiff was a licensed building contractor in San Francisco who operated his
business as a sole proprietorship under the name “Asbestos Siding Company.
Defendant worked as a job superintendent and estimator for a number of building
contractors in the same city. In November 1952, plaintiff told defendant that
plaintiff had an opportunity to do kitchen remodeling work for Sears, asking
defendant to become his job superintendent and estimate in the venture. Plaintiff
said that he had $10,000 to invest in the venture and that if defendant
superintended and estimate the jobs, he’d share the profits on a 50-50 basis. He
didn’t ask defendant to share in any losses. The subject of losses was not
discussed. Defendant accepted the proposal and started work. Reed’s only
contribution was his own labor. The venture attained a number of remodeling jobs
and Reed worked on all of them. In August 1953, Kovacik informed Reed that the
venture wasn’t profitable and demanded contribution from Reed for amounts that
Kovacik claimed to have advanced in excess of the income from the venture.
Reed refused. The venture was terminated on August 31, 1953. Kovacik sued for
half of the losses. Trial court found that evidence indicated that both parties had
agreed to share equally in the profits and losses.
Issue
Whether Reed should be liable for one half of the monetary losses.
Holding Upon the loss of the money the party who contributed it is not entitled to recover
any part of it from the party who contributed only services
- Rationale: where one party contributes money and the other contributes
services, in the event of a loss, each would lose his own capital – the one
his money and the other his labor
Analysis It is the general rule that in the absence of an agreement to the contrary the
law presumes that partners and joint adventures intended to participate
equally in the profits and losses of the common enterprise, irrespective of
any inequality in the amounts each contributed to the capital employed in
the venture, with the losses being shared by them in the same proportions
as they share the profits.
- However, the cases applying this general rule have only included
agreements where both parties have contributed some type of capital
(monetary, land, etc.)
- Where, however, as in the present case, one partner or joint
adventurer contributes the money capital as against the other’s skill
and labor, neither party is liable to the other for contribution for any
loss sustained.
UPA (1997) §401(h) - A partner is not entitled to remuneration for services
performed for the partnership, except for reasonable compensation for services
rendered in winding up the business of the partnership.
- If a partner wanted to have their skills represented in the form of
payments/equity, then they need to be memorialized in the contract.
- That is, this labor is not compensable absent agreement to the contrary.
- It is presumed that all work done on behalf of the partnership by a partner
is non-compensable outside of things like ordinary draws (e.g., expenses
incurred trying to wind the business up)
Facts
Shamloo v. Ladd
Facts
Around July 1995, Shamloo and Ladd formed Ginnytex which was to be
incorporated in California but was not active. The parties did not complete all
required formalities to conduct business under Ginnytex as a corporation. Thus,
the partnership operated under an oral partnership agreement. The business
purpose of Ginnytex was to manufacture yarn into fabric for resale. The business
was to use Shamloo’s facilities for processing the yarn and he was to be paid for
this usage according to the market rate. Ladd contributed a $75,000 capital
investment and another $75,000 loan. Shamloo contributed “sweat equity” (labor,
knowledge, and industry expertise). Shamloo devoted approximately 50% of his
time and energy to running this business. Shamloo filed a complaint that alleged
that Ladd breached the partnership agreement by failing to pay Shamloo his share
of partnership assets; converting partnership assets; and failing to pay creditors of
Ginnytex. The trial court awarded Shamloo damages.
Issue
Is a partner’s “sweat equity” presumed to be the equivalent of a capital
contribution? Where a partner lends money to the partnership, are they
presumptively entitled to repayment of the loan with interest? Where a partner
receives his or her capital contribution, is he or she presumptively entitled to
repayment of that investment with interest?
Holding Reversal of the damages award to Shamloo. Ladd is not entitled to interest on his
capital contribution, but he is entitled to interest on the loan unless the evidence
establishes the parties agreed to the contrary. No evidence was introduced that
the parties agreed not to pay Ladd interest on the loan to Ginntex. Accordingly, he
is entitled to interest on the loan from the date of the advance.
Analysis It was undisputed that as a result of a failure to incorporate, Ginnytex was a de
facto partnership.
The rule is that, absent an agreement, a partner is not entitled to
compensation for rendering services for the partnership other than profits.
A partner is only entitled to compensation where the evidence discloses an
express or implied agreement that such partner will be compensated.
- There is no substantial evidence that the… agreement between the parties
contemplated, much less resolved, the issue of whether Shamloo was to
be compensated upon dissolution of the partnership for his contribution of
services to the enterprise in lieu of an actual capital contribution.
- Ladd categorically denied that there was ever an understanding that
Shamloo’s expertise would be treated as a percentage of capital
- Accordingly, the damages are reversed.
Ladd also made a claim for interest on the $75,000 loan he contributed
- California UPA s. 15018 states that “A partner, who in aid of the
partnership makes any payment or advance beyond the amount of the
capital which he agreed to contribute, shall be paid interest from the date
of the payment or advance.” – this clearly and unequivocally states that a
partner should be paid interest from the date of an advance
- An advance is not a capital contribution but is treated as a loan or
obligation to the partnership requiring the payment of interest. Under s.
15018 (c), interest is payable on an advance unless there is a contrary
agreement.
Seems like Ladd strategically classified half of his $150,000 investment ($75,000)
as a loan. So he sat as both a creditor and a capital contributor.
Ratio
Sweat equity is not compensable as equity in a partnership…
Debt obligations are addressed first, before refunding capital contributions (hence, the (likely)
reason why Ladd strategically classified his $150,000 as half loan and half capital contribution.
Problem 2-3
(a) Full-time gets 0$, because sweat equity is not compensable. Part-time, although contributing
capital, would get 0$, because there is no residual cash. Full-time would get the same thing.
(b) None would get $50,000, Part-time would get $25,000, None would get $0 (because of sat
equity)
(c) None would get $50,000 as a result of their capital contribution, Part-time would get $25,000
as a result of their capital contribution, and the remaining $25,000 “profit” would be split evenly
among the three.
Problem 2-4
The Partner as Fiduciary
UPA (1997), §§103, 403, 404
UPA (1997), §103(a) & (b) – recognizes that the partnership agreement is a flexible document,
but (a) and (b) set up some limits on that freedom.
UPA (1997), §403 – records and access to records
UPA (1997), §404 – standards of conduct
The Common Law Duty of Loyalty
Facts
Issue
Meinhard v. Salmon
Salmon entered into a lease agreement for a 20-year lease (Bristol Lease) for the
Hotel Bristol with the intention of converting it into a space for shops and offices.
While negotiating the Bristol Lease, Salmon formed a joint venture with Meinhard.
The joint venture’s terms (which were in writing) provided that Meinhard would pay
Salmon half the amount required to reconstruct, alter, 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. Near the end of the lease, a new lessor came in, 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 negotiated a new 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 percent interest in the Midpoint Lease. On appeal,
the appellate division affirmed, and upped Meinhard’s interest in the Midpoint
Lease to 50%.
Did the defendant in this matter violate his duty of loyalty to his partner?
Holding
Salmon should have informed Meinhard because coadventurers owe each other a
high level of fiduciary duty. The opportunity arose as a result of Salmon’s
management of the Hotel Bristol property and Salmon breached his fiduciary duty
by keeping this transaction from Meinhard and Meinhard lost an opportunity to
compete.
Analysis Joint adventurers, like copartners, owe to one another, while the enterprise
continues, the duty of the finest loyalty. Many forms of conduct permissible in a
workaday world for those acting at arm’s length are forbidden to those bound by
fiduciary ties. A trustee is held to something stricter than the morals of the
marketplace. Not honesty alone, but the punctilio of an honor the most sensitive,
is then the standard of behavior.
The issue with Salmon’s conduct is that he excluded his coadventurer from any
chance to compete, from any chance to enjoy the opportunity for benefit that had
come to him alone by virtue of his agency.
- Had Meinhard been involved, he could have made his own bid for the
lease, asked to extend the current lease at a higher rent, etc.
The very fact that Salmon was in control (as the manager of the operations) with
exclusive powers of direction charged him the more obviously with the duty of
disclosure, since only through disclosure could opportunity be equalized
- As a managing coadventurer, the rule of undivided loyalty is relentless and
supreme.
- The issue would be different if there weren’t a nexus of relation between
the business conducted by the manager and the opportunity brought to
him as an incident of management.
- Here, the subject matter of the new lease was an extension and
enlargement of the subject matter of the old one.
Regarding the equity in the new lease:
- The number of shares to be allotted to the plaintiff should be reduced to
such an extent as may be necessary to preserve to the defendant Salmon
the expected measure of dominion
Dissent:
- Distinction between joint venture and partnership:
- Joint venture = formed for a specific purpose and duration
- Partnership contemplates operation in perpetuity
- But when a joint venture carries on for an extended period of time, it may
begin to invite the concept that there is little distinction between the
fiduciary duties owed in JV vs Partnership
Ratio
Members of a partnership owe duty of loyalty to each other and so must
disclose opportunities that arise in order for both to have an equal chance
to take advantage of it.
The joint venture element of this discussion matters, because it shapes the behavior of the
parties. That is, since the joint venture here contemplated was limited in duration, Salmon was
acting under the impression/assumption that the joint venture was coming to an end and
therefore he wouldn’t face the same obligations at the end of term. However, the majority
concluded that it was a partnership, which extended the fiduciary duty beyond the length of the
so-called “venture”/lease term.
-
Generally, the fiduciary duties owed in both a joint venture and partnership are similar,
but they start to differentiate when the details of the different agreements differ more
-
greatly (i.e., the timing/length of the JV vs perpetual nature of the Partnership) AND the
distinction is further highlighted with the type of violation of the duty
TL;DR – it is context dependent (ex., majority in Salmon noted that had Salmon sought a
lease for land far away from the Bristol Lease, then it might not have been a breach of
fiduciary duty)
UPA (1997) §405 – recognizes a partner’s right to a formal accounting to enforce fiduciary
duties or contractual rights. A formal accounting is an equitable proceeding
UPA (1997) §403 – requires a partner, on demand, to furnish the requesting partner with full
and complete information about partnership affairs.
Regarding burdens of proof with fiduciary duty: Under the normal rule, fiduciaries must carry the
burden of proving by clear and convincing evidence that they have fulfilled their fiduciary
obligations.
Self-Dealing
Regardless of how badly the departing partner has behaved, they are always entitled to the
return of their capital contribution (Vigneau v. Storch Engineers)
-
-
Facts
When there is a prima facie case for a violation of fiduciary duties, the onus shifts on to
the person who is claimed to have engaged in self-dealing, to prove that they were
engaged in fair dealing (i.e., to prove that they have honored their fiduciary obligations).
(4th para on p.83)
As to defendant’s counterclaim of breach of fiduciary duty, the court recognizes the rule
that once a fiduciary relationship is established, as is the fact here, the burden of proof of
fair dealing shifts to the plaintiff and he must meet that burden by clear and convincing
evidence.
Vigneau v. Storch Engineers
Donald Vigneau (plaintiff) was partner in Storch Engineers (Storch) (defendant), a
consulting firm. Storch’s partnership agreement required Vigneau to “devote his
whole time and attention” to the business of the partnership, and to always give
the other partners “full information and truthful explanations of all matters relating
to” partnership business. The agreement also provided that the partnership must
purchase the partnership interest of retiring partners. In 1983, Vigneau and
Joseph Merluzzo, another Storch employee, formed a real estate development
partnership known as Highview Condominium Associates (HCA). Without
informing Storch of his dual role, Vigneau caused HCA to hire Storch to do the
engineering work for its project. Vigneau earned a profit of over $28,000 for his
investment in the HCA venture. Vigneau and Merluzzo launched a second real
estate venture, also without Storch’s knowledge, called Granford Associates. They
similarly hired Storch to do the engineering work. Granford was unprofitable,
ultimately resulting in a $22,000 loss to Vigneau. Storch was paid at a fair market
rate for its work for both Granford and HCA. Vigneau resigned from Storch in 1987
and should have been entitled to capital contribution. In 1989, Storch
discovered Vigneau’s role in HCA and Granford.
Vigneau sued for the value of his partnership interest pursuant to retirement
provisions of the partnership agreement (pg. 82), stipulated to be worth $167,794.
Storch argued that it was not required to do so, since Vigneau breached his duty
of loyalty by engaging in self-dealing, violating the partnership agreement.
Storch also counterclaimed against Vigneau for breach of fiduciary duty, seeking
recovery of the $164,105 Vigneau received in compensation for his work for
Storch during the time of his breach.
Issue
Does breach of fiduciary duty deprive P of his right to be paid for his vested
partnership interest? NO (based on precedent in Meechan v Shaughnessy)
Holding The court concluded that plaintiff violated his fiduciary duty (couldn’t meet
burden), and breached the agreement requiring him to give full information and
truthful explanation of all matters relating to partnership affairs and ethical duties.
- The court held that defendant could recover on his counterclaims of
breach of fiduciary duty, fraud, and CUTPA plus interest less the value of
plaintiff's vested partnership interest, which was owed to him despite his
self-dealing.
Analysis For breach of fiduciary duty, court recognizes the rule that once a fiduciary
relationship is established, burden of proof of fair dealing shifts to P, and he
must meet that burden by CLEAR and convincing evidence
- Self dealing: pattern of conduct where 1 partner acts in his best interest in
a transaction, rather than the interests of partnership or the other partners
o S.404(3) – partner must refrain from competing w/ partnership
before dissolution
Fiduciary Duty and Management of the Partnership’s Business and Affairs
UPA (1997) §401(f) and (j)
Under UPA (1997) §401(f), each partner has equal rights in the management and conduct of the
partnership business.
Under UPA (1997) §401(j), differences as to ordinary matters connected with partnership
business may be decided by a majority of the partners. However, no act in contravention of an
agreement between the partners may be done rightfully without the consent of all partners.
Thus, if partners have agreed to deal with even an ordinary matter in a certain way, such
agreement will control until changed by subsequent consent of all partners. UPA (1997) §401(j)
also requires that disagreements about extraordinary matters be decided unanimously.
-
In effect, §401(j) provides that business decisions are decided by a vote of the partners.
Equitable and fiduciary duty considerations for when a majority’s opportunistic refusal to “vote”
for needed changes in partnership policies may be constrained:
Facts
Covalt v. High
Covalt and High were corporate officers and shareholders in CSI. Covalt owned
25% of the stock and High owned the remaining 75% of the stock. Both received
salaries and bonuses from CSI. In 1971, both High and Covalt orally agreed to
form a partnership. The partnership bought real estate and constructed an office
and warehouse building on the land. They leased this land to CSI. In December
1978, Covalt resigned from his corporate position at CSI and was employed by a
competitor of CSI. In January 1979, Covalt wrote to High demanding that they
increase the rent for CSI from $1,850 to $2,850. After receiving the letter, High
informed Covalt that would look into the rent increase, but never agreed to
increase the rent and took no action to renegotiate the rent. At trial, High testified
that he didn’t think CSI could afford the higher rent due to poor financial status,
but the trial court found that it could afford the higher rent (and that a reasonable
rent for the time was $2,850) – the trial court found that High’s failure to assent to
his partner’s demand was a breach of fiduciary duty to Covalt and awarded Covalt
damages of $9,500 as lost rentals + prejudgment interest.
Issue
Did High breach a fiduciary duty to Covalt warranting an award of damages?
Holding In the absence of mutual agreement to increase the rent of the partnership realty,
one partner may not recover damages for the failure of the co-partner to
acquiesce in a demand by the plaintiff that High negotiate and execute an
increase in monthly rentals of partnership property with CSI. Thus, there was no
breach of fiduciary duty. In the absence of a mutual agreement, or a written
instrument detailing the rights of the parties, the remedy for such an impasse is a
dissolution of the partnership.
Analysis The status resulting from the formation of a partnership creates a fiduciary
relationship between partners. The status of partnership requires of each
member an obligation of good faith and fairness in their dealings with one
another, and a duty to act in furtherance of the common benefit of all
partners in transactions conducted within the ambit of the partnership.
- Except where the partners expressly agree to the contrary, it is a
fundamental principle of the law of partnership that all partners have
equal rights in the management and conduct of the business of the
partnership.
Any difference arising as to ordinary matters connected with the partnership
business may be decided by a majority of the partners.
- “[I]f the partners are equally divided, those who forbid a change must have
their way… [O]ne partner cannot either engage a new or dismiss an old
servant against the will of his co-partner; nor, if the lease of the
partnership place of business expires, insist on renewing the lease and
continuing the business at the old place.”
An act involving the partnership business may not be compelled by the copartner. If the partners are equally divided, then, as between the partners,
the power to exercise discretion on behalf of the partners is suspended so
long as the division continues. – in the case of two partners, the only course
of action is to dissolve the partnership
- At the formation of the partnership, both Covalt and High were officers and
shareholders of CSI. Each was aware of the potential for conflict between
their duties as corporate officers and their role as partners in leasing realty
to the corporation for the benefit of the partnership. Even after Covalt
resigned, he continued to remain a shareholder of CSI.
Can’t force one party to go along with the other. If there are only two partners, then there should
be some sort of tie breaking mechanism, to avoid a judicial dissolution.
Contracting for Absolute Discretion
UPA (1997) §§103(b)(3), 404
UPA (1997) §§103(b)(3), 404 provide that the fiduciary duty is partly mutable, but with an
irreducible core.
Starr v. Fordham
In 1984, plaintiff was a partner in the law firm Foley, Hoag & Eliot. Two of the
other partners at Foley Hoag left the partnership in 1985 to establish a new law
firm with another attorney. They established Kilburn, Fordham & Starrett in
January 1985. The partners at the new firm invited the plaintiff to join – the plaintiff
was hesitant because he was not a “rainmaker”, but the partners assured him that
would not be a significant factor in determining profit allocation. Before signing the
agreement, plaintiff expressed concern with certain provisions, namely Para 1
which vested in the founding partners and Kilburn, the authority to determine, both
prospectively and retroactively, each partner’s share in the firm’s profits. The
partners told him to take it or leave it, and the plaintiff signed without any
revisions. In August 1985, Kilburn withdrew. The founding partners divided the
firm’s profits equally in 1985. The plaintiff withdrew in December 1986 – the only
partners remaining in the firm were the two founding partners, who determined
that plaintiff’s share of the firms 1986 profits was 6.3% of the total (despite the
findings of the judge that he had produced billable hours and dollar amounts of
16.4% and 15%, respectively). The trial judge found that the founding partners
violated their fiduciary duties to the plaintiff as well as the implied covenant of
good faith and fair dealings in the partnership agreement when they determined
the plaintiff’s share of the firm’s profits for 1986 – the judge awarded the plaintiff
damages + interest.
Issue
Whether the founding partners of Kilburn, Fordham & Starrett violated their
fiduciary duties and implied covenant of good faith and fair dealing in the manner
they assigned the share of the firm’s 1986 profits to plaintiff.
Holding Yes, they did. The Court found that it could not conclude that the judge committed
a mistake in finding that the founding partners had violated both their fiduciary
duties to the plaintiff and the implied covenant of good faith and fair dealing.
Analysis Partners owe to each other a fiduciary duty of the highest degree of good faith and
fair dealing. When a partner has engaged in self-dealing, that partner has the
burden to prove the fairness of his actions and to prove that his actions did not
result in harm to the partnership (Similar to Vigneau v Storch Engineers above).
- The trial judge concluded that the founding partners engaged in self
dealing when they assigned the plaintiff his share of the profits, since they
had a self-interest in designating each partner’s respective share, and a
lower share for the others would benefit them
Business Judgment Rule
- The founding partners argued that the business judgment rule precluded
judicial review of their determination of the plaintiff’s share of profits
- The test to be applied when one partner alleges that another partner
has violated his duty of strict faith is whether the allegedly violating
partner can demonstrate a legitimate business purpose for his
action. Nevertheless, the business judgment rule does not apply if
the plaintiff can demonstrate self-dealing on the part of the allegedly
wrongdoing partner.
- Since the trial judge properly concluded that the founding partners
engaged in self-dealing, the judge did not err in concluding that the
business judgment rule did not apply
Fiduciary Duties and Covenant of Good Faith
Facts
Founding partners argue that the trial judge’s conclusion that they violated
both their fiduciary duties and the implied covenant of good faith and fair
dealing in allocating the profits was clearly erroneous
- An implied covenant of good faith and fair dealing exists in every contract.
Thus, an unfair determination of a partner’s respective share of a
partnership’s earnings is a breach not only of one’s fiduciary duty, but also
of the implied covenant of good faith and fair dealing.
- A court has the power to determine whether a partner’s share of the profits
is fair and equitable as a matter of law.
- The trial court looked at the plaintiff’s billable hours and dollar amounts,
compared to the total amounts of all the partners (16.4% and 15%,
respectively) & compared it to the 6.3% that the partners awarded plaintiff.
Additionally, the trial judge concluded that the founding partners fabricated
a list of negative factors that the founding partners used in determining
plaintiff’s share of the firm profits. As a result, the trial judge concluded that
the founding partners violated their respective fiduciary duties and implied
covenant of good faith and fair dealing. The appellate court upheld these
findings and conclusions.
When a partner has engaged in self-dealing, that partner has the burden to
prove the fairness of his actions and to prove that his actions did not result
in harm to the partnership. See Meehan v. Shaughnessy
Where there is an opportunity for discretion, an obligation to be honest and act in good faith
opens up when the circumstances call upon them to do so.
-
The Duty of Care
UPA (1997) §404(c)
Restatement (Second) of Agency §379(1) (1958) provides: “Unless otherwise agreed, a paid
agent is subject to a duty to the principal to act with standard care and with the skill which is
standard in the locality for the kind of work which he is employed to perform…” Thus, in any
business association a nonowner agent, including a managerial agent, owes a fiduciary duty of
care to her principal.
The statutory and limited case law regarding partnerships on this same issue is contradictory.
UPA §404(c) imposes a duty of care on general partners. Limited partnership statutes are silent
concerning a duty of care, but most provide that general partners have the same powers, and
are subject to the same restrictions, as partners in a general partnership.
The view for limited partnership settings is that general partners owe limited partners a fiduciary
duty of loyalty and care in the exercise of management functions.
Facts
Ferguson v. Williams
Ferguson and Welborn, doing business as F&W Development Company,
purchased two apartment buildings. The buildings were to be removed to a new
location, rehabilitated, leased to tenants, and then sold at a profit by the partners.
Two months after, the appellants started to run low on cash and contacted
appellee, Williams, and sold him a one fourth interest in the venture of $15,000.
They used $5,000 of this to purchase more land and the other $10,000 to secure
a $300,000 mortgage. However, the inability to obtain interim or construction
financing caused the venture to fail and the buildings were eventually dismantled
and sold to settle debt obligations. The court found that Williams actually played a
significant role in the venture: volunteering his employees to help with the building
moves, volunteering his front-end loader, speaking with Ferguson twice a week,
even advancing an additional $5,000 to help get the project “rolling.” He helped
obtain an $11,000 loan and even signed a loan application for a permanent loan
commitment for the partnership. The trial court found that the appellants were
guilty of negligence in the management of the affairs of the business and that
such negligence was the proximate cause of Williams’ loss of his invested funds
Issue
Holding
None of the trial court’s findings of negligence involve any breach of trust or
fiduciary duty of Ferguson and Welborn to Williams.
Analysis Given Williams’ involvement, the court agreed with the appellants that his conduct
was that of a partner, rather than a “passive investor”
- The court that: negligence in the management of the affairs of a
general partnership or joint venture does not create any right of
action against that partner by other members of the partnership. It is
only when there is a breach of trust, such as when one partner or
joint venturer holds property or assets belonging to the partnership
or venture, and converts such to his own use, would such action lie.
Ratio
In the ordinary management and operation of a general partnership or joint
venture, there is no liability to the other partners or joint venturers for the
negligence in the management or operation of the affairs of the enterprise
UPA (1997) 404(c) – Behavior rising to the level of recklessness is what runs counter to the
partner’s duty of care (there is little case law that weighs in on what rises to the level of
recklessness – courts are loath to second guess business judgments)
Dissolution and Dissociation
Basic Framework
UPA (1997) §§103(b)(6), 404, 601, 602, 603, 701, 801-803, 807(a)
UPA (1914) §§29-31, 38, 42
Dissolution framework application to an at-will partnership (partnership formed without
agreement that the partnership shall continue for a specified term or undertaking)
Under partnership law norms, the general partnership is an at-will relationship that can continue
only as long as every member assents. The at-will characteristic ensures that any partner will be
able to adapt to changed circumstances by dissociation from the partnership and redeploying
his talents and capital elsewhere.
In an at-will general partnership, any partner may “dissociate” and thereby cause a “dissolution”
of the partnership by simply expressing his will to cease association with the partnership. Under
partnership law norms, once dissolution occurs, the partnership must wind up its business, pay
off its debts, and settle accounts with partners.
Under UPA (1914), upon the non-wrongful dissolution of a partnership, whether caused by a
partner’s death or dissociation, or otherwise, any partner normally has the right to require that
the partnership’s assets be liquidated via a judicially supervised auction, with any cash
remaining after satisfaction of superior claims being distributed to the partners in accordance
with their respective profit shares. However, partners may avoid the normal rule by agreement
entered into either before or after dissolution.
Under UPA (1997), any partner normally has the right to require that the partnership’s
assets be liquidated via a judicially supervised auction only if the partnership is at will
and has been dissolved by a partner’s expression of will to dissociate. As under UPA
(1914), partner may avoid such a forced sale by ex ante or ex post agreement. A partner’s
death or non-wrongful dissociation by any means other than her expression of will does not give
any partner the right to force a liquidating sale as was the case under UPA (1914). Instead, the
partnership interest of a deceased or otherwise dissociating partner will be purchased by the
partnership for a “buyout price” based on the greater of the partnership’s liquidating or goingconcern value.
The normal rule found in UPA (1914) and UPA (1997) can be viewed as a device whereby
upon dissolution any partner or partner’s representative may force a competition for the
right to continue the firm, with the winner being the party that submits the highest cash
big at the judicial sale of the partnership’s assets. Thus, triggering the judicial sale wrests
the control of the partnership assets from the partners and forces them into an auction sale (i.e.,
forcing those interested in keeping the assets to have to compete for them).
McCormick v. Brevig
Joan McCormick and Clark Brevig are siblings whose parents owned a ranch as
joint tenants. When their parents divorced, Clark and the father owned the ranch
in equal shares and began operating the ranch as Brevig Land, Live & Lumber, a
partnership, pursuant to a written agreement. Joan was not part of the
partnership, but assisted in ranch operations from 1975-1981. In 1981 the ranch
hit severe financial hardship and Joan began working as an oil and gas “landman”
to help the finances. In 1982, Clark and their father went to the bank to refinance
their debt, but the bank required Joan to sign the mortgage to assist in the
repayment of the ranch’s debt. Eventually, Joan became a 50/50 partner with
Clark, after their father’s death (pursuant to a written agreement). At some point
after that, their relationship deteriorated and Joan sued Clark alleging that he had
converted partnership property for his own personal use, and seeking dissolution
and winding up of the Partnership. The trial court ordered that the partnership be
dissolved and wound up and appointed a special master to do this. It determined
Joan’s share in the partnership to be worth $1,107,672 and ordered Clark to pay
Joan that amount. Joan refused to accept the payment and appealed the order,
arguing that the partnership assets must be sold and the proceeds distributed.
Issue
Whether the District court erred in failing to order liquidation of the Partnership
assets, and instead granting Clark the right to purchase Joan’s Partnership
interest at a price determined by the court.
Holding When a partnership’s dissolution is court ordered pursuant to [Montana
UPA statute], the partnership assets necessarily must be reduced to cash in
order to satisfy the obligations of the partnership and distribute any net
surplus in cash to the remaining partners in accordance with their
respective interests. By adopting a judicially created alternative to this
statutorily mandated requirement, the District Court erred.
Analysis In Montana, the revised UPA (RUPA) provides two separate tracks for an exiting
partner from a partnership:
Facts
-
Ratio
1) Upon the happening of one of ten events specified in the Montana
statute, when a partner is dissociating, it does not result in a dissolution,
but rather in a buy-out of the dissociating partner’s interest in the
partnership
- 2) Events causing the dissolution and winding up of the partnership when
a partner dissociates (including a judicial decree)
Since the district court dissolved the Partnership, it recognized that, in the
absence of a partnership agreement to the contrary, the only possible result under
RUPA was for liquidation of the partnership assets. Using the Black’s Law
Dictionary definition of liquidation, the court concluded that a judicially ordered
buy-out of Joan’s interest by Clark was an acceptable alternative to liquidation
through compelled sale.
- However, this court determined through its reading of the RUPA that
liquidation clearly meant using assets to discharge obligations and
applying any surplus in cash to the partners in accordance with their
distributions
Clark tried to rely on a case called Creel, where one partner in a partnership died
and the court in Creel determined that the UPA did not mandate a forced sale of
all partnership assets and “winding up” was not always synonymous with
liquidation.
- This court found that the case was distinguishable, because no one has
died in the present case. Instead, Joan is seeking a court order for
dissolution.
Regarding Joan’s petition for an accounting of the Partnership’s business affairs:
- Every partner is generally entitled to have an accounting of the
partnership’s affairs, even in the absence of an express contract so
providing. Moreover, RUPA provides that a partner may maintain an action
against the partnership or another partner for legal or equitable relief,
including an accounting as to partnership business, or to enforce a right to
compel a dissolution and winding up of the partnership business.
- Since this court concluded that the assets must be liquidated, it will be
necessary for the district court, on remand, to perform a full accounting of
the Partnership’s affairs. This entails a detailed accounting of all the
Partnership’s assets and liabilities, as well as distributions of assets and
liabilities to the partners in accordance with their respective interests in the
Partnership.
The Revised UPA requires liquidation of partnership assets and distribution
of the net surplus in cash to the partners upon dissolution entered by
judicial decree when it is no longer reasonably practicable to carry on the
business of the partnership.
A buyout is not sufficient.
Wrongful Dissociation
UPA (1997) §§103(b)(6), 404co, 601, 602, 603, 701, 801-803
UPA (1914) §§31, 32, 38
The rules governing partner dissociation and partnership dissolution necessarily must strike a
balance between the individual partners’ ability to adapt to changed circumstances and the
firm’s desire for stability and continuity.
The value of the individual partner’s unilateral right to exit and the dominant group of partners’
unilateral right to expel an unwanted partner must be weighed against the costs.
Partners can easily shift the balance between adaptability and continuity by agreeing that the
partnership will continue for a fixed term or particular undertaking. So doing brings into play the
wrongful dissociation provisions of partnership law. If a partner dissociates from the partnership
before completion of the agreed term or undertaking, such dissociation will be wrongful. This
brings about two questions:
-
1) Is there partnership at will, or for a term or undertaking?
2) Have the partners already conducted themselves in a way that will be labeled
wrongful?
Drashner v. Sorenson
Facts
In January 1951, plaintiff C.H. Drashner, and defendants, A.D. Sorenson and
Jacob P. Deis, formed a real estate, loan and insurance business as co-owners at
Rapid City. They bought a real estate and insurance agency for $7,500, which
was advanced for the partnership by the defendants. By the time of trial $3,000 of
that money had been repaid to them by the partnership. Differences arose in the
partnership and in June 1951, plaintiff commenced this action seeking an
accounting, dissolution and winding up of the partnership. The defendants
counterclaimed for similar relief. The trial court made the following findings:
That the plaintiff violated the terms of the partnership agreement by demanding a
larger share of the income than he was entitled to receive under the agreement;
that plaintiff was arrested for reckless driving and served a term in jail for this
offense; plaintiff demanded that defendants permit him to draw money for his own
personal use out of moneys held in escrow by the partnership; that the plaintiff
spent a large amount of time during business hours in the Brass Rail Bar and
neglected his duties in connection with the business of the partnership… that
plaintiff, by the actions described, made it impossible to carry on the partnership.
The trial judge entered a judgment dissolving the partnership, which entitled the
defendants to carry on the business of the partnership, conditioned on paying the
plaintiff his share of the value of the property of the partnership (excluding the
good will of the partnership). However, at a hearing at a later date, the court found
that here was not sufficient partnership property to reimburse defendants for their
invested capital and that the plaintiff had no interest in the property and the
defendants were the sole owners.
Issue
Whether the plaintiff’s actions amounted to the wrongful dissolution of the
partnership.
Holding The trial court reasonably concluded that the insistent and continuing demands of
the plaintiff and his attendant conduct rendered it reasonably impracticable to
carry on the business in partnership with him. It follows that the evidence supports
the finding that plaintiff caused the dissolution wrongfully.
Analysis The agreement of the parties contemplated an association which would continue
at least until the $7,500 advance of defendants had been repaid from the gross
earnings of the business. Thus, it was not a partnership at will.
The breach between the parties resulted from a continuing controversy over the
right of plaintiff to withdraw sufficient money from the partnership to defray his
living expenses.
-
Plaintiff alleged that he was permitted to withdraw money from the
earnings as he needed it, but Defendants contended that there was no
such agreement (which was corroborated by a written admission from
Plaintiff)
- The trial judge concluded that the oral agreement provided that each
partner was able to withdraw one-third of one-half of the commission
earned by the partnership, with the other half going towards operating
expenses, and the excess left over to reimburse the defendants for the
capital advanced for the initial acquisition
- Thus, plaintiff’s claim was contrary to the partnership agreement found by
the court
Since this was not an at-will partnership, Drashner could not trigger liquidation
through dissolution.
McCormick v. Brevig
Facts above.
Did the District Court err in ruling that Clark did not dissociate by withdrawing from
the Partnership?
Holding Based on the district court’s findings (below), it’s conclusion that Clark did not
dissociate from the Partnership was not in err.
Analysis In her amended complaint, Joan alleged that Clark’s wrongful conduct of
converting Partnership assets to his own personal use warranted expelling Clark
from the Partnership, to which the district court denied Joan’s request for an order
of expulsion.
- On appeal, Joan contended that the district court failed to consider
evidence showing that Clark had dissociated from the Partnership; the
evidence being that Clark denied the existence of the Partnership and had
taken steps to transfer legal title of the Partnership’s primary asset- the
ranch- to his name, and had converted over $400,000 of Partnership funds
to his own personal use; also the fact that Clark had instigated criminal
charges against her in 1994, which later proved frivolous.
Section 35-10-616 of the MCA delineates ten events causing a partner’s
dissociation from a partnership, one of which is expulsion by judicial decree
made upon application by the partnership or another partner, because:
- (a) The partner engaged in wrongful conduct that adversely and
materially affected the partnership business;
- (b) the partner willfully or persistently committed a material breach of
the partnership agreement or of a duty owed to the partners or other
partners under 35-10-405;
- (c) the partner engaged in conduct relating to the partnership
business that made it not reasonably practical to carry on business
in partnership with that partner
Since Joan did not make a specific request for relief under 35-10-616(5), the
district court only considered her claim generally. In so doing, the court concluded
that:
- Clark had not given notice of his express will to withdraw as a partner
- The partnership agreement did not apply
- Clark had continued to work the ranch since his alleged dissociation in
1994, which Joan and the Partnership had benefitted from
Facts
Issue
-
Although Clark obtained loans in his individual name from 1994 onward,
this did not constitute dissociation since it was a necessary action in light
of the parties’ inability to communicate about ranch finances
Additionally, it does not appear that Joan raised the argument of Clark converting
the $400,000 worth of Partnership assets to his personal use in a timely fashion.
As well, the claim that Clark dissociated by instigating criminal charges fails,
because the district court found that both parties were at least partially at fault for
the deterioration of the Partnership and taking alternate legal positions during the
course of the dispute did not amount to dissociation.
Notes:
-
When a court concludes, as in Drashner, that a partner’s conduct over a period of time
has caused a dissolution of the partnership, it will also be necessary to determine when
dissolution occurred.
Fiduciary Limits on Dissolution “At Will”
With an “at will” partnership, if the association becomes unwanted by any partner, then that
partner may dissolve the relationship at will. Moreover, in most circumstances, after dissolution
of an at-will partnership, any former partner may force a liquidating sale of the business.
Page v. Page
Plaintiff and defendant were partners in a linen supply business in California.
Plaintiff appeals from a judgment declaring the partnership to be for a term rather
than at will. The partners entered into an oral partnership agreement in 1949. In
the first two years, each partner contributed approximately $43,000 to purchase
land, machinery, and linen. From 1949 to 1957 the enterprise was unprofitable.
Plaintiff also a corporation that was the main creditor supplying funds for the
partnership. This corporation held a $47,000 demand note of the partnership.
After 1958, a military base opened up nearby and the partnership began to be
profitable. Defendant testified that the terms of the partnership were similar to
previous partnerships between plaintiff and defendant, where the understanding
was to let the business operations pay for themselves and let the business pay
itself out.” The trial court found that the partnership is for a term, namely, “such
reasonable time as is necessary to enable said partnership to repay from
partnership profits, indebtedness incurred for the purchase of land, buildings,
laundry and delivery equipment and linen for the operation of such business…”.
Plaintiff appealed.
Issue
Whether the trial court erred in concluding that this was a partnership for a term,
and whether the plaintiff acted in bad faith.
Holding This is a partnership at will, and the plaintiff did not act in bad faith. If, however, it
is proved that the plaintiff acted in bad faith and violated his fiduciary duties by
attempting to appropriate his own use of the new prosperity of the partnership
without adequate compensation to his co-partner, the dissolution would be
wrongful and the plaintiff would be liable as provided by [UPA §38(2)(a)]… for
violation of the implied agreement not to exclude defendant wrongfully from the
partnership business opportunity.
Analysis The Uniform Partnership Act provides that a partnership may be dissolved “[b]y
the express will of any partner when no definite term or particular undertaking is
specified.”
Facts
Plaintiff correctly contends that the trial court’s finding of a term partnership
is without support in evidence.
- Under cross-examination the defendant admitted that the former
partnership agreements referenced were substantially different from the
present agreement.
The evidence suggests that the partners expected to meet current expenses from
current income and to recoup their investment if the business were successful.
- Defendant contended that such an expectation was sufficient to create a
partnership for a term under Owen v Cohen (which suggested that
partners may impliedly agree to continue in business until a certain sum of
money is earned, or one or more partners recoup their investments, or
until certain debts are paid, or until certain property could be disposed of
on favorable terms.
- In each of the cases similar to Owen, however, the implied agreement
found support in the evidence (e.g., in Owen, the partners borrowed
substantial amounts of money to launch the enterprise and there was an
understanding that the loans would be repaid from partnership profits). In
those cases, the court properly held that the partners impliedly promised to
continue the partnership for a term reasonably required to allow the
partnership to earn sufficient money to accomplish the understood
objective
- In the instance case, however, the defendant failed to prove any facts from
which an agreement to continue the partnership for a term may be implied.
The understanding to which defendant testified was no more than a
common hope that the partnership earnings would pay for all the
necessary expenses. Such a hope does not establish even by implication
a “definite term or particular undertaking” as required by [UPA s.31(1)(b)].
- All partnerships are ordinarily entered into with the hope that they will be
profitable, but that alone does not make them all partnerships for a term
and obligate the partners to continue in the partnerships until all of the
losses over a period of many years have been recovered.
Defendant also contends that plaintiff was acting in bad faith since he is in a
superior financial position (due to the loan note) and is attempting to use that
benefit to appropriate the now profitable business of the partnership.
- These contentions are irrelevant to the issue of whether the partnership is
for a term or at will, but regardless, the defendant is amply protected by
the fiduciary duties of co-partners*
*Although the UPA provides that a partnership at will may be dissolved by
the express will of any partner, this power, like any other power held by a
fiduciary, must be exercised in good faith.
- A partner at will is not bound to remain in a partnership, regardless
of whether the business is profitable or unprofitable. A partner may
not, however, by use of adverse pressure “freeze out” a co-partner
and appropriate the business to his own use. A partner may not
dissolve the partnership to gain the benefits of the business for
himself, unless he fully compensates his co-partner for his shares of
the prospective business opportunity. In this regard, his fiduciary
duties are at least as great as those of a shareholder of a corporation.
-
Ratio
Fiduciary Limits on Expulsion of Unwanted Partners
UPA (1997) §§601(3), 701, 801(1)
Facts
Bohatch v. Butler & Binion
Colette Bohatch (plaintiff) was a partner in the Washington, D.C. office of the law
firm Butler & Binion. The office had two other attorneys, McDonald and Powers,
both partners. Almost all of the D.C. office’s work was done for Pennzoil. In 1990,
based on her review of billing reports and time records, Bohatch began to suspect
that McDonald was overbilling Pennzoil. She reported her concerns to Powers,
and to other partners and members of Butler & Binion’s management committee.
The management committee investigated the allegations. Pennzoil’s in-house
counsel told committee members that Pennzoil believed McDonald’s bills to be
reasonable. The management committee determined that there was no basis for
Bohatch’s allegation that McDonald was overbilling. In January 1991 Butler &
Binion denied Bohatch her year-end partnership distribution, and reduced her
tentative distribution share for 1991 to zero. It continued to pay Bohatch her
monthly draw until June 1991. On October 21, 1991 the firm voted to expel
Bohatch from the partnership. Bohatch brought claims against Butler & Binion and
its partners (the firm) (defendants) for breach of fiduciary duty and breach of
contract. The jury found that the firm breached the partnership agreement and its
fiduciary duty, and awarded damages. The court of appeals found that the firm’s
only duty to Bohatch was not to expel her in bad faith, that is, for self-gain. Finding
no evidence that the firm had expelled her for self-gain, the court of appeals found
that Bohatch could not recover on the breach of fiduciary duty claim. The court of
appeals also found that the firm breached the partnership agreement by reducing
Bohatch’s tentative distribution for 1991 to zero without notice, and for terminating
her monthly draw three months before she left the firm.
Issue
Holding
Fiduciary relationships do not create exceptions to the at will nature of
partnerships among law partners. The firm did not have a duty to not expel
Bohatch for reporting suspected overbilling by another partner. Bohatch’s claim of
being expelled improperly was governed by the partnership agreement, however,
her claim of an improper reason for expulsion is not subject to the partnership
agreement. Look to common law
Analysis Bohatch more of less blows the whistle, which upsets the other partners, who then
want to kick her out. The other partners perceive it as Bohatch accusing them of
being fraudsters.
Ratio
Partners in at-will partnerships have the freedom to expel another partner if
the offending partner damages the personal confidence and trust of the
partnership.
Contracting to Prevent Opportunistic Withdrawal: The Fiduciary Duties Owed to Withdrawing
Partners
UPA (1997) §§601, 602, 701, 801
In service partnerships, it is common for one or more partners to dissociate, form a new firm that
carries on a similar business, and then attract a number of their former firm’s clients to the new
firm. It is also common for partners to contract in advance concerning the rights and obligations
of continuing and withdrawing partners.
Facts
Issue
Holding
Meehan v. Shaughnessy
James Meehan and Leo Boyle (plaintiffs), were partners in the law firm of Parker,
Coulter, Daley & White (Parker Coulter) (defendants). They decided to quit that
firm and form their own firm. 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.
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.
The MBC partners’ breach of duty consisted of their method of acquiring consent
from clients to remove cases and Parker Coulter’s recovery is limited to only those
losses which were caused by this breach of duty (but place the burden of
disproving causation of the MCB partners).
Analysis Statutory Considerations: The Partnership Agreement
- The Parker Coulter partnership agreement provided for rights on a
dissolution caused by the will of a partner which are different from those
[provided by the UPA default provisions]
- The UPA gives a partner the power to dissolve a partnership at any
time. Under the UPA, the assets of the dissolved partnership are
divided among the former partners through the process of liquidation
and windup. The UPA, however, allows partners to design their own
methods of dividing assets and, provided the dissolution is not
premature, expressly states that the partners’ method controls.
- The Court found: Under the Parker Coulter agreement, a partner who
separates his or her practice from that of the firm receives: (1) the right to
his or her capital contribution, (2) the right to a share of the net income to
which the dissolved partnership is currently entitled, and (3) the right to a
portion of the firm’s unfinished business, and in exchange gives up all
other rights in the dissolved firm’s remaining assets  as to (3), the
partner gives up all right to proceeds from any unfinished business of the
dissolved firm which the new, surviving firm retains – the departing partner
takes certain of the unfinished business (on payment of a “fair charge”)
and the new Parker Coulter takes the remainder
- The two entities surviving after the dissolution possess “new business”,
unconnected to that of the old firm, and the former partners no longer have
a continuing fiduciary obligation to wind up for the benefit of each other the
business they shared in their former partnerships
Fiduciary Duties; Breach
- Parker Coulter claimed that Meehan & Boyle breached their fiduciary
duties (1) by improperly handling cases for their own, and not the
partnership’s benefit, (2) by secretly competing with the partnership, and
(3) by unfairly acquiring from clients and referring attorneys consent to
withdraw cases from MBC.
- The Court disagreed with the first 2, but agreed with 3.
- (1) The MBC partners performed at the same level as they were prior to
forming the intention to leave. Additionally, they were only forming
logistical arrangements for the new partnership (similar to Hamburger v
Hamburger = permissible).
- (2) fiduciaries can plan to compete with the entity to which they owe
allegiance, “provided that in the course of such arrangements they [do] not
otherwise act in violation of their fiduciary duties.” (trial court found that
Meehan and Boyle made permissible logistical arrangements for the
establishment of MBC – e.g., executing a lease, preparing list of clients
expected to leave Parker Coulter, obtaining financing)
- (3) Meehan and Boyle through their preparation for obtaining clients’
consent, their secrecy concerning which clients they intended to take, and
the substance and method of their communications with clients, obtained
an unfair advantage over their former partners in breach of their fiduciary
duties (Evidence: Meehan affirmatively denied to partners that he had any
plans for leaving, obtained authorizations for clients during this time,
prepared letters on Parker Coulter’s letterhead for authorizations, + breach
of ethical standards in letters sent to clients because they did not “clearly
present to the clients the choice they had between remaining at PC and
moving to MBC)
Consequences of Breach
- For Parker Coulter to recover any amount in addition to what it would
be entitled to receive upon dissolution under the agreement or the
UPA, there must be a causal connection between its claimed losses
and the breach of duty on the part of the MBC partners. Since the
MBC partners unfairly acquired consent from clients, Parker Coulter,
therefore, is entitled to recover only those amounts which flow from
this breach of duty
- If there hadn’t been a breach, the assets would have been divided
according to the partnership agreement
- A partner does not forfeit his or her right to the accrued profit or a
partnership simply by breaching the partnership agreement – the
same applies to a partner’s capital contributions. Thus, Meehan and
Boyle are entitled to have their capital contributions returned
- Burden of proof regarding the fees from the removed cases: Once it is
established that a partner or corporate manager has engaged in selfdealing, or has acquired a corporate or partnership opportunity,
these courts require the fiduciary to prove that his or her actions
were intrinsically fair, and did not result in harm of the corporation or
partnership. In this case, Meehan and Boyle hold that burden –
remand to trial court
Takeaways:
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Give fair notice
Engage in honest and fair dealings with partnership (other partners)
Be honest with partnership’s clients in the process
Partners as Agents – Allocating the Risk of Loss in Transactions with Third Parties
A Partner’s Apparent and Inherent Authority
UPA (1997) §§102, 301, 303, 306, 603
Partnerships face a contractual risk common to all agency relationships.
State partnership statutes provide specific rules delineating a general partner’s authority. Such
statutes incorporate by reference the law of agency, and should be interpreted in light of the law
of agency, including the principles of actual, apparent, and inherent authority.
Under agency law, authority comes from the principal’s manifestations of consent to either the
agent or the third party (this is dependent on a case-by-case analysis to determine if any
manifestations exist, and to what extent).
The broadest possible grant of agency power is the general agency power granted to one who
is the general manager in charge of the entire business. However, the existence of that authority
must be traceable to a manifestation of consent by the principal, requiring application of agency
principles.
Facts
Issue
P.A. Properties, Inc. v. B.S. Moss’ Criterion Center Corp.
In February 1988, United Artists entered into a joint venture agreement with Moss
Ventures (defendant is successor of Moss Ventures). Moss and UA agreed to
operate the JV as “Moss/United Artists Joint Venture,” with termination scheduled
for July 31, 2034. The JV was governed by New York partnership law and
provided that the members of the JV were “liable for all debts, liabilities and
obligations of the JV in proportion to the Allocable Shares.” Under the venture
agreement, UA was the managing venturer and had “complete authority and
responsibility” to operate the business and make day-to-day business decisions.
In September 1992, UA entered into a consulting agreement with P.A. Properties,
Inc. (PAP) (plaintiff). In the consulting agreement, PAP agreed to analyze and
investigate possible overcharges in the lease arrangements – the agreement did
not mention the JV and UA entered the agreement in its own name. UA filed for
bankruptcy in 2000, having never paid PAP for its services. PAP filed a claim in
bankruptcy against UA in the amount of $1,059,716, which was later negotiated
down to $600,000. PAP ultimately received only $35,000 from UA. To recover the
balance of its debt, PAP then sued B.S. Moss’ Criterion Center Corporation
(defendant), the successor entity to Moss Venturers.
Whether UA’s consulting agreement with PAP was an obligation of the JV, such
that the remaining solvent co-venturer, Moss, is liable thereon. (that is, whether
UA entering into the Consulting Agreement falls within their scope of authority
within the JV)
Holding The consulting agreement was an obligation of the operator's joint venture with
the partner pursuant to N.Y. Partnership Law § 20(1) as it was entered into during
the life of the joint venture and was clearly for the benefit of the joint venture.
- The dissolution of the operator's joint venture with the partner did not
discharge the operator's liability under the consulting agreement pursuant
to N.Y. Partnership Law § 67, but that there were factual issues regarding
whether the joint venture's obligations under the consulting agreement had
been met
- The partner's bankruptcy did not extinguish the operator's indemnification
claim because the operator's claim under their joint venture constituted a
valid pre-petition claim under 11 U.S.C.S. § 101(5).
Analysis The UPA adopted by NY provides in pertinent part that “[e]very 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.”
- It is undisputed that the Consulting Agreement was entered into during the
life of the JV, at a time when UA served as Managing Venturer. It is
equally undisputed that UA executed the Consulting Agreement in its own
name, that neither the agreement nor the Douglaston lease itself mentions
the JV at all, and that PAP was unaware of the existence of the JV when it
contracted to perform its services.
- Moss then contends correctly that it is not a party to the Consulting
Agreement as a matter of contract law, nor is there any basis for holding
the JV or Moss responsible for the payment of liabilities under the contract
on the agency law principle of apparent authority, as no conduct of Moss
or of the JV led PAP to believe that UA was authorized to bind the JV.
However, the undisputed facts make it clear that the Consulting Agreement is an
obligation of the JV by virtue of the doctrine of inherent liability of an undisclosed
principal for acts within the scope of a general agency, at least with respect to
PAP’s claims relating to periods during which the Douglaston theatre was
operated by and for the benefit of the JV. UA was managing venturer of the JV at
the time entering into the Consulting Agreement, which was clearly for the benefit
of the JV. The contract was well within the scope of the broad powers of UA as
Managing Venturer. The facts show that UA intended to benefit the JV by entering
into the Consulting Agreement to reduce lease payments.
**PAP is using Agency Theory as a way to link Moss to the unanswered debt from UA (which
they can’t pursue because of UA’s bankruptcy).
Facts
Haymond v. Lundy
John Haymond (plaintiff), Robert Hochberg, and Marvin Lundy (defendant)
founded the law firm partnership Haymond & Lundy (H&L) in October 1997. The
partnership agreement provided that a partner must get the approval of a majority
of the partners before purchasing or disposing of a material asset exceeding
$10,000 in value. John Kelly was injured in an accident. He initially retained
attorney Emmett Fitzpatrick to represent him in a personal injury action. After
Fitzpatrick filed the complaint, Kelly said he no longer wanted Fitzpatrick’s
services and turned to Lundy and H&L instead. Without consulting the other
partners, Lundy contacted Fitzpatrick and promised to pay a referral fee out of any
trial proceeds (which was a customary practice of the members of the
Philadelphia personal injury bar) and memorialized this in writing. The case settled
for nearly $2.5 million, including attorney’s fees of $996,500. In satisfaction of their
referral agreement, Lundy paid Fitzpatrick $150,000. H&L dissolved in October
1999. The partners’ various liabilities regarding partnership business were
ultimately sorted out in court. Haymond and Hochberg alleged that the referral fee
was not a liability of the partnership because Lundy lacked authority to pay it
without majority approval. Lundy countered that the referral fee was not a material
asset. No evidence of the firm’s prior treatment of referral fees was presented.
Issue
Whether Lundy’s commitment to pay a standard referral fee exceeded his
authority to bind H&L under the Partnership Agreement.
Holding Yes. Absent persuasive evidence that undivided rights to contingent fees are not
“assets,” Lundy exceeded his authority under the Partnership agreement by not
obtaining his partners’ consent before making this agreement.
Analysis Lundy tried to argue that it was not the custom of the partnership to treat referral
fees as material assets.
- Lundy’s agreement to pay the referral fee to Fitzpatrick was a decision by
a partner of H&L and bound the partnership to pay Fitzpatrick 1/3 of fees
received when the Kelly matter settled. It disposed of a material asset of
the partnership (the undivided right to a contingent fee in the Kelly matter)
exceeding $10,000 (therefore bringing it within the scope of s.5.01 of the
Partnership Agreement
Note: Authority of Joint Ventures
The difference in agency power between a general partner and joint venturer is a function of the
fundamental difference between a joint venture and a general partnership.
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A joint venture is for a limited purpose and normally involves a less than total merging of
the interests and assets of the venturers. Thus, it is not reasonable to assume that the
venturers have granted each other the authority of a general manager (of course, it is
possible to grant this authority in the agreement)
In contrast, a general partnership normally involves a complete merging of interests and
assets to carry on a business. It is reasonable to believe that partners in such ventures
would usually grant each other the agency power appropriate for a general managerial
agent (Consistent with this reasoning – UPA §9 creates a presumption on which third
parties without knowledge to the contrary may rely – that all general partners have the
actual authority of a general managerial agent).
Limited Partnership Act, (Ontario)
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Available to any business in Ontario
Structure requires one general partner: s.2(2)
General partner is considered self-employed for tax purposes
The limited “non-equity” partners are not self-employed
Partners within this structure typically described as equity and non-equity partners
Provides “flow-through” taxation structure for general partner
LLPs under the Partnerships Act, (Ontario)
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-
Not generally available outside of regulated professions
Only regulated professions with statutory permission to form LLPs may do so: s.44.2
An LLP provides a partner protection from:
o The negligent acts or omissions that another partner, employee, agent or
representative of the firm commits on behalf of the firm
o Ordinary trade debts of the firm
The rules governing individually regulated professions operate to assign liability
The Corporate Form and the Specialized Roles of Shareholders, Directors, and Officers
The Corporate Form
Overview
MBCA §§2.06, 8.01, 8.40, 10.01-10.04, 10.20
Delaware G.C.L. §§109, 141(a), 142, 242
As defined by corporations statutes, the archetypical corporation separates ownership and
management functions into three specialized roles:
-
Directors (make major policy decisions)
o Appointed by Shareholders
Officers (execute the policies and provide day-to-day management)
o Appointed by Directors
Shareholders (provide capital and elect directors)
o Liability is limited to the amount of money spent buying shares
Thus, three discrete bundles of rights are created. However, while the corporate form assumes
separation of these functions, it does not require it.
The corporate form provides a hierarchical form for decision making that permits the enterprise
to adapt easily to changed circumstances. By statute, all corporate powers are exercised by, or
under the authority of, a centralized group – the board of directors. In addition, day-to-day
management operations are delegated to the corporation’s officers and other agents. No direct
management role is left to the shareholders.
In addition, the law recognizes the corporation as an entity separate from the directors, officers,
and shareholders who make it up (in most respects, a corporate will be granted the same legal
rights and responsibilities as would any person – e.g., it can own property, assert legal rights,
etc.). A corporation has the potential of perpetual duration, at least until a majority of directors or
shareholders decide to end its existence.
Directors
The board of directors is the locus of all legal power and authority exercised by the corporation.
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Collectively, directors determine basic corporate policies, appoint and monitor the
corporate officers, and determine when and if dividends are to be paid to shareholders.
Director’s management power must be exercised collectively and by majority rule, and
individual directors are not given general agency power to deal with outsiders.
Directors owe fiduciary duties to the corporation and its shareholders.
Directors are paid for their services, but are not entitled to share in profits
In publicly traded corporations, there must be a majority of independent outside directors
(required by listing standards of national stock exchanges, instead of corporations statutes)
Officers
Corporate law considers officers as agents and the corporation as principal (acting through its
board of directors) and leaves it to the board to work out the oversight that it desires as to its
agents. More recently, federal law, as opposed to the laws of the 50 states that are the source
of corporate law, has begun to play a role in the specification of officers’ duties.
-
-
E.g., the Sarbanes-Oxley Act of 2002 requires that the CEO and CFO of a corporation
certify the financial reports of the corporation that are made pursuant to disclosure rules
of the federal securities laws.
Like directors, officers receive compensation for services they perform, but do not share
in the corporation’s residual profit unless they also own shares.
The term “officer” connotes a corporate employee who ranks above other corporate employees
in a corporation’s management hierarchy. Modern statutes allow corporations to have the
officers specified in the bylaws or determined by the board (See MBCA §8.40 and Delaware
G.C.L. §142).
The only remaining requirement in most codes is that the corporation designate an individual to
be responsible for keeping and verifying corporate records, a duty often identified with the title
“corporate secretary.” A corporation’s principal officer is often termed the chief executive officer,
or “CEO”, but that designation does not come from the corporations statute. Often this person
serves as chair of the board of directors – a combination that has been controversial to the
extent that it impedes the monitoring or oversight of the CEO by the board of directors.
Shareholders
Corporate ownership interests are represented by shares – fungible ownership units – that
typically entitle the holder to a pro rata share of the firm’s profits and net assets when the
corporation dissolves and winds up its business.
Shareholders collectively have the power to elect annually the corporation’s directors and
approve fundamental changes in the corporation’s governing rules or structure.
Normally, a shareholder has no obligation or liability to the corporation or its creditors beyond
the amount she paid for the shares = “limited liability” – allows a shareholder to risk only a
predetermined amount of capital in each corporate investment, instead of potentially risking her
entire wealth as would be the case if shareholders were personally liable for a corporation’s
debts.
The governance role of shareholders – statutory norms provide for annual and special
shareholders’ meetings and sometimes actions by written consent. Shareholders may use such
a forum to elect (and possibly remove) directors and to vote on certain fundamental corporate
actions such as mergers or amendments to the articles of incorporation, but only if such items
have first been submitted by the directors acting as a gatekeeper. Additionally, shareholders
can make some changes to the bylaws without prior approval by the directors.
Can have dual class of shares (e.g., Class A & Class B), but intra-class equity means that all
shareholders of the same class have to be treated the same.
Articles of Incorporation
Almost all state corporation codes now provide that the business of a corporation shall be
entrusted to directors, except as otherwise provided in the articles of incorporation.
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Thus, the original articles of incorporation can give shareholders a right to control, or
participate in control of, ordinary business matters
Like the corporation’s constitution
When the original articles of incorporation have not made advance provision for direct
shareholder management, the shareholders may amend the articles of incorporation to give
themselves such a right. HOWEVER, the normal corporate law rule is that only the directors
may initiate an amendment to the articles.
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See the default rules in MBCA §8.01 and Delaware G.C.L. §141(a).
o Both sections limit the methods of opting out of or contracting around their default
rules to provisions contained in the articles of incorporation.
Since the MBCA and Delaware G.C.L. require that the board of directors initiates
amendments to the articles, and since directors will not initiate an amendment curbing
their own powers, §§8.01 and 141(a) effectively are immutable rules for corporations that
do not opt out in the initial articles of incorporation
MBCA §8.01 – Requirement For and Duties of Board of Directors
(a) Except as provided in section 7.32, each corporation must have a board of directors.
(b) All corporate powers shall be exercised by or under the authority of, and the business and
affairs of the corporation managed by or under the direction of, its board of directors, subject
to any limitation set forth in the articles of incorporation or in an agreement authorized under
section 7.32.
CROSS-REFERENCES
Amendment of articles of incorporation, see ch. 10A.
Articles of incorporation, see § 2.02.
Close corporations, see Model Statutory Corporation Supplement.
Director standards of conduct, see § 8.30.
Indemnification, see §§ 8.50-8.59.
Number of shareholders, see § 1.42.
Officers, see §§ 8.40 & 8.41.
Delaware G.C.L. §141(a)
(a) The business and affairs of every corporation organized under this chapter shall be
managed by or under the direction of a board of directors, except as may be otherwise
provided in this chapter or in its certificate of incorporation. If any such provision is made in
the certificate of incorporation, the powers and duties conferred or imposed upon the board of
directors by this chapter shall be exercised or performed to such extent and by such person
or persons as shall be provided in the certificate of incorporation.
By-laws
Most states do allow shareholders to initiate a change in the corporation’s bylaws (see e.g., Del.
§109). However, shareholders normally may not amend the bylaws to make ordinary business
decisions or to establish corporate policies. That power belongs to the directors and can be
taken away from them only by contrary provision in the articles of incorporation (See e.g., Del.
§141)
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There is some overlap and tension between these statutory provisions:
CA, Inc. v. AFSMCE Employees Pension Plan – Delaware Supreme Court upheld the
right of shareholders to pass bylaws on “the process for electing directors – a subject in
which shareholders of Delaware corporations have a legitimate and protected interest.”
o The court contrasted this “proper function of bylaws” from bylaws that would
mandate how a board should decide specific substantive business decisions
Despite their inability to make management decisions, shareholders do have the right to
suggest that the directors take a particular action or adopt a new policy (e.g., Auer v. Dressel –
shareholders may call meeting to support ousted president and urge his reinstatement, even
though they have no power to force his reappointment).
Shareholder Agreement
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Sets out the rights and obligations of shareholders
The Formation of the Corporation and the Governance Expectations of the Initial Participants
Core Characteristics of the Corporate Form (as Distinguished from Traditional Partnerships)
The law’s recognition of the corporation as legally separate from its investors and managers
provides for an often desirable set of governance arrangements:
-
-
-
-
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Business creditors can focus exclusively on the firm’s creditworthiness and disregard the
shareholder’s creditworthiness, as asset partitioning characteristic that facilitates risk
allocation among different participants and more efficient monitoring by creditors;
Limited liability, by insulating shareholders from the risks of the business, encourages
individuals to invest in corporate enterprises (while increasing risks to other creditors
who are exposed to more liability if the entity ends up unable to pay all of its debts);
The corporation is a separate taxpayer from the shareholders = the possibility of two
layers of tax on the same business income;
The corporate entity facilitates a specialization of function among those providing
financial capital for the entity (e.g., shareholders) and human capital (usually officers and
directors); the corporate form also facilitates centralized control (through directors) and
often provides majority rule to resolve any differences among participants, all of which
facilitate adaptability so that the enterprise can respond to changing conditions
The corporate norm is for shares to be freely transferable without the consent of coowners and with no effect on the continuance of the firm; as a result shareholder liquidity
needs can be met by stock market transactions in which new investors “cash-out” old
ones, and the firm’s resources are unaffected
Entity permanence – at least until the directors and majority shareholders decide it
should dissolve; this prevents an individual investor’s withdrawal from destroying the
going concern value of the enterprise or interfering with the business planning of those
given governance control of the corporation
Entity Status
Liability
Tax
Traditional Corporation
Entity separateness from
shareholders; asset partitioning
protects entity creditors’ claims to
entity assets
Limited liability of shareholders for
debts of corporation (limited to the
amount invested in shares)
Corporation taxed as separate
entity, and shareholders taxed
separately on receipt of dividends
or sale of shares
Control
Centralized control and separation
of function (e.g., financial capital
from shareholders & human capital
from managers)
Transferability
Free transferability of shares
Permanence/Exit Enduring entity (exit only if
available through market)
Traditional Partnerships
No entity; no partition
Personal liability – unlimited
liability (except for in limited liability
partnerships)
Partnership not treated as
separate taxable entity; all
partnership income passedthrough and taxed directly to
partners
Each partner has an equal right to
participate in management and to
use partnership property
Transfer only by member consent
Easy exit (e.g., automatic
dissociation)
Where to Incorporate: State Corporation Laws and Competing Sets of Standard Form Rules
Corporations incorporated in one state are recognized by other states.
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Under traditional choice-of-law rules, termed the “internal affairs doctrine,” courts look to
the laws of the incorporating state to determine the basic rights and duties applicable to
a particular corporation.
Most states base their corporation code on, or draw heavily from, some version of the Model
Business Corporation Act (MBCA), which was developed (and is frequently updated) by the
American Bar Association Section of Business Law, Committee on Corporate Laws.
Delaware, one of the states that does not follow the MBCA, is the preeminent American
corporate law jurisdiction. More than half of the country’s largest corporations are incorporated
there, under the Delaware General Corporation Law (Delaware G.C.L.).
The so-called common of corporations carries substantial uniformity – many courts cite
decisions from the Delaware courts, as they are frequently called on to decide major questions
of corporate law and have developed a large body of judicial rules and precedent on major
corporate law issues.
The American Law Institute’s Principles of Corporate Governance: Analysis and
Recommendations (hereafter Principles) are the product of a thorough examination of the
fundamentals of corporate governance.
A corporation can be formed/domiciled in one state and incorporated in another (e.g., Facebook
is legally domiciled in California, but is incorporated in Delaware = Delaware is the legal system
they chose to adopt and organize their corporate structure around)
Formation: The Articles of Incorporation
MBCA §§2.01-2.06; 3.01
Delaware G.C.L. §§101, 102, 361-368
The process of forming a corporation is fairly simple. Participants complete the articles of
incorporation and file them with the appropriate state official in the chosen state, often a
designee of the secretary of state.
-
-
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The state requirements are now fairly minimal – certain basic facts (see MBCA §2.01),
including the corporation’s name, its registered office and agent for services of process,
and the number of shares it is authorized to issue.
After the articles are filed, there is usually an initial organizational meeting at which
directors are elected, shares are issued in exchange for consideration that the
corporation receives to undertake its business, and bylaws governing corporate
procedures are adopted.
Under the Model Act, the corporation’s purpose may but need not be stated in the
articles and every corporation is declared to have the purpose of engaging in any lawful
business unless a more limited purpose is set forth in the articles; Delaware requires a
purpose to be stated in the certificate and provides it will be sufficient to state the
purpose is to engage in any lawful act or activity, which is the common language in
Delaware charters.
o Many states, including Delaware (and by suggested language from the MBCA),
now permit public benefit corporations or a similar designation to PBC, which
identifies a corporation that has included a public benefit purpose in its articles.
Articles of Incorporation differ from ordinary partnership law – in partnership law, partners can
establish a de facto partnership in certain circumstances, whereas corporations generally
require filing of paperwork (i.e., the Articles of Incorporation)
Problem 3-3
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Article One: MBCA §2.01(a)(1)  §4.01(a)(1) – Name has to contain one of words
outlined in 4.01
Article Two: Under the MBCA §2.02(a)(3), requirement that the agent be a citizen of the
state incorporated
Article Three: MBCA §2.02(b)(2)(i) & §3.01(a) –
Article Four: MBCA §2.02(a)(2) – no change
Article Five: MBCA §2.02(b)(4) – this would be permissible, so long as they comply with
the limits outlined in this section
MBCA §2.02(b)(4) is an exculpation clause
Determining Shares to Issue
MBCA §6.01
Delaware G.C.L. §151
A corporation may have several different types of classes of shares with characteristics as
specified in the articles of incorporation. Corporate norms specify that there must be a class of
shares that carry authority to elect directors and exercise all other shareholder voting rights.
There must also be a class that entitles the bearer to receive the corporation’s net assets upon
dissolution.
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Shares that combine both residual claimant status and voting rights are called
“common shares”
Shares in a given class with be fungible (will have identical rights, preferences, and
limitations) – see MBCA §6.01.
Where a corporation or its promoters find that there are different groups of investors with risk
preferences that require a different set of incentives in order to get the investors to part with
their money, the corporation may issue other classes of stick with different rights.
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E.g., “Preferred shares” might be granted a dividend or liquidation preference over
common shares (it is not uncommon to couple this “preference” with a limitation or denial
of voting rights)
Preferred shares of the same class have identical rights, but preferred shares do not
have identical rights across classes or from corporation to corporation
MBCA §6.01
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(a) the shares in the same class must be treated the same, but there is no obligation for
this equal treatment between classes
Determining Voting Rights: Using Articles and Bylaws to Change Legal Norms
***For exam purposes, operate on assumption that there is 1 vote per share.
Most state corporation law norms take the form of default rules – for example, that all shares
have the same voting and economic rights or that centralized power resides in the board. Often,
however, the default rules may not fit the needs of a particular enterprise or group of
entrepreneurs.
Most (though not all) of these state-provided rules may be changed by private ordering, such as
shareholders’ agreements. Alternatively, the corporate law default rules can be changed by
inclusion of the preferred rule in the articles of incorporation or bylaws.
Articles are public documents that can be changed only by action of a corporation’s directors
and shareholders.
Bylaws often can be changed by the directors alone and are not publicly filed documents.
Overview of Normal Rules of Shareholder Voting for Election of Directors
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MBCA §§8.04, 7.21, 7.28
Delaware G.C.L. §§141(d), 212(a), 214, 216
Straight Voting
The default rules governing shareholders’ ability to elect directors are straightforward:
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Directors are annually elected by plurality vote, according to votes cast on a one vote
per share basis (majority voting is an alternative increasingly being used in public
corporations)
The number of directors is usually specified in the initial articles or bylaws.
In straight voting systems, one shareholder with 51 percent of all voting shares
effectively controls the board’s composition and, by extension, the corporation itself
o
o
o
Similarly, two or more shareholders representing at least 51 percent of all shares
may vote in a block in order to achieve the same result
This can be problematic for minority shareholders, who may feel their interests
are never fairly protected in electoral processes that may seem rigged against
them
Cumulative voting, dual (or multiple) class share structures, and staggered voting
regimes are designed to alleviate some of these problems.
Cumulative Voting
In a cumulative voting scheme, a shareholder can cast a total number of votes equal to the
number of shares multiplied by the number of positions to be filled, and these votes can be
spread among as many candidates as there are seats to be filled or concentrated in as few as
one candidate.
-
The purpose of cumulative voting is to permit some minority shareholders to have a
place on the board
The maximum voting power of a given block of shares (i.e., how many seats on the
board of directors can be controlled by a given number of shares) can be determined by
the following formula:
o (D G.C.L. s.214) To elect “X” number of directors, a shareholder must have
more than
(S x X) ÷ (D + 1) shares; where
 S = the number of shares voting
 D = the number of directors to be elected
Problem 3-5
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-
1) The maximum number of directors that the Cabal can elect is 3:
2,000,000 > (6,000,000 x X) / (9 + 1)
(9+1)(2,000,000) > (6,000,000 x X)
20,000,000/6,000,000 > X
3.33 > X
2)
Class Voting, Including Dual-Class Voting Structures
Normally, power to elect directors rests with the voting shareholders as a whole. However, a
corporation may, in its articles of incorporation, divide its shares into classes and permit each
class to select a specified number of directors.
A dual-class voting structure separate shareholders into two classes and gives one class
disproportionate voting power as compared to their capital contribution to the corporation.
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-
Example: The original founders could retain a class of voting common stock that has 10
votes per share (or some other number designated in the articles), while selling common
stock to the public that has only 1 vote per share.
These dual-class voting schemes for companies already publicly traded have been
disfavored by the SEC and curtailed by stock exchange rules but are permitted in
Delaware.
A Classified Board with Staggered Terms – Adaptability Versus Stability
MBCA §8.06
Delaware G.C.L. §141(d)
Almost all state corporation codes provide as a norm that directors be elected annually.
However, these laws expressly allow corporations to adopt longer and staggered terms for
directors (and Massachusetts requires a staggered board).
-
MBCA §8.06 allows classification of directors into two or three groups, then each
director serves a two-year term, and if classified into three groups, each director serves
term. The terms of all directors are staggered so that the term of only one group expires
each year.
Staggered terms theoretically ensure that a corporation will always have experienced directors
in office. Absent removal of directors, having staggered terms means that two annual meetings
would be required to replace a majority of the board of directors. (and also an effective
antitakeover defense in public companies)
-
Staggering terms operates as a constraint on the majority shareholders’ ability to adapt
to changed circumstances by quickly naming new directors
Looking Ahead: How Shareholders Act
The Annual Meeting and Other Forums for Shareholder Action
MBCA §§7.01-7.07, 7.21
Delaware G.C.L. §§211-213, 216, 222, 228
On the one hand, shareholders are responsible for the election of directors and the approval of
major changes in the corporation’s structure or ‘constitution’. On the other hand, directors must
manage the corporation’s business, a role that includes supervision of the shareholder
governance process. Necessarily, directors have conflicting interests when they perceive that
shareholders may seek to use their voting power either to elect a different slate of directors or to
advocate policies that the directors oppose.
To minimize the risk that directors will act unfairly, corporation statutes specify in detail the
substance of shareholder’s voting and meeting rights, as well as the procedural rules that
safeguard the shareholder’s exercise of these rights.
Some of the important substantive and procedural rules:
The annual meeting and election of directors
-
-
Most corporation codes protect the exercise of the shareholders right to elect directors
by specifying immutably that directors shall be elected at an annually held meeting of
shareholders.
Most codes provide summary judicial procedures to ensure that a failure to hold a
required annual meeting is quickly remedied. MBCA §7.03(a) and Delaware G.C.L.
§211(c). Thus, shareholders are usually guaranteed a chance to meet at least once per
year
o
The shareholders meetings must occur, so it is difficult for directors/management
to avoid a meeting
Special shareholders’ meetings
-
-
-
All state corporation codes provide for special shareholders’ meetings to address issues
expressly identified in the meeting notice.
Delaware G.C.L. §211(d): Delaware’s list of who can call a special meeting: Directors,
or whoever may be listed in the charter. (more limited than MBCA)
o This effectively blocks shareholder-initiated special meetings to oppose the
current board.
Many states follow MBCA §7.02, which authorizes the holders of 10 percent or more of
a corporation’s stock to call a special meeting. (greater ability for shareholder
participation)
As with annual meetings, the board has some discretion as to the timing and location of
special meetings, but may not avoid holding them if validly called as specified in the
statutes, articles, or bylaws.
Action by written consent
-
-
A third forum by which shareholders can act – written consent in lieu of a meeting.
The MBCA permits action by written consent only be unanimity (which effectively limits
its use to small corporations with a few shareholders) (MBCA §7.04)
Delaware permits written consent by the vote of a number of shareholders otherwise
required by corporate action – a simple majority in most cases. (Delaware G.C.L.
§228(a))
These are default rules which can be changed by contrary provisions in the articles of
incorporation
Record date: determining shareholders entitled to vote
-
The shareholders who are entitled to participate and vote at a meeting are not
necessarily the shareholders who own shares on the date of the meeting.
State corporation codes provide that the shareholders entitled to vote are those owning
shares on the “record date” specified by directors.
o Normally, the “record date” can be set anywhere between 60 to 10 days before
the meeting in question
o In states like Delaware, which allow shareholder action by nonunanimous written
consent, the setting of a “record date” is somewhat more complicated. See
Delaware G.C.L. §228.
The following case illustrates the importance courts attach to fundamental shareholder voting
and meeting rights when resolving cases of conflict between shareholders’ suffrage rights and
directors’ use of statutorily conferred rights.
Facts
Hoschett v. TSI International Software, Ltd.
Plaintiff Fred Hoschett is the registered owner of 1200 shares of common stock of
the defendant TSI International Software, a Delaware corporation with its principal
place of business in Connecticut. TSI is a privately held corporation formed in
1993, with a total of 962,274 shares of common stock and 860,869 shares of
convertible preferred stock issued and outstanding, which are held by less than 40
stockholders of record. Both the common and preferred stockholders can vote on
the election of directors, with each share of either type having the right to cast one
vote. TSI has never held an annual meeting for the election of directors. Plaintiff
filed this action on October 5, 1995 seeking an order compelling an annual
meeting of stockholders for the election of directors. Both parties filed for
summary judgment, with the Defendant contending that it had received a written
consent representing a majority of the voting power of the corporation that
“elected” five individuals each “to serve as a director of [TSI] until his or her
successor is duly elected and qualified”, which satisfied the need to hold an
annual meeting for the election of directors.
Issue
Whether a controlling shareholder or a majority group may effectively avoid the
annual meeting requirement, despite the command of Delaware G.C.L. Section
211, by using the consent action to designate directors under Section 228.
Holding No. The mandatory requirement that an annual meeting of shareholders be held
(in DGCL §211(b)) is not satisfied by shareholder action pursuant to DGLC §228
purporting to elect a new board or to re-elect an old one. Also, absent unanimous
consent, Section 211(b) places on TSI the legal obligation to convene a meeting
of the shareholders to elect directors pursuant to the constitutional documents of
the firm.
Analysis The obligation to hold an annual meeting at which directors are to be elected,
either for one year or for staggered terms, as the charter may provide, is one of
the very few mandatory features of Delaware corporation law. Delaware courts
have long recognized the central role of annual meetings in the scheme of
corporate governance.
- The critical importance of shareholder voting both to the theory and to the
reality of corporate governance may be thought to justify the mandatory
nature of the obligation to call and hold an annual meeting.
Knowing that election of directors is necessarily to be faced annually may itself
have a marginally beneficial effect on managerial attention and performance.
Certainly, the annual meeting may in some instances be a both to management,
or even, though rarely, a strain, but in all events it provides a certain discipline and
an occasion for interaction and participation of a kind. Whether it is welcomed or
resented by management, however, is in the end, irrelevant under section 211(b)
and (c) of the DGCL and similar statutes in other jurisdictions.
To the argument supporting the use of a consent action due to practical
considerations:
- The principle for which this practicality argument must contend is not
limited to small coherent groups of shareholders who together can
exercise control. If the principle is correct, management of public
companies without a small controlling group, could solicit consents to “reelect” or “elect” some or all of the board without ever having an annual
meeting. This would put public shareholders at a tactical disadvantage.
- Also, the purposes served by the annual meeting include affording to
shareholders an opportunity to bring matters before the shareholder body,
as provided by the corporation charter and bylaws, such as bylaw
changes.
- Finally, while the model of democratic forms should not too strictly be
applied to the economic institution of a business corporation, it is
nevertheless a not unimportant feature of corporate governance that at a
noticed annual meeting a form of discourse (i.e., oral reports, questions
and answers, etc.) among investors and between shareholders and
managers is possible.
Conflict between write-in (written consent) requirement of Section 228 and
obligation to hold an annual meeting under Section 211.
- Court said that you can’t use the write-in system as an alternative to
the general obligation to have an annual meeting
**After Hoschett v. TSI International Software, Ltd., Delaware amended Section 211 —
authorizing non-unanimous written consent in lieu of an annual meeting if all directorships to be
filled at the annual meeting are vacant.
Removal of Directors and Other Midstream Private Ordering
MBCA §§8.08-8.10
Delaware G.C.L. §§141(k), 223
Directors are elected to serve a term that normally runs from one annual meeting to the next,
but under staggered terms can cover a three-year span.
The normal rule today allows shareholders to remove directors with or without cause by majority
vote, including before the expiration of their terms.
Statutory rules that limit or eliminate shareholders’ removal power when the corporation has
instituted cumulative voting, staggered terms for directors, or class election of directors:
-
-
Under the MBCA §8.08, there are no restrictions on shareholders’ power to remove
directors if the corporation has staggered the board into staggered terms. However, if
the corporation has cumulative voting, shareholders cannot remove a director if the
votes cast against removal would have been sufficient to elect that director. And, if a
director is elected by a particular class of shareholders, that director can be removed
only by a majority vote of that class, even if the majority of the shareholders of all
classes are in favor of removal.
o These statutory restrictions are immutable. However, there are provisions for
judicial removal for cause under certain circumstances (MBCA §8.09)
o MBCA §8.08
 (a) Can be removed with or without cause
 (b) Only by the shareholders eligible to remove directors
 (c) Removal must be by the same voting method in which the director
was voted in
 (d) Only at a meeting for which the purpose is removal
The Delaware approach, found in Delaware G.C.L. §141(k), differs in three important
respects:
o (1) members of staggered boards to the list of directors protected from removal
– they can only be removed for cause, a powerful insulation for the boards of
such companies
o These Delaware protective provisions preserve the shareholders’ power to
remove even protected directors if done for cause (on a majority vote)
o Finally, a majority retains the ability to change the default rules and thereby
permit removal in any of these situations by amending the articles (if the board is
agreeable to proposing such a change) to permit a without-cause removal for a
staggered board or to remove cumulative voting itself.
The ability to remove a director for cause, as permitted in Delaware, is not easy. Both the
substantive limitation imposed by the definition of “for cause,” and the procedural safeguards
that must be employed, make removal for cause a weapon of last resort. Whether director
conduct constitutes cause is a fact-dependent analysis.
-
Before directors can be removed for cause “there must be the service of specific
charges, adequate notice and full opportunity of meeting the accusation.”
Adlerstein v. Wertheimer
Facts
Action brought by Joseph Alderstein pursuant to Section 225 of the Delaware
G.C.L. Alderstein was the former Chairman and CEO of SpectruMedix
Corporation (a Delaware Corporation), which manufactured and sold instruments
to the genetics and pharmaceutical industries. Wertheimer, who is an investment
banker, was elected to the Board of directors in January 2000, and Mencher, who
is a money manager, was elected to the Board in March 2000. SpectruMedix had
an IPO in 1997 to raise cash to pay off some of its debts, but eventually ran into
financial troubles again. In 1999, Alderstein loaned the company $500,000 in
exchange for a convertible loan note, which he eventually converted to stock
raising his controlling voting share to 73.27%. In late 1999, Wertheimer convinced
Alderstein to hire Manus O’Donnell, to conduct a study and report of the
company’s management and finances. The report concluded that the company
only had enough cash to continue operating until September 2001. Wertheimer
convinced Alderstein to hire O’Donnell several more times. The company survived
past this date, but Alderstein had a sexual harassment claim filed against him, and
was found guilty by an independent consultant, who he refused to pay. In July
2001, O’Donnell prepared a report detailing that Alderstein was the central
problem at the company and that for SpectruMedix to have any chance, Alderstein
needed to be removed. Wertheimer and Mench then engaged an investor to
possibly invest in the company, named Reich. Reich agreed to invest, so long as
he could run the company – neither Mench nor Wertheimer informed Alderstein of
this proposal until July 9. Subsequent to this, a board meeting was called for July
9 (although it is disputed who called it), allegedly by Alderstein, ahead of a
meeting with an arbitrator. At this meeting, a proposal to issue new Series C
shares to Reich (giving him voting control) was proposed and voted on (Alderstein
was the only one opposed) and it succeeded. Reich executed and delivered a
stockholder’s written consent removing Alderstein as a director, with Reich being
chosen to replace him. Some months later, Alderstein also executed a written
consent purporting to vote his Series B shares to remove Wertheimer and
Mencher from the board and initiated this action.
Issue
Whether the meeting held on July 9 was a meeting of the board of directors, or
not. If it was a board meeting, were the actions taken valid?
Holding The meeting of July 9 was called as a board meeting, but the actions taken at it
must be invalidated.
Analysis The general purpose of Section 225 is to provide “a quick method of review of the
corporate election process in order to prevent a corporation from being
immobilized by controversies as to who are its proper officers and directors.”
- Because it is summary in nature, a Section 225 proceeding is limited to
those issues that must necessarily be considered in order to resolve a
disputed corporate election process. A Section 225 action focuses
narrowly on the corporate election at issue and is not an appropriate
occasion to resolve matters ancillary or secondary to that election.
Notice
- The record supports that on the July 5 phone call between Werthstein and
Alderstein, Alderstein indicated that he wanted to call the meeting in view
of the many urgent problems facing the company at the time. Also, the
bylaws provide that special meetings of the board may be called on 2
days’ notice to the board.
Validity of actions taken at the July 9 meeting
- In the context of the set of legal rights that existed within
SpectruMedix at the time of the July 9 meeting, Alderstein was
entitled to know ahead of time of the plan to issue new Series C stock
with the purposeful effect of destroying his voting control over the
Company.
- This right of advance notice derives from a basic requirement of
corporation law that boards of directors conduct their affairs in a
manner that satisfies minimum standards or fairness.
- Alderstein possessed contractual power to prevent the issuance of
Class C shares by executing a written consent removing one or both
of Wertheimer and Mencher from the board – he may or may not have
exercised this power had he been told about the plan in advance. But
he was fully entitled to the opportunity to do so and the machinations
of those individuals who deprived him of this opportunity were unfair
- However, there was a meeting of the board called, so the question
remained of whether Alderstein had adequate opportunity to protect his
interests. Analogizing to another case, the court held that Alderstein was
disadvantaged “by the other directors’ failure to communicate their plans to
him.” Had he known in advance, he may have exercised his legal right to
remove one or both of them, and thus prevent the completion of those
plans.
As well, since Alderstein was both a shareholder and director, he was entitled to
notice in both roles
Problem 3-8
-
-
Delaware:
o Appears to be a classified board
o Directors have to call the meeting and provide notice to Robbins
o Also have to give notice to shareholders
MBCA:
o Could be removal with or without cause (doesn’t matter if classified board or not)
o Can call a meeting for that purpose
Using Shareholder Authority to Change the Bylaws
MBCA §§2.06, 8.01, 10.20
Delaware G.C.L. §§109, 112, 113, 141
Limits from the Charter or Management Planning
Shareholders may desire to use their power to amend bylaws in order to change statutory
default rules or modifications that have been made to those rules.
A recurring setting for the battle between shareholders and directors over changes to bylaws
has been insurgent shareholder attempts to either eliminate or get around a staggered board
provision.
In Centaur Partners IV v. National Intergroup, Inc., National Intergroup’s certification of
incorporation provided for a staggered board and required a vote of at least 80 percent of the
shareholders to amend or repeal the charter provision or any similar provision in the bylaws.
The bylaws provision implementing the staggered board provision, which had a parallel 80
percent supermajority requirement for repeal or changes, also provided that the number of
directors shall be fixed by a resolution of a majority of the entire board. Centaur Partners, a 16%
shareholder, sought to enlarge the board from 9 to15 and to elect the new directors at the next
annual meeting, and wanted that action to be covered by the default rule of majority vote, not
the supermajority specified for staggered board provisions. The Delaware Supreme Court first
noted the strong presumption in favor of majority rule in corporate law but nevertheless rejected
Centaur Partners’ argument that majority rule should apply to this change.
-
-
Facts
There exists in Delaware “a general policy against disenfranchisement.” This policy is
based upon the belief that “[t]he shareholder franchise is the ideological underpinning
upon which the legitimacy of directorial power rests.” Therefore, high vote requirements
which purport to protect minority shareholders by disenfranchising the majority, must be
clear and unambiguous. There must be no doubt that the shareholders intended that a
supermajority would be required. When a provision which seeks to require the approval
of a supermajority is unclear or ambiguous, the fundamental principle of majority rule will
be held to apply.
Corporate charters and bylaws are contracts among the shareholders of a corporation
and the general rules of contract interpretation are held to apply. Thus, the intent of the
shareholders in enacting particular charter or bylaw amendments is instructive in
determining whether ambiguity exists.
Airgas, Inc. v. Air Products and Chemicals, Inc.
Air Products and Chemicals, Inc and Airgas, Inc are competitors in the industrial
gas business. Starting in February 2010, Air Products launched several public
tender offers to acquire 100% of Airgas’s shares. The Airgas BOD received and
rejected all of these bids from Air Products because the board determined that
each one undervalued the company. During the entire attempted takeover period,
Airgas stock exceeded Air Products’ offer. Airgas traditionally held its annual
meetings in late summer or early fall to afford Airgas time to prepare its annual
reports, and it held these meetings annually approximately 12 months apart, never
having a consecutive meeting sooner than 11 months. Air Products engaged in a
proxy contest at the last annual meeting of Airgas stockholders. Airgas had a
staggered board with nine directors and three were up for election at that meeting.
At Airgas’s last meeting on September 15, 2010, Air Products nominated three
directors to Airgas’ board, and the Airgas shareholders elected them. Air Products
also proposed a bylaw (the “January Bylaw”) that would schedule Airgas’s next
annual meeting for January 2011. The January Bylaw approved by only 45.8% of
the shares entitled to vote, effectively reduced the full term of the incumbent
directors by eight months. Airgas brought this action alleging that the January
Bylaw was invalid under section 141 of the Delaware GCL and the Airgas
corporate charter provision that creates a staggered board. Airgas’s charter
requires an affirmative vote of the holders of at least 67% of the voting power of all
shares to alter, amend, or repeal the staggered board provision, or to adopt any
bylaw inconsistent with that provision. The Court of Chancery upheld the January
Bylaw, finding that the Airgas charter provides that directors serve terms that
expire at “the annual meeting of stockholders held in the third year following the
year after the directors’ elections” and that the January meeting would occur “in
the third year after the directors’ election.”
Issue
Whether the Airgas Charter requires that each class of directors serves three-year
terms or whether it provides for a term that can expire at whatever time the annual
meeting is scheduled in the third year following election.
Holding The Airgas charter language defining the duration of directors’ terms is
ambiguous. Looking to extrinsic evidence, the language has been understood to
mean that the Airgas directors serve three-year terms. Because the January
Bylaw prematurely terminates the Airgas directors’ terms, conferred by the charter
and the statute, by eight months, the January Bylaw is invalid. It also amounted to
a de facto removal of the directors without cause, without the required 67% vote
(i.e., trying to do indirectly what they weren’t allowed to do directly).
Analysis Corporate charters and bylaws are contracts among a corporation’s shareholders;
therefore, rules of contract interpretation apply. If charter or bylaw provisions are
unclear, we resolve any doubt in favor of the stockholders’ electoral rights.
- “Words and phrases used in a bylaw are given their commonly accepted
meaning unless the context clearly requires a different one or unless legal
phrases having a special meaning are used.”
- Where extrinsic evidence resolves any ambiguity, we “must give effect to
the intent of the parties as revealed by the language of the certificate and
the circumstances surrounding its creation and adoption.”
Section 141(d) of the DGCL
- Section 141(d) of the Delaware G.C.L. allows corporations to implement a
staggered board.
- To implement staggered board, corporations typically use two forms of
language:
o Annual Meeting Term Alternative: many corporations provide in
their charters that each class of directors serves until the “annual
meeting of stockholders to be held in the third year following the
year of their election
o Defined Term Alternative: Some corporations provide in their
charters that each class serves for a “term of three years.”
- Airgas’s Charter employs the Annual Meeting Term Alternative
Airgas’s Charter Ambiguity
- The Court agreed with the Court of Chancery’s conclusion that the Airgas
charter was ambiguous in defining “full term” and “annual meeting” in the
“third year”. However, it concluded that there was overwhelming extrinsic
evidence that under the Annual Meeting Term Alternative adopted by
Airgas, a term of three years was intended. Therefore, the January Bylaw
was inconsistent with the Article 5, Section 1 of the Charter, because it
materially shortened the directors’ full three year term that the Charter
language required.
-
Delaware precedents interpreting similar charter language regard that
language as creating a staggered board with classes of directors who
serve three year terms
- Looking at Annual Meeting Term Alternative language in practice, a large
majority of Delaware Fortune 500 companies use provision consistent with
Airgas’s to create staggered boards
- Also, commentary on the ABA’s model forms confirms the understanding
that the Annual Meeting Term Alternative intends to provide that each
class of directors is elected for a three year term.
Essential Enterprises v Automatic Steel Products, Inc
- At issue in this case was whether a bylaw that authorized the removal of
directors by a majority vote was inconsistent with a charter provision that
provided for staggered, three-year terms for the corporation’s directors.
- The court held that it was invalid because it was inconsistent with the
charter provision authorizing the staggered terms and that the bylaw would
“frustrate the plan and purpose behind the provision for staggered terms.”
- This court found that the Annual Meeting Term Alternative and Defined
Term Alternative meant the same thing.
- In this case, the January Bylaw so extremely truncated the directors’ terms
(by 8 months) so as to constitute de facto removal that was inconsistent
with Airgas’s Charter. Finding the consequence similar to that of Essential
Enterprises, the January Bylaw serves to “frustrate the plan and purpose
behind the provision for Airgas’s staggered terms and it is incompatible
with the pertinent language of the statute and the Charter.”
The extrinsic evidence was facts such as the established practice of holding
meetings approximately 12 months apart, and others.
Courts will generally look at (1) the language of the articles of information and bylaws and (2)
will also look at the context and the interpretation in practice.
Poison Pill – one of the ways to fend off hostile takeover bids. Essentially, during the designing
of the structure of the business/corporation, included in the structure is the right of the
corporation to issue more shares once a certain shareholder acquires more than “x%” of all
shares (i.e., diluting the share voting power of those shareholder(s))
Limits on what Shareholders can do in Bylaws:
Shareholder ability to use the bylaw to change governance is also constrained by limits on what
bylaws can do. State corporation law grants primary management authority to the board of
directors while reserving to the shareholders concurrent authority to make and amend bylaws.
Delaware G.C.L. §141(a) provides that “[t]he business and affairs of [a] corporation… shall be
managed by or under the direction of the board of directors, except as may be otherwise
provided in this chapter or in the certificate of incorporation.”
Delaware G.C.L. §109(b) provides that “[t]he bylaws may contain any provision, not inconsistent
with law or with the certificate of incorporation, relating to the business of the corporation, the
conduct of its affairs, and its rights or powers or the rights or powers of its stockholders,
directors, officers or employees.”
-
Under §109(a), “the power to adopt, amend or repeal bylaws shall be in the stockholders
entitled to vote…” Directors may be given concurrent authority to adopt, amend, or
repeal bylaws by provision in the certificate of incorporation.
Thus, there is overlapping grants of authority between shareholders and boards of directors.
The following case gives the Delaware Supreme Court’s answer on how to reconcile this
potentially conflicting authority:
CA, Inc. v. AFSCME Employees Pension Plan
CA is a Delaware corporation with a BOD consisting of twelve persons, all of
whom sit for reelection each year. CA’s annual meeting was scheduled for
September 9, 2008. CA intends to file its definitive proxy materials with the SEC
on July 24, 2008 in connection with that meeting. AFSCME is stockholder of CA.
On March 13, 2008, it proposed a bylaw for inclusion in the proxy materials. The
proposed bylaw would amend the current bylaw to provide that the corporation
would provide reimbursement of proxy expenses to stockholders. However, in
CA’s Certification of Incorporation, Article 7 provides that “The management of the
business and the conduct of the affairs of the corporation shall be vested in [CA’s]
Board of Directors. It is also undisputed that the decision whether to reimburse
election expenses is presently vested in the discretion of CA’s board of directors,
subject to their fiduciary duties and applicable Delaware Law. CA notified the SEC
of its intention to exclude the proposed bylaw. Both parties dispute whether the
bylaw is the proper subject of shareholder action.
Issue
Two questions certified to this court by the SEC:
1 – Is the AFSCME Proposal a proper subject for action by shareholders as a
matter of Delaware law?
2 – Would the AFSCME Proposal, if adopted, caused CA to violate any Delaware
law to which it is subject?
Holding 1 – The Bylaw would accomplish the encouragement of candidates other than
board-sponsored nominees to stand for election by committing the corporation to
reimburse the election expenses of shareholders whose candidates are
successfully elected. That the implementation of that proposal would require the
expenditure of corporate funds will not, in and of itself, make such a bylaw an
improper subject matter for shareholder action. Accordingly, the first question is
answered in the affirmative.
2 – the Bylaw, as drafted, would violate the prohibition, which our decisions have
derived from Section 141(a), against contractual arrangements that commit the
board of directors to a course of action that would preclude them from full
discharging their fiduciary duties to the corporation and its shareholders.
Analysis The First Question
- The DGCL empowers both the board of directors and the
shareholders of a Delaware corporation to adopt, amend or repeal the
corporation’s bylaws, both concurrently and independently (DGCL
§109(a)).
- Section 109(a) must be read together with Section 141(a), which
pertinently provides: “The business and affairs of every corporation
organized under this chapter shall be managed by or under the direction of
a board of directors, except as otherwise provided in this chapter or the
certificate of incorporation.” No such broad management power is
statutorily allocated to the shareholders. In fact, it is well established that
Facts
Ratio
stockholders of a corporation subject to the DGCL may not directly
manage the business affairs of the corporation
- Therefore, the shareholders statutory power to adopt, amend, or
repeal bylaws is not coextensive with the board’s concurrent power
and is limited by the board’s management prerogatives under
Section 141(a).
- To determine whether the proposed Bylaw is proper subject of
shareholder action under Delaware law, it must be determined: (1) the
scope or reach of the shareholder’s power to adopt, alter or repeal
the bylaws of a Delaware corporation, and (2) whether the Bylaw at
issue here falls within that permissible scope.
Analysis
- It is well-established Delaware law that a proper function of bylaws is
not to mandate how the board should decide specific substantive
business decisions, but rather, to define the process and procedures
by which those decisions are made (examples of procedural, process
oriented nature of bylaws can be found in statutes and case law –
e.g., §141(b) authorizes bylaws that fix the number of directors on the
board)
- The Bylaw is couched as a command to reimburse in its language, but the
bylaws wording is not dispositive. Whether or not a bylaw is processrelated must necessarily be determined in light of its context and purpose.
- The context of the Bylaw at issue here is the process for electing directors
– a subject in which shareholders of Delaware corporations have a
legitimate and protected interest. The purpose of the Bylaw is to promote
the integrity of that electoral process by facilitating the nomination of
director candidates by stockholders or groups of stockholders.
- The Bylaw would encourage the nomination of non-management board
candidates by promising reimbursement of the nominating stockholders’
proxy expenses - this would also encourage shareholder participation in
nomination
The Second Question
- In answering the first question, it’s already determined that the Bylaw does
not facially violate any provision of the DGCL or CA’s Certificate of
Incorporation, so the question remains whether it violates any common law
rule or precept.
- The Court determined that since this question was asked in the abstract, it
needed to consider whether there were any possible circumstances under
which a BOD would violate the law complying with the Bylaw. They
determined that there was a possibility of such circumstances.
- The circumstance would arise as the bylaw would prevent the directors
from exercising their full managerial power in circumstances where their
fiduciary duties would otherwise require them to deny reimbursement to a
dissident slate (for example, where a proxy context is motivated by
personal or petty concerns, or to promote interests that do not further, or
are adverse to, those of the corporation, the board’s fiduciary duty could
compel that reimbursement be denied altogether)
- Even though the Bylaw provides the Board with discretion in determining
the amount of reimbursement appropriate, that does not go far enough
A bylaw is permissible if it defines the process and procedure by which a
board of directors makes business decisions. A corporation’s board can’t
enter a contract that requires it to act in a manner that would violate its
fiduciary duties.
PRECATORY = proposals must be suggestive but cannot signal a positive obligation on the
board to do something (shareholder proposals must be precatory)
Notes:
-
The Court in CA noted in footnote 32 that the distinction between shareholder and
director action would be dispositive if the bylaw were enacted as an amendment to the
certificate of incorporation.
Problem 3-9
-
SEC Rule 14a-8 – requires shareholders to have at least $2000 or 1% of the total value
of shares
o New changes to this rule:
o (i) You must have continuously held:
(A) At least $2,000 in market value of the company's securities entitled to vote on
the proposal for at least three years; or
(B) At least $15,000 in market value of the company's securities entitled to vote
on the proposal for at least two years; or
(C) At least $25,000 in market value of the company's securities entitled to vote
on the proposal for at least one year;
Initial Issuance of Securities
The Securities Act of 1933 and Its Requirement of Extensive Disclosure
Securities Act of 1933 §§5, 11, 12, 17
If the financing of the corporation includes the public offering of securities, the corporation and
its lawyers will have to comply with federal and state securities laws. Federal regulation of the
issuance of securities began with the Securities Act of 1933. Similar state laws, often referred to
as “blue sky laws,” were enacted even earlier in this century, beginning in Kansas in 1914.
Regulation of securities reflects the perception that securities are different from most other
commodities in a way that creates the need for special protection. Securities are intangible,
pieces of paper that have no intrinsic value in themselves; their value comes because they
represent an interest in something else.
The primary mechanism used by the 1933 Act to protect investors has been full and fair
disclosure of material facts concerning securities, to tell the investor what stands behind the
paper.
The second major aim of the 1933 Act is to deal with fraud in the sale of securities. Securities
are created, not produced; they can be issued in unlimited amounts – virtually without cost –
which increases the possibility of manipulation. The 1933 Act therefore provides fraud
provisions tailored for these particular forms of investment.
“Blue Sky” laws were enacted to regulate securities.
Section 11 of the 1933 imposes civil strict liability standards
Securities and Exchange Commission, What We Do
Securities Act of 1933
Often referred to as the “truth in securities” law, the Securities Act of 1933 has two basic
objectives:
- Require that investors receive financial and other significant information concerning
securities being offered for public sale; and
- Prohibit deceit, misrepresentations, and other fraud in the sale of securities…
Purpose of Registration
A primary means of accomplishing these goals is the disclosure of financial information
through the registration of securities. This information enables investors, not the government,
to make informed judgments about whether to purchase a company’s securities. While the
SEC requires that the information provided be accurate, it does not guarantee it. Investors
who purchase securities and suffer losses have important recovery rights if they can prove
that there was incomplete or inaccurate disclosure of important information.
The Registration Process
In general, securities sold in the United States must be registered. The registration forms
companies file provide essential facts while minimizing the burden and expense of complying
with the law. In general, registration forms call for:
- a description of the company’s properties and business;
- a description of the security to be offered for sale;
- information about the management of the company; and
- financial statements certified by independent accountants
Not all offerings of securities must be registered with the Commission. Some exemptions from
the registration requirement include:
- private offerings to a limited number of persons or institutions;
- offerings of limited size;
- intrastate offerings; and
- securities of municipal, state, and federal governments.
By exempting many small offerings from the regulation process, the SEC seeks to foster
capital formation by lowering the cost of offering securities to the public.
Section 5 of the 1933 Act prohibits the offer or sale of a security unless it has been registered
under the act or falls under an exemption. Registration requires extensive disclosure to the SEC
and to each individual purchaser by means of a prospectus.
Four primary exceptions to Section 5 of the 1933 Act:
-
-
The offering is made to a limited number of persons or institutions;
o (e.g., a private placement)
The offering is of limited size;
The offering is an intrastate offerings;
o Federal regulations will generally not get involved if all investors are within the
same state/jurisdiction. This is not to say that state regulations won’t apply in the
situation, but federal regulations won’t
Securities being offered are those of municipal, state, and federal government
The disclosure affirmatively required by the 1933 Act expands the more indirect disclosure
required by the common law prohibitions against fraud. The common law aimed at
misstatements or half-truths in statements that had been voluntarily made and seldom imposed
a duty to speak absent an unusual fiduciary duty relationship. The 1933 Act not only required
affirmative disclosure beyond what existed at common law, but it also substantially reduced the
elements that a plaintiff must show to recover, as compared to what would be required at
common law. If a misstatement appears in a prospectus, it is usually not necessary for the
plaintiff to show reliance. Similarly, the issuer is strictly liable with no showing of intent or other
scienter required.
The SEC does not ask if an investment is good or not, but focuses instead on disclosure, with
the investor then being able to decide whether to purchase. In contrast, some states expressly
regulate the substance of a transaction and exclude those that do not meet the state standards
(usually referred to as “merit” regulation)
In 1996, Congress partially preempted state law. Under amended Section 18(a) of the 1933
Act, stocks listed on national stock markets (the New York Stock Exchange or NASDAQ’s larger
market) are exempt from the registration coverage of the various states.
Securities Exchange Act of 1934
-
Governs the exchange of securities after the IPO (e.g., provides remedies for fraudulent
actions such as insider trading, imposes continuing disclosure obligations)
What Transactions Are Covered?
Facts
Issue
Securities and Exchange Commission v. Edwards
Charles Edwards was the chairman, CEO, and sole shareholder of ETS
Payphones, Inc. ETS sold payphones to the public, offering a package of 5-year
leaseback and management agreement, and buyback agreement. Almost all
purchasers chose this package. Under the agreement, the purchaser would
receive a 14% annual return. ETS managed all the logistics of managing the
payphones and also promised to refund the full purchase price at the end of the
lease or within 180 days of the purchaser’s request. In its marketing materials,
ETS promoted the pay phones as “incomparable pay phones” and an “exciting
business opportunities”. The payphones did not generate enough revenue for ETS
to pay its obligations on the lease agreements and it eventually filed for
bankruptcy protection.
Around 10,000 people invested a total of $300 million in the payphone and saleand-leaseback arrangements touted by the respondent. The SEC argues that the
arrangements were investment contracts, and thus were subject to regulation
under the federal jurisdiction securities laws. Specifically, that it violated §§5(a)
and (c) of the Securities Act of 1933, the antifraud provisions of both §17(a), and
§10(b) of the Securities Exchange Act of 1934, and Rule 10b-5. The District Court
determined that the arrangements were investment contracts within the meaning
of, and therefore was subject to, the federal securities laws. The Court of Appeals
reversed.
Whether a moneymaking scheme is excluded from the term “investment contract”
simply because the scheme offered a contractual entitlement to a fixed, rather
than a variable, return.
An investment scheme promising a fixed rate of return can be an “investment
contract” and thus a “security” subject to federal securities laws.
Analysis “Congress’ purpose in enacting the securities laws was to regulate investments, in
whatever form they are made and by whatever name they are called.”
- To that end, it enacted a broad definition of “security,” sufficient “to
encompass virtually any instrument that might be sold as an investment.”
Section 2(a)(1) of the 1933 Act and Section 3(a)(10) of the 1934 Act, in slightly
different formulations which we have treated as essentially identical in meaning,
define “security” to include “any note, stock, treasury stock, security future, bond,
debenture,… investment contract,… [or any] instrument commonly known as a
‘security.’”
The test for whether a particular scheme is an investment contract
(established in SEC v W.J. Howey Co.): Look to “whether the scheme
involves an investment of money in a common enterprise with profits to
come solely from the efforts of others.”
- This definition “embodies a flexible rather than a static principle, one
that is capable of adaptation to meet the countless and variable
schemes devised by those who seek the use of the money of others
on the promise of profits.”
- Profits coming solely from the efforts of others means the profits that
investors seek on their investment, and not the profits of the scheme
in which they invest (e.g., use of “profits” in the sense of income or
return, to include, for example, dividends, other periodic payments,
or the increased value of the investment.)
- No reason to distinguish between promises of fixed returns and
promises of variable returns for the purposes of this test – in both
cases, the investing public is attracted by representations of
investment income
The Court of Appeals perfunctory holding that respondent’s scheme falls outside
the definition because purchasers had a contractual entitlement to a return is
incorrect and inconsistent with precedent. We are considering investment
contracts. The fact that investors have bargained for a return on their investment
does not mean that the return is not also expected to come solely from the efforts
of others.
Ratio
Howey test for what constitutes a security (4-part test):
- An investment of money
- An expectation of profits from the investment
- The investment of money is in a common enterprise
- Any profit comes from the efforts of a promoter or third party such that
investors profited from the efforts of others
Holding
Exemption from Registration
Securities Act of 1933 §§3, 4
SEC Rules 147, 501-504, 506-508
Section 4(2) of the Securities Act of 1933 exempts “transactions by an issuer not involving any
public offering” from the registration requirements of §5.
Securities and Exchange Commission v. Ralston Purina Co.
Facts
Ralston Purina manufactures and distributes various feed and cereal products in
processing and distribution facilities throughout the U.S. and Canada, staffed with
some 7000 employees. Since 1911, the company had a policy of encouraging
stock ownership among its employees; more particularly, since 1942 it has made
authorized but unissued common shares available to some of them. Ralston sold
almost $2 million of stock to employees without registration between 1947-1951.
Through a corporation resolution, Ralston reserved the purchase of these stock
only to those employees who inquired about purchasing them through their own
initiative. A wide variety of employees with different job types bought the stock.
Ralston conceded that an offering to all of its employees would be a public one,
but claimed that it only offered to “key employees.”
Issue
Whether Ralston Purina’s offerings of treasury stock to its “key employees” are
within the Section 4(2) exemption.
Holding The focus of inquiry should be on the need of the offerrees for the
protections afforded by registration. The employees here were not shown to
have access to the kind of information which registration would disclose.
The obvious opportunities for pressure and imposition made it advisable
that they be entitled to compliance with §5.
Analysis To be public, an offer need not be open to the whole world.
The Securities Act nowhere defines the scope of §4(2)’s private offering
exemption.
- The design of the Securities Act is to protect investors by promoting full
disclosure of information thought necessary to informed investment
decisions.
- The natural way to interpret the private offering exemption is in light of the
statutory purpose.
- Since exempt transactions are those to which “there is no practical need
for… [the bill’s] application,” the applicability of §4(2) should turn on
whether the particular class of persons affected need the protection of the
Act. An offering to those who are shown to be able to fend for themselves
is a transaction “not involving any public offering.”
The exemption, as it is construed here, does not deprive corporate employees, as
a class, of the safeguards of the Act. Some employee offerings may come within
§4(2) (e.g., one made to executive personnel who because of their position have
access to the same kind of information that the act would make available in the
form of a registration statement)
- But absent such a showing of special circumstances, employees are just
as members of the investing “public” as any of their neighbors in the
community.
House Report notes to the 1934 Act indicate that “the participants in the
employees’ stock-investment plans may be in as great need of the protection
afforded by availability of information concerning the issuer for which they work as
are most other members of the public.”
- Keeping in mind the broadly remedial purposes of federal securities
legislation, imposition of the burden of proof on an issuer who would
plead the exemption seems to us fair and reasonable. Once it is seen
that the exemption question turns on the knowledge of the offerrees,
the issuer’s motives, laudable though they may be, fade into
irrelevance.
Notes:
-
-
Most small companies try to avoid the registration provisions because the costs will
consume a significant portion of the funds to be raised. The principal costs are
commissions to those who sell the securities, attorneys’ fees in preparation of the
material, accounting fees for the financial statements, and printing and filing fees for the
disclosed documents.
Exemptions are provided for private placements, small offerings and intrastate offerings.
Rule 506, promulgated by the SEC under the 1933 Act, is the most used current
example of the §4(2) exemption discussed in Ralston Purina. Such private placements
are conditioned on meeting requirements regarding disclosure, the sophistication of the
purchasers, a limitation of the offerings to not more than 35 purchasers, and restrictions
on selling by general solicitation. Significantly, if the issuer limits the offering only to
accredited investors (e.g., banks and wealthy individuals), it can skip the requirements
based on sophistication, disclosure, the ban on general solicitation, and the numerical
limit on the number of purchasers.
Common questions to ask:
-
What constitutes a security?
What constitutes public?
Where are your investors located?
o How many are there?
How much money is trying to be raised?
Shareholder Investment and Governance in Publicly Held Corporations and in the Impact of
Federal Law
How Publicly Held Corporations Are Different
The Shareholder Census: The Dominance of Institutional Investors
During the past 60 years, share ownership has become increasingly concentrated in the hands
of larger institutional investors (the institutional investor category includes retirement vehicles
such as private pensions funds and public pension funds, notably those of state and local
government retirement systems and multiemployer plans for unionized employees that are
visible in corporate governance.
-
Mutual funds make up the largest category of investment funds
The census of shareholders in public corporations has broadened to include not only traditional
institutional investors but also other large stakes, repeat investors who affect collective
behavior.
-
“Arbitrageurs” seek out companies whose stock is in play and seek to encourage the
trends that will make them money.
“Value investors” actively seek to influence corporate management so as to produce
higher share value from underperforming companies
“Relational investors” purchase large blocks in particular companies and seek a longterm relationship with management.
“Social investors” give explicit priority to social needs in guiding investment decisions.
This dramatic change in shareholder composition suggests an evolving model of shareholder
governance not limited to gaining control or even exercising voting rights at formal meetings.
Politically active institutional investors and allied “activist investors” can use their larger
shareholdings both to carry out traditional shareholder responsibilities and to engage corporate
management in a sustained conversation about how corporations should be managed.
Proxy Voting
Although institutional investors may rationally invest the time and resources necessary to attend
a shareholders’ meeting or be required by fiduciary duties to do so, most individual shareholders
in a publicly held corporation lack sufficient incentive to do so.
By executing a simple agreement appointing a “proxy” to act on his behalf, a shareholder need
not be physically present to participate in a meeting. Moreover, the proxy provides a means for
institutional or other significant investors to collect voting power from smaller investors or each
other in advance of an actual election, and thus is a valuable tool even for the active
shareholder.
The term “proxy” has multiple overlapping uses:
-
(1) the legal relationship under which one party is given the power to vote the shares of
another, as in “she voted her shares by proxy”
(2) the person or entity given the power to vote, as in “she acted as his proxy”
(3) the tangible document that evidences the relationship, as in “he mailed his proxy”
A proxy designation may create an agency relationship that requires the proxy holder to follow
the shareholder’s instruction. Alternatively, a proxy holder may be given absolute discretion to
vote as he sees fit.
The proxy process is federally regulated (the SEC plays a significant role in setting the rules for
the proxy and shareholders’ meeting process and in settling disputes between management and
shareholders concerning the conduct of that process)
Federal Regulation of Publicly Held Companies
Securities Exchange Act of 1934 §§12(b), 12(g), 13(a), 14(a), 14(d), 14A
1934 Exchange Act Rules 14a-3, 14a-4, 14a-5, 14a-9, Schedule S-K
Forms 10-K, 10-Q, 8-K
Federal law requires disclosure (and some ancillary regulation) in five contexts (think of these
as five activities that trigger federal disclosure obligations):
-
Issuing securities – disclosure and related regulation is triggered by a company
decision to raise money in the public markets
Periodic reporting – required of public companies under §13 of the Securities
Exchange Act of 1934. This requirement is an annual report (usually referred to by the
form on which it must be filed, a 10-K), quarterly reports (10-Q), and certain immediate
reports (8-K). These reports require disclosure from issuers about, for example, their
business, their property, their management, and the conflicts of interest their managers
might have.
-
-
-
Proxy Solicitation – Based on section 14(a) of the Act and intended to cure deficiencies
in the shareholder voting process. The federal role is ancillary to the state role, requiring
disclosure only when state law requires or permits shareholders to act.
Tender offers – disclosure when shareholders are asked to respond to a tender offer (a
form of corporate takeover). These rules are designed to allow shareholders to make an
informed decision on corporate decisions in which they have a role
Insider trading
The periodic, proxy, and tender offer regulations apply to companies with a class of stock
registered on a national securities exchange or over a minimum size (as of 2012, $10 million in
assets and at least 2000 shareholders of record or at least 500 “non-accredited” shareholders of
record (i.e., not an institution or not wealthy)).
SEC Regulations S-K spell out what must be disclosed, for example: about the business and
property of the company (items 101-103), selected financial data (items 301-306), and core
information about managers and their conflicts of interest (items 401-405).
The increase in federal disclosure requirements connected with periodic reporting acts to
constrain the space within which managers operate.
While state law normally determines the substantive law governing relations between a
corporation and its shareholders, federal law plays the dominant role in regulating vote-related
communications between and among shareholders and the corporation.
-
Section 14(a) of the 1934 Securities Exchange Act gives the SEC authority to regulate
the proxy or consent solicitation process of the shares of a corporation required to
register securities with the SEC.
Rule 14a-3
-
-
-
Prohibits any proxy solicitation unless the person solicited is first furnished a publicly
filed preliminary or final proxy statement containing the information specified in Schedule
14A of the Exchange Act rules.
The required disclosure includes basic facts that informed voters would presumably
possess (e.g., time, date and place of the meeting, revocability of the proxy, solicitor’s
identity and source of funds, and the identity of and basic information about candidates
for director (if the solicitation concerns the election of directors).
Rule 14a-3 also requires that the proxy statement sent by management in connection
with proxy solicitation for the annual shareholders’ meeting shall be accompanied by an
annual report in prescribed form.
Rule 14a-5
-
Regulates the form of the proxy statement (the principle requirements relate to
readability)
E.g., specifies the type style (roman) and type size (normally 10 point), the manner in
which material must be presented (where practicable, information should be in tabular
form; all amounts should be stated in figures), and how information shall generally be
presented (statements shall be divided into groups according to subject matter, and
each group shall be preceded by appropriate headings).
Rule 14a-4
-
-
Regulates the form of the proxy that solicitors ask shareholders to execute (this was
traditionally printed on a rectangular card and it became commonplace to refer to a
proxy form as a “proxy card”).
Imposes readability requirements
Overriding concern of Rule 14a-4 is to ensure that shareholders are given an opportunity
to do more than grant the authority requested by the solicitor.
Thus, the proxy card must provide boxes whereby the shareholder may specify whether
she approves, disapproves, or abstains with respect to each matter covered by the proxy
(if covering election of directors, must explicitly provide a method whereby solicited
shareholder may withhold authority to vote for nominees favored by the solicitor).
Rule 14a-9
-
Catch-all provision designed to supplement and reinforce the specific disclosure
mandates.
Prohibits the making of false or misleading statements as to any material fact, or the
misleading omission of a material fact, in connection with a proxy solicitation.
Shareholder Governance in the Public Corporation
The federal government chose not to implement a federal incorporation statute and thereby
prescribe internal governance rules. Substantive governance rights were largely left to state law.
Rather, the federal government focused on improving the position of investors by requiring
disclosure, particularly when they buy or sell securities or when they vote as shareholders.
Federal Substantive Rules as to Corporate Governance
Federal authority has been expanded to cover some areas of corporate governance, such as:
-
Federal law requires that boards of directors have compensation and nomination
committees and that independent directors compose these committees
Public corporations must have internal controls, as specified in federal statutes;
Federal law requires that public companies have claw-back provisions that recoup
compensation from executives after particular financial events
Sometimes the federal push for governance rules has been indirect, felt through federal
pressure on self-regulatory organizations (SROs), such as stock exchanges, ostensibly private
participants in the market who are subject to federal oversight.
-
There is a longer history of SRO regulation of corporate governance independent of
federal rules. For example, the listing standards of the NYSE required audited financial
statements before the federal government required them.
Enhancing Shareholder Power Through More High-Powered Disclosure Requirements
The importance of disclosure as required by federal law has grown dramatically over recent
decades. First, there has been an increase in the amount of mandatory disclosure. Second,
technology has made information more widely and quickly available. Third, growth in information
technology has promoted more voluntary disclosure, which companies make through press
releases or websites; the mandatory disclosure provides a baseline against which voluntary
disclosures can be compared. Fourth, there has been a dramatic expansion of the scope of
liability, both public (i.e., Sarbanes-Oxley Act of 2002) and private.
-
Sometimes disclosure is a thinly disguised effort to change the substance of an officer’s
or director’s behavior (something that traditionally would be determined by state law)
o E.g., Sarbanes-Oxley Act requiring disclosure of whether a company has
adopted a code of ethics for senior officers, and if not, the reason therefore
Federal Rules Providing Shareholders Access to Persuasive Communication: Rule 14a-8
Federal law has also enhanced the shareholder governance role by expanding the matters on
which shareholders may vote beyond what state law requires. So far, the federally created
voting rights have only been “precatory” (i.e., advisory only). Shareholders can only “act” for the
corporation pursuant to authority granted by state corporations law.
SEC Rule 14a-8, first promulgated in 1942, permits a “qualifying shareholder” to insert a
proposal into the company’s proxy for the annual meeting, the most common way that voting
takes place in public corporations.
-
-
-
-
-
Under its current framework, Rule 14a-8 requires that shareholders hold $2000 or 1% of
the issuer’s shares for a year prior to the date they submit their proposal and to retain
this share ownership through to the date of the meeting at which the proposal would be
voted on.
In September of 2020, the SEC announced its adoption of more stringent shareholder
standing requirements, which replace existing thresholds with three alternative
thresholds that will require a shareholder to demonstrate continuous ownership of at
least:
$2,000 of the company’s securities for at least three years;
$15,000 of the company’s securities for at least two years; or
$25,000 of the company’s securities for at least one year.
A shareholder can require her corporation to include a “shareholder proposal” and an
accompanying supporting statement in the company’s proxy materials. The proposal and
supporting statement may not exceed 500 words.
The rule was recast as a series of questions and answers in an effort to more clearly
communicate with investors so that Rule 14a-8(a) (Question One) defines a
“shareholder proposal” as “your recommendation or requirement that the company
and/or its board of directors take action, which you intend to present at a meeting of the
company’s shareholders.”
o In effect, the qualifying shareholder is making a motion at the shareholders’
meeting, but is using the company’s proxy material as the medium for effectively
communicating her proposal to other shareholders.
To be a “qualifying shareholder” a person must at the time she submits her proposal own
a minimum stake of the shares for a minimum holding period and continuously own such
stock through the date of the meeting.
o A qualifying shareholder may use Rule 14a-8 to make only one proposal per
meeting
-
Rule 14a-8 permits shareholders persuasive communication with the directors as to
matters that are not directly within the shareholder space for decisions.
The access provided by Rule 14a-8 is subject to a number of exceptions, catalogued
and explained in Rule 14a-8(i) (Question Nine) (if any exception applies, the corporation
may refuse to include the submitted proposal in its proxy material)
o Rule 14a-8(i)(1) allows a corporation to exclude proposals that are “not a proper
subject for shareholder action under state law.” (e.g., initiating amendments to
the Articles of Incorporation, in most states)
 The SEC takes the position that assumes “that a proposal drafted as a
recommendation or suggestion is proper unless the company
demonstrates otherwise.”
 In other words, the SEC and the14a-8(i) rules recognize the importance
of shareholders’ ability to try to persuade the board to take action that
shareholders do not have the power to directly mandate or carry out.
o From a Directors perspective, the primary means to exclude such shareholder
proposals from a company’s proxy statement are the “economic irrelevance” test
contained in Rule 14a-8(i)(5) and the “ordinary business” exclusion found in 14a8(i)(7).
Contours of the “socially significant” limitation on a corporation’s ability to exclude shareholder
proposals:
Lovenheim v. Iroquois Brands, Ltd.
Facts
Plaintiff filed a motion for preliminary injunction. Lovenheim is the owner of two
hundred shares of common stock in Iroquois Brands and was seeking to bar
Iroquois Brands from excluding from the proxy materials being sent to all the
shareholders in preparation for an upcoming shareholder meeting information
concerning a proposed resolution he intended to offer at the meeting. The
proposal related to the procedure used to force-feed geese for production of pate
de foie gras in France, a type of pate imported by Iroquois Brands (specifically
calling on the Directors to look into whether their suppliers cause any undue
distress, pain or suffering to the animals and to discontinue distribution if so, until
a more humane production method is developed). Iroquois Brands was refusing to
allow this information in the proxy materials being sent in relation to the next
annual meeting, relying on the exception found in Rule 14a-8(i)(5), which allows
exclusion of proposals that relates to operations which account for less than 5% of
total assets.
Issue
Whether Rule 14a-8(i)(5) limits the exception to economic criteria (of 5%) or is
inclusive or non-economic criteria.
Holding After looking at the history of the rule, the court concluded that “it seems clear”
that “the meaning of ‘significantly related’ is not limited to economic significance.”
- The 1983 revision adopted a five percent test of economic significance in
an effort to create a more objective standard. Nevertheless, in adopting
this standard, the Commission stated that proposals will be includable
notwithstanding their “failure to reach the specified economic thresholds if
a significant relationship to the issuer’s business is demonstrated on the
face of the resolution or supporting statement.”
- The ethical/social nature of the proposal matters, notwithstanding the fact
that it engages less than 5% of the issuers overall revenues.
Analysis Applicability of Rule 14a-8(i)(5) Exception.
None of the company’s net earnings and less than .05% of its assets are
implicated by plaintiff’s proposal. These levels are far below the 5%
threshold set forth in the first portion of the exception claimed.
- Plaintiff does not dispute the “economic significance” aspect, but
nevertheless contends that the 14a-8(i)(5) exception is not applicable as it
cannot be said that his proposal “is not otherwise significantly related to
the issuer’s business” as is required by the final portion of that exception.
- In other words, he contends that Rule 14a-8 does not permit omission
merely because a proposal is not economically significant where a
proposal has “ethical or social significance.” (essentially focusing on the
word “otherwise” in the rule suggesting that the drafters intended to include
other noneconomic tests of significance)
The Court cannot ignore the history of the rule which reveals no decision by the
Commission to limit the determination to the economic criteria.
- In light of the ethical and social significance of plaintiff’s proposal and the
fact that it implicates significant levels of sales, plaintiff has shown a
likelihood of prevailing on the merits (for injunction purposes) with regard
to the issue of whether his proposal is “otherwise significantly related” to
Iroqouis Brands’ business.
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Strategic Combinations of Federal Rules with State Law and Market Power
Case Study: Classified Boards
Staggered-board provisions are almost always in the firm’s articles incorporation, usually placed
there before the firm’s IPO so that a vote of the firm’s public shareholders would not be
required. As a result, shareholders lack sufficient power to remove this provision without first
removing the directors.
-
Recall the default provisions of state law that require both director and shareholder
approval to amend the articles; directors thus have a gatekeeper role that permits them
to veto changes they dislike by simply refusing to propose a change to the articles.
Directors became more inclined to entertain Rule 14a-8 shareholder proposals to change to
annual election of all directors (despite the proposals being precatory), because institutional
shareholders began to show a willingness to exercise their state law power to vote directors out
if they didn’t.
Case Study: Majority Voting
The shift from plurality voting to majority voting for the election of directors represents another
significant change in public corporation governance norms in the twenty-first century that turned
on coalition building among corporate governance groups interacting with some (smaller)
changes in state and federal law. Plurality voting for the election of directors is the norm in most
states.
SEC moves to provide “proxy access,” i.e., so shareholders could put nominees on the
company’s proxy, thereby lowering the barriers to entry (for shareholders), failed to gain
passage or were struck down by courts (e.g., Business Roundtable vs. SEC).
Recall that shareholders as well as directors may amend bylaws and that shareholders may
address procedural matters so long as they do not interfere with the board’s management of the
corporation. In 2006, both the Delaware G.C.L. and the MBCA were amended to address the
possibility of a majority vote requirement.
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-
The Delaware amendments permitted a director resignation to be made conditional and
effective upon the happening of a future event, such as failure to receive a majority vote.
This opened up the possibility of voluntary agreements by corporations and their
directors that a director would resign if failing to receive a majority vote, but provided
less certainty for more hostile efforts. (the amendments also expressly permitted a
provision that would make such advance resignations irrevocable)
The MBCA amendments authorize bylaw provisions whereby a director who fails to
receive a majority vote must resign within 90 days.
Pfizer-style corporate governance
-
-
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Facts
If an incumbent Director fails to receive the required vote for re-election, then, within 90
days following certification of the shareholder vote, the Corporate Governance
Committee will act to determine whether to accept the Director’s resignation and will
submit such recommendation for prompt consideration by the Board and the Board will
act on the Committee’s recommendation. The Corporate Governance Committee may
consider any factors they deem relevant in deciding whether to accept a Director’s
resignation.
Any Director who tenders his or her resignation pursuant to this provision shall not
participate in the Corporate Governance Committee recommendation or Board action
regarding whether to accept the resignation offer.
Thereafter, the board will promptly disclose its decision-making process and decision
regarding whether to accept the Director’s resignation offer (or the reason(s) for rejecting
the resignation offer, if applicable) in a Form 8-K furnished to the SEC.
Kistefos AS v. Trico Marine Services, Inc.
Trico is a Delaware corporation that provides marine support vessels to the global
offshore oil and gas industry and operates primarily in international markets.
Kistefos owns 22.2% of the outstanding common stock. Trico had an upcoming
annual meeting scheduled for June 16, 2009. On March 14, Kistefos sent a letter
to the board with several proposals, including a proposal to amend the bylaws to
mandate that directors must receive a majority vote in order to be eligible to sit as
a director, including incumbent directors. Under Trico’s current bylaws, directors
who are elected by a majority vote are eligible, but an incumbent director who
receives only a plurality of votes can continue to serve until a successor director is
elected or until resignation or removal. Trico rejected this proposal, citing
Delaware GCL. Kistefos initiated this action seeking a motion to expedite a final
disposition on the claim, so that it can solicit votes in favor of its proposal at the
annual meeting. The following is Proposal 8, put forward by Kistefos:
“A Person shall be ineligible to serve as a director if such person fails to
receive the number of votes required to elect directors at any meeting of
stockholders at which such person is to be elected. . . . The term of any
existing director of the Corporation who fails to receive the number of
votes required to re-elect such existing directors is nominated to be re-
elected and shall immediately expire, and a vacancy in the Board of
Directors shall be deemed to exist.”
Issue
Whether the Kistefos proposal is valid.
Holding Motion to expedite is denied.
The Court preserved Trico’s legal position, saying:
- Because its legal position has been preserved, Trico has no reason to
prevent a stockholder vote on the proposal.
- Accordingly, Kistefos will be permitted to solicit proxies and present
arguments at the annual meeting regarding the proposal in the same
manner that it is permitted to do with respect to other proposed bylaws
(i.e., the stockholders will be permitted to vote on the proposal at the
annual meeting in the same manner as they are permitted to vote on other
proposed bylaws)
Regarding expedited proceedings:
- In light of the now pending stockholder vote on Proposal 8, plaintiff faces
no irreparable injury.
- If the proposal is successfully voted on, then the issue will be preserved
and ripe for judicial review.
- Additionally, pending the stockholder vote on Proposal 8 at Trico’s 2009
annual meeting, the issue of the legal validity of Proposal 8 is not ripe
because the relevant events that must occur before the issue requires
adjudication (i.e., approval by stockholders) may never occur.
Analysis Trico argued that the proposal was invalid because it violated its certificate of
incorporation and Delaware law. Trico offered to collect and preserve the proxies
submitted for and against the proposal, so that it could later be determined if the
proposal received the required vote. Kistefos agreed in principle with this offer, but
claimed that it should be able to present the proposal at the meeting.
- Trico, in order to preserve its legal position that the proposal is invalid, held
fast that it must “disregard” the proposal if it is presented at the meeting
The Court did not want to render an advisory opinion.
Notes:
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The Trico case involves a different context than Rule 14a-8. In the Trico-type conflict, the
insurgent shareholder is willing to solicit proxies itself, as opposed to trying to get its
proposal included in the company’s proxy.
o This strategy is available only if the shareholder is able to pay, at least initially,
the expense of solicitation and mailing. In order to make such a solicitation, the
shareholder also would need to know who the shareholders are and their
addresses.
Case Study: Say on Pay
The Dodd-Frank Act requires public companies to conduct shareholder votes on executive
compensation, often referred to as “say on pay.”
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Like Rule 14a-8 votes, these votes are not binding on the corporation. Executive
compensation remains in the hands of the directors, not the shareholders.
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Nonetheless, say on pay is now a part of the governance fabric of the public corporation,
illustrating the intertwined workings of state and federal law and market forces that are
the focus of this section.
Say on pay is an area where the presence of proxy advisory firms has been particularly
important and visible.
Shareholder Access to Corporate Records and Shareholder List
MBCA §§7.20, 16.01-16.04, 16.20
Delaware G.C.L. §§219, 220
1934 Securities Exchange Act Rule 14a-7
State corporation laws generally provide shareholders with access to a shareholders’ list on
demand not only for use in connection with proxy solicitations, but for other “proper purposes.”
The MBCA departs from early state corporation codes by (1) mandating certain basic record
keeping; (2) requiring that annual reports and financial statements be available to shareholders
(upon written request of a shareholder as provided in a 2016 amendment); and (3) granting
shareholders an absolute right of access to minutes of shareholders’ meetings, all corporate
communications to shareholders in the preceding three years, a list of directors, the
corporation’s most recent annual report to the secretary of state, and copies of its articles and
bylaws.
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Moreover, under the MBCA, shareholder access rights are not contingent on the period
of time that shares have been owned or on the percentage of stock owned.
MBCA §16.02 gives shareholders a right to inspect corporate accounting records, the minutes
or other records of board and board committee meetings, and the list of shareholders, but only
when the demand is made in good faith for a proper purpose to which the records are directly
related.
The statutory provision in Delaware are set forth with less detail than the MBCA. However,
Delaware compensates for lack of statutory detail with a wealth of judicial precedent.
MBCA §16.02(a) and Delaware G.C.L. § 220(b) prescribe the mandatory access.
MBCA §16.02(d) and Delaware G.C.L. § 220(c) prescribe the permissive access.
Regarding shareholder efforts to access shareholder lists and other books and records (in
Delaware):
Facts
Issue
Conservative Caucus v. Chevron Corp.
Conservative Caucus Research Analysts & Education Foundation (nonprofit)
owned 30 shares in defendant Chevron Corp. Conservative Caucus was seeking
a stockholder lists in order to communicate with other stockholders about the
alleged economic risks of Chevron’s business activity in Angola and a proposal to
be submitted at the next annual meeting. The proposal, named the Danielson
Resolution, proposed that the corporation state to the Angolan government that it
will terminate operations in Angola unless the government abandons the
Communist system of government, and other similar political acts.
Whether the records request was proper within the meaning of Delaware law.
Chevron has not borne its burden of showing that plaintiff’s urging Chevron to
cease to do business in Angola because of the possible negative economic
consequences of that activity is an improper purpose and that any other purpose
is irrelevant.
Analysis The statute providing for the obtaining of a stockholder list states in part: “Any
stockholder, in person or by attorney or other agent, shall, upon written demand
under oath stating the purpose thereof, have the right during the usual hours for
business to inspect for any proper purpose the corporation’s stock ledger, a list of
its stockholders, and its other books and records, and to make copies or extracts
therefrom. A proper purpose shall mean a purpose reasonably related to
such person’s interest as a stockholder…”
- A communication with other stockholders about specific matters of
corporate concern, especially in connection with a pending
stockholders’ meeting, has consistently been held to be a proper
purpose for a stockholder to obtain a stocklist.
Since Conservative Caucus stated that it sought to communicate with the other
stockholders about the economic risks, it has complied with the form and manner
of making a demand for a stockholder list. The burden is on Chevron to establish
that the inspection would be for an improper purpose.
Chevron’s claims for why the purpose is improper:
- The purpose is not reasonably related to plaintiff’s interest as stockholder,
but merely to harass the corporation – plaintiff testified at trial that its
primary purpose was to call the issue to the stockholders’ attention that the
company may suffer economic loss, which is a proper purpose for
discussion
o A proper purpose having been stated, all other contentions are
irrelevant
- Next, Chevron urges that plaintiff does not have an interest as a
stockholder in obtaining the list because its interest is solely political –
however, plaintiff was seeking the stocklist to warn the stockholders about
the allegedly dire economic consequences which will fall upon Chevron if it
continues to do business in Angola.
- Next, Chevron asserts that the Danielson Resolution is not a proper
subject for stockholder action; however, just because the resolution only
requests the board to take certain action, does not make it improper or
change its purpose.
- Finally, Chevron asserts that its stockholders are entitled to privacy and
should not be subject to pressure from others whose interest is to assert
opposition or criticism on a range of issues having not impact on the
primary interests of the corporation – while stockholders should be free
from harassment, plaintiff has testified that it will only communicate by mail
to the stockholders and in the present day, one more letter in the mail can
hardly be harassment.
As long as you can come up with purpose that has a loose economic purpose, this
will allow…
Holding
City of Westland Police & Fire Retirement System v. Axcelis Technologies, Inc.
Facts
Axcelis is a Delaware corporation specializing in the manufacture of ion
implantation and semiconductor equipment. Its stock is publicly traded on the
NASDAQ. Westland is a Michigan pension fund, that beneficially owns Axcelis
Issue
common stock. Axcelis had been engaged in a joint venture (SEN) with a
Japanese company, SHI, since 1983. In February and March 2008, SHI made an
unsolicited bid to acquire Axcelis, which it rejected. In June 2008, SHI and Axcelis
agreed to enter into confidential discussions concerning the possible acquisition.
But in September 2008, SHI informed Axcelis that it was putting the discussions
on hold, which was slightly before Axcelis shares had dropped a significant
amount. In between the February/March and June/September discussions,
Axcelis had an annual meeting to fill three of seven director seats, for which three
incumbent directors were running unopposed. Axcelis had previously adopted a
“plurality plus” policy, which stated that if a director failed to get more votes for
than withheld, then they would tender their resignation to the Nominating and
Governance committee, who had discretion to accept their resignation or not. All
three directors received less than majority and all tendered their resignations to
the committee, which did not accept them, citing potential harm to the company if
they did. In December 2008, Westland sent a demand letter to Axcelis under
Delaware Code §220, requesting seven categories of books and records of
Axcelis (relating to meeting agendas, minutes, etc. relating to SHI’s proposals and
the committee). Westland’s stated purpose was to investigate whether the
directors complied with fiduciary duties. Axcelis rejected this demand. In January,
2009 Axcelis failed to make a required payment of outstanding notes, but in
February 2009 it agreed to sell Axcelis’ stake in SEN to SHI, and the proceeds
were used to pay off these notes. Westland subsequently filed a complaint with
the Court of Chancery for a court ordered inspection of Axcelis’ books and records
under Delaware Code §220(c) – which required that Westland have a “proper
purpose” for doing so. The Court dismissed Westland’s action, holding that
Westland had failed to demonstrate a “proper purpose,” by failing to present any
evidence that not accepting the three directors’ resignations thwarted the will of
the shareholders or impeded their voting franchise (because it was pursuant to a
governance policy)
Whether a stated purpose of “investigating possible mismanagement” is a “proper
purpose” for seeking inspection under Delaware Code §220(b).
Holding
Analysis The standard applicable to a Section 220(b) demand is well established. A
stockholder seeking to inspect the books and records of a corporation must
demonstrate a “proper purpose” for the inspection. A “proper purpose” is
one that is “reasonably related to such person’s interest as a stockholder.”
- Our law recognizes investigating possible wrongdoing or
mismanagement as a “proper purpose.” To obtain Section 220 relief
based on that purpose, the plaintiff-stockholder must present “some
evidence” to suggest a “credible basis” from which a court could
infer possible mismanagement that would warrant further
investigation.
- “Credible basis” standard must strike the appropriate balance
between (on the one hand) affording shareholders access to
corporate records that may provide some evidence of possible
wrongdoing and (on the other) safeguarding the corporation’s right
to deny requests for inspection based solely upon suspicion or
curiosity. (Seinfeld v. Verizon Comm’n Inc.)
- Thus, a “mere statement of a purpose to investigate possible general
mismanagement, without more, will not entitle a shareholder to broad
§220 inspection relief.”
-
A plaintiff may establish a credible basis to infer wrongdoing
“through documents, logic, testimony or otherwise.” Such evidence
need not prove that wrongdoing, in fact, occurred. The “credible
basis” standard “sets the lowest possible burden of proof,” thus any
reduction of that burden would be tantamount to permitting inspection
based on the plaintiff-stockholder’s mere suspicion of wrongdoing.
Westland failed to establish a credible basis to infer wrongdoing
- The record provides no credible basis to infer that the Board’s rejection of
the acquisition proposals were other than good faith business decisions
- Deferred to Court of Chancery’s holding that Axcelis’ rejection of SHI’s
unsolicited acquisition proposals, without more, are no “defensive action”
Proper Purpose to investigate suitability of directors
- Westland attempted to rely on Blasius, which created a standard that when
reviewing a BOD’s decision to reject a director resignation under a
“plurality plus” policy, the board must demonstrate a “compelling
justification” for interfering with a shareholder vote.
- However, this improperly attempts to shift the burden from Westland on to
Axcelis, to establish a “proper purpose” for a Section 220 inspection.
Court further elaborated on “proper purpose”:
- Examining a treatise on this topic, a past Court of Chancery decision
(Pershing Square) stated that determining an individual’s suitability to
serve as a director” would serve as a proper purpose. However,
merely stating that purpose does not automatically entitle a
shareholder to Section 220 inspection relief.
- In this case, the Axcelis “plurality plus” policy was adopted unilaterally as a
resolution of the Board, rather than as a bylaw or as part of the certificate
of incorporation (both of which would require shareholder approval)
- Where, as here, the Board confers upon itself the power to override an
exercised shareholder voting right without prior shareholder approval (as
would be required in the case of a shareholder-adopted by-law or charter
provision), the board should be accountable for its exercise of that
unilaterally conferred power. In this specific context, that accountability
should take the form of being subject to a shareholder’s Section 220 right
to seek inspection of any documents and other records upon which the
board relied in deciding not to accept the tendered resignations.
- A showing that enough stockholders withheld their votes to trigger a
corporation’s (board adopted) “plurality plus” policy satisfies the Pershing
Square requirement that “a stockholder must establish a credible basis to
infer that a director is unsuitable, thereby warranting further investigation.”
Nevertheless, to be entitled to relief, the plaintiff must still make the
additional showing articulated in Pershing Square
Pershing Square requirements:
- First, a plaintiff must prove a proper purpose
- Second, the plaintiff must present some evidence to establish a
credible basis from which it can be inferred there is a legitimate
concern regarding a director’s suitability
- Third, a plaintiff must also prove that the information it seeks is
necessary and essential to assessing whether a director is
unsuitable to stand for reelection
- Finally, access to board documents may be further limited by the
need to protect confidential board communications.
Notes:
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Under Rule 14a-7, any shareholder desiring to make a proxy solicitation at an upcoming
meeting may inform the corporation in writing of the planned solicitation and ask the
corporation to provide “14a-7 assistance.”
o For most solicitations, the corporation then has the choice of either mailing the
proxy material for the shareholder (but at the shareholder’s expense) or providing
the shareholder with a list of shareholders. Not surprisingly, corporations almost
always choose to mail materials for the shareholders, because this allows the
corporation some control over the timing of the shareholder’s mailing and
eliminates concern that the shareholder will use a shareholder’s list for a
shareholder context that might evolve.
Note 3 on p.262 explains the breadth of inspection rights under §220
Fiduciary Duty, Shareholder Litigation, and the Business Judgment Rule
Introduction to the Role of Fiduciary Duty and the Business Judgment Rule
MBCA §§8.01, 8.30, 8.31, 8.41, 8.42
The fiduciary duty of loyalty operates to constrain directors and officers in their pursuit of selfinterest. Thus, it is an actionable wrong for an officer or director to compete with her
corporation or divert to personal use assets or opportunities belonging to her
corporation. In this first aspect, fiduciary duty applies in a similar fashion to the officers
and directors of both closely held and publicly traded corporations.
The second focus of corporate law fiduciary duty is directors’ official conduct in directing and
managing the business and affairs of the corporation. Both statutory and judge-made law assign
to the directors the power, authority, and responsibility to manage the business and affairs of
the corporation. In this context, fiduciary duty (note that the MBCA uses the term
“standards of conduct” rather than “fiduciary duty”) broadens to include not only a duty
of loyalty, but also a duty of care. In this aspect, much of the case law involves publicly
traded firms.
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In the Delaware system, the business judgment rule is derived from Section 141(a) (less
direct than the MBCA)
Centralized management for the corporation is a key value-enhancing attribute of corporate
form, particularly for publicly traded corporations. Thus, an essential element of the director’s
authority and power is the business judgment rule – a judicial presumption that the
directors have acted in accordance with their fiduciary duties of care, loyalty, and good
faith.
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The protection provided by the business judgment rule lies in the much greater pleading
and evidentiary burden that it places on plaintiffs seeking to hold directors liable for
allegedly breaching their fiduciary duties while engaged in official conduct on behalf of
the corporation.
Merely alleging that a decision has turned out badly, even very badly, does not state a
cause of action.
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In other words, with regard to directors’ actions taken as managers, such as major
business decisions or determining the corporation’s long term goals and strategies,
judges interpret fiduciary duty and use the business judgment rule to provide
directors with broad discretion to manage the corporation’s business.
Thus, shareholders bear the risk of bad managerial judgment when they buy shares in a
company
Gries Sports Enter., Inc. v. Cleveland Browns Football Co., Inc. on the business judgment rule:
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The business judgment rule has operated as a shield to protect directors from liability for
their decisions for 150 years.
The rule is a rebuttable presumption that directors are better equipped than the courts to
make business judgments and that the directors acted without self-dealing or personal
interest and exercised reasonable diligence and acted with good faith.
o A party challenging a board of directors’ decision bears the burden of rebutting
the presumption that the decision was a proper exercise of the business
judgment of the board
According to the Delaware Supreme Court: The business judgment rule is an
acknowledgement of the managerial prerogatives of Delaware directors under Section
141(a). It is a presumption that in making a business decision the directors of a
corporation acted on an informed basis, in good faith and in the honest belief that the
action taken was in the best interests of the company. Absent an abuse of discretion,
that judgment will be respected by the courts. The burden is on the party challenging the
decision to establish facts rebutting the presumption.
In some circumstances, directors owe fiduciary duties directly to the shareholders, in
which case shareholders may seek to enforce those duties via a lawsuit in their own right
– often a class action if occurring in a publicly-held corporation.
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E.g., if Corporation A directors decide to merge with Corporation B and all Corporation A
shares are going to be converted to Corporation B shares, in a way which results in an
unfairly low valuation of Corporation A, then the shareholders of Corporation A will have
suffered a direct loss for being forced to surrender their shares for insufficient value and
may sue the directors for breach of their fiduciary duty.
In most circumstances, a director (or officer) owes fiduciary duties to the corporation
and not to the shareholders directly.
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E.g., if the directors of Corporation A decide to have the company enter into a new and
exceptionally risky line of business and that decision backfires causing substantial
operating losses to the company, any claim against the directors for breach of fiduciary
duty in connection with approving the failed venture belongs to the corporation and not
the shareholders. This is because the corporation suffered the loss in questions, and
shareholder losses are indirect, and felt by all shareholders equally through loss in share
value.
Normally, it is the directors’ responsibility to institute (or choose not to institute) litigation against
any officer or director who has violated his or her fiduciary duty, just as it is the directors’
responsibility to make any other business decision. But this may not happen for a variety of
reasons, including the material and emotional consequences of the director and other members
of the board.
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Thus, rather than entrust the litigation of all such claims to the directors, courts
developed the shareholder derivative suit, whereby shareholders could commence
and manage fiduciary litigation on the corporation’s behalf.
Shareholder Derivative Suit:
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In its classic form, a derivative suit involves two actions brought by an individual
shareholder:
o i) an action against the corporation for failing to bring a specified suit, and
o ii) an action on behalf of the corporation for harm to it identical to the one which
the corporation failed to bring.
The shareholder plaintiffs are quite often little more than a formality for purposes of the
caption rather than parties with a real interest in the outcome. Since any judgment runs
to the corporation, shareholder plaintiffs at best realize an appreciation in the value of
their shares.
The real incentive to bring derivative actions is usually not the hope of return to the
corporation the hope of handsome fees to be recovered by plaintiffs’ counsel (since very
few shareholders would be willing to pay legal fees out of their own pocket for a suit on
behalf of the corporation)
Discretion to Determine Business Goals, Strategies, and Policies
Facts
Shlensky v. Wrigley
Plaintiff is a minority stockholder of defendant corporation, Chicago National
League Ball Club (Inc.), a Delaware corporation with a principle place of business
in Chicago, Illinois. Chicago National owns and operates the Chicago Cubs. The
corporation also engages in the operation of Wrigley Fields, the Cubs’ home park,
the concessionaire sales during Cubs’ home games, television and radio
broadcasts of Cubs’ home games, the leasing of the field for football games and
other events and receives its share, as visiting team, of admission moneys from
games played in other National League stadia. The individual defendants are
directors of the Cubs. Defendant Philip Wrigley is also president of the corporation
and owner of approximately 80% of stock therein. Plaintiff alleges that since 1935,
nineteen out of twenty major league teams have scheduled night games. In 1966,
out of a total of 1620 games in the major leagues, 932 were played at night.
Plaintiff also alleges that every member of the league, other than the Cubs,
scheduled substantially all of its home games in 1966 at night, for the purpose of
maximizing attendance and therefore revenue and income. Plaintiff contends that
from 1961-65, the Cubs sustained losses from its baseball operations due to low
attendance. He contends that if the directors refused to install lights at Wrigley
Field and schedule night baseball games, they will continue to sustain losses. He
also contends that defendant Wrigley has refused to install lights because of his
personal opinion “that baseball is a ‘daytime sport’ and that the installation of
lights and night baseball games will have a deteriorating effect upon the
surrounding neighborhood.” It is alleged that he has admitted that he is not
interested in whether the Cubs would benefit financially from such action because
of his concern for the neighborhood, and that he would be willing for the team to
play night games if a new stadium were built in Chicago. The Plaintiff alleges that
the other defendant directors with full knowledge of these matters, have
acquiesced to Wrigley, even though they knew he wasn’t motivated by benefiting
the company. The complaint alleges that the directors are actin for reasons
contrary to and wholly unrelated to the business interest of the corporation; that
such arbitrary and capricious acts constitute mismanagement and waste of
corporate assets.
Issue
Whether plaintiff’s amended complaint states a cause of action. (whether fraud,
illegality, or conflict of interest are a sufficient basis for shareholder derivative
suits)
Holding The decision is one properly before directors and the motives alleged in the
amended complaint showed no fraud, illegality or conflict of interest in their
making of that decisions.
Court is not satisfied that the motives assigned to Wrigley and through him to the
other directors, are contrary to the best interests of the corporation and the
stockholders. For example, it appears that the effect on the surrounding
neighborhood might well be considered by a director who was considering the
patrons who would or would not attend the games if the park were in a poor
neighborhood. Furthermore, the long run interest of the corporation in its property
value at Wrigley Field might demand all efforts to keep the neighborhood from
deteriorating. This does not mean the decision of the directors was a correct one,
that is beyond the jurisdiction and ability of the court.
Plaintiff’s amended complaint was also defective in failing to allege damage
to the corporation. The well pleaded facts must be taken as true for the purpose
of judging the sufficiency of the amended complaint, but one need not accept the
conclusions drawn by the pleader.
Finally, the court disagreed with plaintiff’s contention that failure to follow
the example of the other major league clubs in scheduling night games
constituted negligence.
Analysis While all the courts do not insist that one or more of the three elements
must be present for a stockholder’s derivative action to lie, nevertheless we
feel that unless the conduct of the defendants at least borders on one of the
elements, the courts should not interfere.
Damages to Corporation Claim
- There is no allegation that the night games played by the other nineteen
teams enhanced their financial position.
- While it is alleged that the installation of lights would have resulted in large
amounts of additional revenues and income, it is not alleged that there will
be a net benefit to the corporation of such action, considering all increased
costs.
- Also, plaintiff claims that the losses of defendant corporation are due to
poor attendance at home games. However, it appears that factors other
than attendance affect the net earnings of losses, from the plaintiff’s
amended complaint
Negligence Claim
- Plaintiff made no allegation that other team’s scheduling night games were
profitable
- Directors are elected for their business judgment because of the decisions
of directors of other companies. Courts may not decide these questions in
the absence of a clear showing of dereliction of duty on the part of the
Ratio
specific directors and mere failure to “follow the crowd” is not such a
dereliction.
A court will not interfere with an honest business judgment absent a
showing of fraud, illegality or conflict of interest. If a corporation’s directors
can show a valid business purpose for their decision, this decision will be
given great deference by courts.
Discretion to Consider Interests of Non-Shareholder Constituencies
In economic terms, a corporation is made up of a number of constituencies – officers, directors,
shareholders, employees, customers, suppliers, and the community in which it operates. Each
of these constituencies has an obvious stake in the success or failure of the firm, and the
actions of these constituents play a direct role in determining the firm’s success or failure.
The directors are the most powerful stakeholder, empowered by state corporation codes to
manage the corporation. This power carries with it the ability to determine how profits are
allocated and how the competing claims of other stakeholders are resolved.
In allocating surplus profits, shareholders have the strongest claim. Shareholders are after all
the “owners” of the firm – the residual claimants who take last after all other claims have been
satisfied.
Appropriately taking other shareholder interests into account – paying employees fairly,
providing a safe work environment, making products that meet customer expectations,
protecting the community in which the corporation lives and works – is consistent with the goal
of maximizing shareholder value, at least in the long run, and the business judgment rule
protects directors from judicial second-guessing as to such decisions.
Directors may consider the interests of other constituencies if there is “some rationally related
benefit accruing to the stockholders,” or if doing so “bears some reasonable relation to general
shareholder interests.”
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As part of the effort by state legislatures to protect local companies and jobs, more than
30 states added “other constituency” statutes in the wake of the unfriendly takeover
boom. Most of these statutes provide that in determining the best interest of the
corporation, directors may consider the interests of suppliers, employees, customers,
and affected communities. These statutes do not necessarily require a change in the
traditional interpretation of fiduciary duty (as evidenced by their use of the permissive
verb “may” rather than the mandatory “shall”).
Dodge v. Ford Motor Co. is generally understood to stand for the proposition that directors’
prime obligation is to maximize shareholder wealth. At the same time, it stands as a stark
reminder of the extent of both director power and judicial deference to director decision-making.
Facts
Dodge v. Ford Motor Co.
The Dodge brothers (plaintiffs) were two of a small number of minority investors in
the young Ford Motor Company; Henry Ford owned 58% of the company’s stock
and dominated the company. Plaintiffs challenged the company’s actions in
refusing to pay dividends while expanding the company’s facilities and lowering
the price of its cars. A lower court enjoined planned expansion of the company’s
Issue
Holding
facilities and ordered the company to pay a dividend in the amount of around
$19.2 million. When plaintiffs made their complaint, Ford had one of its most
prosperous years of business. It’s expected profit for the following year was
upwards of $60 million, and it had assets for $132 million, with only $20 million in
liabilities. It had not declared a special dividend during the business year except
for in October of 1915. It had been the practice, under similar circumstances, to
declare larger dividends. Considering these facts, a refusal to declare and pay
further dividends appears to be not an exercise of discretion but an arbitrary
refusal to do what the circumstances required to be done. However, the
defendants offered further testimony: The corporation had a plan to expand to
another plant to produce more vehicles, and to reduce the price of vehicles in the
following business year. Mr. Ford evinced the attitude towards shareholders that
he is one who has dispensed and distributed to them large gains and that they
should be content to take what he chooses to give. His testimony also created the
impression that he thinks Ford Motor Co. has made too much money and that
although there are still large profits to be earned, sharing them with the public by
reducing the price of the output of the company, ought to be undertaken.
Whether the Board members violated their fiduciary duty to the stockholders by
not paying out a dividend when the company made immense profits, and instead,
chose to place in the financial priorities list the benefit of the world at large.
The decree of the court below fixing and determining the specific amount to
be distributed to stockholders is affirmed.
The court was not satisfied that the alleged motives of the directors, in so
far as they are reflected in the conduct of the business, menace the
interests of shareholders.
- It is recognized that plans must often be made for a long future, for
expected competition, for a continuing as well as an immediately profitable
venture. The experience of the Ford Motor Co. is evidence of capable
management of its affairs.
However, the directors had a duty to distribute on or near August 1, 1916, a
very large sum of money to stockholders.
- While it is true that a considerable cash balance must be at all times
carried, there was a large daily, weekly, and monthly, receipt of cash. The
output was practically continuous and was continuously, and within a few
days, turned into cash. Moreover, the contemplated expenditures for the
plant were not to be immediately made (it was payable over an extended
period of time).
Analysis The difference between an incidental humanitarian expenditure of corporate funds
for the benefit of the employees, like the building of a hospital for their use and the
employment of agencies for the betterment of their condition, and a general
purpose and plan to benefit making at the expense of others, is obvious.
- There should be no confusion of the duties which Mr. Ford conceives that
he and the stockholders owe to the general public and the duties which in
law he and his codirectors owe to protesting, minority stockholders. A
business corporation is organized and carried on primarily for the profit of
the stockholders. The power of the directors are to be employed for that
end. The discretion of directors is to be exercised in the choice of means
to attain that end and does not extend to a change in the end itself, to the
reduction of profits or to the nondistribution of profits among stockholders
in order to devote them to other purposes.
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There is committed to the discretion of directors, a discretion to be
exercised in good faith, the infinite details of business, including the wages
which shall be paid to employees, the number of hours they shall work, the
conditions under which labor shall be carried on, and the prices for which
products shall be offered to the public.
It is not within the lawful powers of a board of directors to shape and
conduct the affairs of a corporation for the merely incidental benefit of
shareholders and for the primary purpose of benefitting others, and no one
will contend that if the avowed purpose of the defendant directors was to
sacrifice the interests of shareholders it would not be the duty of the courts
to interfere.
Assuming the general plan and policy of expansion and the details of it to have
been sufficiently, formally, approved at the October and November, 1917,
meetings of directors, and assuming further that the plan and police and the
details agreed upon were for the best ultimate interest of the company and
therefore of its shareholders, what does it amount to in justification of a refusal to
declare and pay a special dividend or dividends?
Since the Dodge Brothers were also in the auto manufacturing business, it’s likely that they are
trying to use the business judgment rule to prevent Ford from increasing wages, which would
create a wage floor that they would also likely have to face with payment of their own workers.
Benefit Corporations
Delaware G.C.L. Subchapter XV (§§361-368)
The business judgment rule, as reflected in cases like Shlensky v. Wrigley and Dodge v. Ford,
gives a corporation’s directors considerable space in determining how to allocate the firm’s
resources, including considerable space to operate in a social responsible manner, even if
doing so has a possible negative effect on profits.
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For example, courts will not entertain a shareholder lawsuit seeking to force Costco to
reduce the total compensation it provides to its workforce even if the pay and benefits
package for the average Costco worker is more generous than the industry norm, so
long as Costco justifies such policy as in the long-term best-interest of the corporation
and its shareholders.
Likewise, Courts will not entertain a shareholder lawsuit against Alphabet, Inc. (Google)
seeking to modify or recover damages resulting from charitable giving practices
substantially more generous than those of other corporations.
However, these results obtain because outliers like Costco and Alphabet do not describe
their policies as altruistic in nature. Rather, they justify such expenditures as being in the
direct best interest of the corporation (e.g., Costco can point to benefits of substantially
higher worker productivity and morale and much lower turnover and argue that its
compensation policies are much less costly than the Walmart model).
Flying in the face of the shareholder-value primacy is a recently created business entity – a
“benefit corporation.”
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Benefit corporations are designed to combat the cultural, ideological, and investor
pressures to use shareholder value maximization as the only legitimate metric for
making or evaluating business decisions.
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A benefit corporation must have a purpose not only to pursue profits, but also to make a
positive impact on society (a “public benefit”).
Additionally, most benefit-corporation statutes require periodic measurement of a
company’s public benefit performance against a reputable third party standard, and
transparent reporting to the results of such audit to shareholders and the public.
Under Delaware’s version of its benefit corporation statute:
o §362(a) and §365(a) Impose the following balancing requirements: Public benefit
corporations must be managed in a manner that balances:
 (i) the stockholders’ pecuniary interests,
 (ii) the interests of those materially affected by the corporation’s conduct,
and
 (iii) a public benefit or public benefits identified in the corporation’s
certificate of incorporation
o §362(a) requires a public benefit corporation to identify in its certificate of
incorporation the specific public benefit or public benefits the corporation will
promote.
o §366(b) requires public benefit corporations, at least every two years, to issue to
stockholders statements that contain certain prescribed information.
o §366(c) permits the corporation in its certificate of incorporation or bylaws to
impose additional specified requirements to facilitate stockholders’ ability to
evaluate the public benefit corporation’s achievement of its purposes.
The Fiduciary Duty of Loyalty
Two classic settings for a directors duty of loyalty:
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1) circumstances in which a director personally takes an opportunity that the corporation
later asserts rightfully belonged to it, and
2) transactions between the corporation and the director, commonly called “conflicting
interest transactions.”
The core of this fiduciary duty is the requirement that a director favor the corporation’s interests
over her own whenever those interests conflict. As with the duty of care, there is a duty of
candor aspect to the duty of loyalty.
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Thus, whenever a director confronts a situation that involves a conflict between her
personal interests and those of the corporation, courts will carefully scrutinize not only
whether she has unfairly favored her personal interest in that transaction, but also
whether she has been completely candid with the corporation and its shareholders.
The Corporate Opportunity Doctrine
The Guth Approach:
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“…if there is presented to a corporate officer or director a business opportunity which the
corporation if financially able to undertake, which is, from its nature, in the line of the
corporation’s business and is of practical advantage to it, is one in which the corporation
has an interest or a reasonable expectancy, and, by embracing the opportunity, the selfinterest of the officer or director will be brought into conflict with that of his corporation,
the law will not permit him to seize the opportunity for himself.”
The Broz approach (used in Delaware – common law application):
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A corporate officer or director may take advantage of a business opportunity if:
o (1) the opportunity is presented to the director or officer in his individual capacity
and not in his corporate capacity;
o (2) the opportunity is not essential to the corporation;
o (3) the corporation holds no interest or expectancy in the opportunity; and
o (4) the director or officer has not wrongfully employed the resources of the
corporation in pursuing or exploiting the opportunity.
A corporate officer or director may not take advantage of a business opportunity if:
o A corporate officer or director may not take a business opportunity for his own if:
(1) the corporation is financially able to exploit the opportunity;
(2) the opportunity is within the corporation's line of business;
(3) the corporation has an interest or expectancy in the opportunity; and
o (4) by taking the opportunity for his own the corporate fiduciary will thereby be
placed in a position inimicable to his duties to the corporation
MBCA §8.70 (codifies for MBCA formed companies)
The American Law Institute and MBCA Approaches
ALI, Principles of Corporate Governance §5.05
MBCA §8.70
Facts
Northeast Harbor Golf Club, Inc. v. Harris
Nancy Harris was the president of the Northeast Harbor Golf Club, a Maine
corporation, from 1971 until she was asked to resign in 1990. The Club’s only
major asset was a golf course in Mount Desert. During Harris’ tenure as president,
the board occasionally discussed the possibility of developing some of the Club’s
real estate in order to raise money, but despite Harris being generally in favor of it,
the board “shied away” from that type of activity.
In 1979, Harris was informed of the Gilpin property being for sale, by the listing
broker named Robert Sumindby, which comprised three noncontiguous parcels
located among the fairways of the golf course, including an unused right-of-way
on which the Club’s parking lot and clubhouse were located. The listing broker
contacted Harris because he knew she was the president of the Club and he
believed the Cub would be interested in buying the property. However, Harris
immediately agreed to purchase the property in her own name. She did not
disclose her plans to purchase the property to the Club’s board prior to the
purchase. Instead, she informed the board at its annual August meeting that she
had purchased the property and intended to hold it for her own name, but that the
Club would be “protected. The board took no action in response, and Harris
testified that at the time of purchase she had no plans to develop the land.
In 1984, Harris learned of another parcel of land surrounded on three sides by the
golf course available for purchase (The Smallidge parcel). Harris learned about
this while playing golf with the postmaster of Northeast Harbor. Harris purchased
the property. She testified that she had told a number of board members of her
intention to purchase prior to actually purchasing and at the board meeting in
August 1985, formally disclosed that she had purchased it. The minutes of the
meeting indicate that she told the board she had no present plans to develop the
Smallidge parcel. But she also testified that at the time of purchase, she thought it
would be nice to have some houses there. Again, the board took no formal action.
The trial court found that the Club would not have been able to purchase either
the Gilpin or Smallidge properties, given its poor financial health. However, there
was evidence to suggest that the club was able to successfully fundraise when it
needed to.
In 1987 and 1988, Harris divided the real estate properties into 42 small lots and
conveyed some to her children. They planned to develop a subdivision on the
Gilpin property (the Bushwood subdivision), which a group of Club directors
formed a separate organization in order to oppose. After the plans for Bushwood
became clear, some directors testified that they truested Harris to act in the best
interest of the Club, while other directors disagreed. One board member, John
Schafer, took issue with Harris’ conduct and eventually asked her to resign in
1990. The Board authorized a lawsuit against Harris in 1991 after resolving that
the proposed housing development was contrary to the best interests of the
corporation. The trial court found that Harris had not usurped a corporate
opportunity because the acquisition of real estate was not in the Club’s line of
business. Also, it found that the Club lacked financial ability to purchase the real
estate. Finally, it placed great emphasis on Harris’s good faith.
Issue
Holding
The Club maintains that the trial court erred in finding that Harris did not breach
her fiduciary duty as president of the Club by purchasing and developing property
abutting the golf course.
Whether Harris breached her fiduciary duty to the Club by purchasing the real
estate land surrounding the golf course in the way she did.
The trial court made a number of factual findings, but did so in light of legal
principles that are different from the principles this court believe to be the
appropriate test. Fairness requires that the order be vacated and remanded for
further evidence and proceedings.
The Court followed the ALI test. The disclosure-oriented approach provides a
clear procedure whereby a corporate officer may insulate herself through prompt
and complete disclosure from the possibility of legal challenge. The requirement of
disclosure recognizes the paramount importance of the corporate fiduciary’s duty
of loyalty. At the same time it protects the fiduciary’s ability pursuant to the proper
procedure to pursue her own business ventures free from the possibility of a
lawsuit.
Analysis The Corporate Opportunity Doctrine
Corporate fiduciaries in Maine must discharge their duties in good faith with a view
toward furthering the interests of the corporation. They must disclose and not
withhold relevant information concerning any potential conflict of interest with the
corporation, and they must refrain from using their position, influence, or
knowledge of the affairs of the corporation to gain personal knowledge.
Defining the scope of the corporation opportunity doctrine:
- Under the “line of business” test, from Delaware in Guth v. Loft, Inc., the
Court looked at whether:
o If there was an opportunity presented to a corporate officer or
director “so closely associated with the existing business
activities… as to bring the transaction within that class of cases
where the acquisition of the property would throw the corporate
officer purchasing it into competition with his company.”
o
o
However, this test is subject to weakness.
First, whether a particular activity is within a corporation’s line of
business is conceptually difficult to answer; i.e., the Club was the
business of running a golf course, not developing real estate.
Nevertheless, the record supports a finding that the Club made a
policy judgment that development of the surrounding land would be
detrimental to the best interests of the Club. The acquisition of the
land surrounding the golf course would have enhanced the ability
of the Club to implement that policy. Harris’s activities effectively
foreclosed the Club from pursuing that option.
o Second, the Guth test includes as an element the financial ability of
the corporation to take advantage of the opportunity. The Club had
a financial incapacity to act on this policy. However, this factor in
the equation unduly favors the inside director or executive who has
command of the facts relating to the finances of the corporation.
- Under the “fairness test”, the Massachusetts court in Durfee established
that: “the true basis of governing doctrine rests on the unfairness in the
particular circumstances of a director, whose relation to the corporations is
fiduciary, taking advantage of an opportunity [for her personal profit] when
the interest of the corporation justly call[s] for protection. This calls for
application of ethical standards of what is fair and equitable… in particular
sets of facts.”
o However, this suffers from the same lack of principled content as
the Guth test. It provides little or no practical guidance to the
corporate officer or director seeking to measure her obligations
- The Minnesota Supreme Court attempted to combine the “line of business”
test with the “fairness” test in a two-step analysis: first, determining
whether a particular opportunity was within the corporation’s line of
business, then scrutinizing “the equitable considerations existing prior to,
at the time of, and following the officer’s acquisition.” This is also an
unsatisfactory test.
- At the bottom of each of these alternatives, the corporate opportunity
doctrine recognizes that a corporate fiduciary should not serve both
corporate and personal interests at the same time.
The American Law Institute Approach
The ALI developed a version of the corporate opportunity doctrine under
Principles of Corporate Governance §5.05 (the Court follows this test).
- The central feature of the ALI test is the strict requirement of full disclosure
prior to taking advantage of any corporate opportunity (§5.05(a)(1)).
- “If the opportunity is not offered to the corporation, the director or senior
executive will not have satisfied §5.05(a). The corporation must then
formally reject the opportunity (§5.05(a)(2)).
- “full disclosure to the appropriate corporate body is… an absolute
condition precedent to the validity of any forthcoming rejection as well as
to the availability to the director or principal senior executive of the defense
of fairness.” (Klinicki)
- A “good faith but defective disclosure” by the corporate officer may be
ratified after the fact only by an affirmative vote of the disinterested
directors or shareholders (§5.05(d)).
- The ALI test defines “corporate opportunity” broadly. It includes
opportunities “closely related to a business in which the corporation is
engaged.” (§5.05(b)). It also encompasses any opportunities that accrue to
the fiduciary as a result of her position within the corporation (this is best
illustrated by the testimony of Suminsby, since the Gilpin property was
offered to Harris specifically in her capacity as president of the Club – if the
factfinder reached that conclusion, then at least the opportunity to acquire
the Gilpin property would be a corporate opportunity).
- Under the ALI standard, once the Club shows that the opportunity is a
corporate opportunity, it must show either that Harris did not offer the
opportunity to the Club or that the Club did not reject it properly. If the Club
shows that the board did not reject the opportunity by a vote of
disinterested directors after full disclosure, then Harris may defend her
actions on the absis that the taking of the opportunity was fair to the
corporation (§5.05(c))
Notes: On remand, the trial court ruled that both the Gilpin and Smallidge properties were
corporate opportunities and that Nancy Harris had wrongfully usurped those opportunities.
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The court found: the Club’s normal business is maintain and operating a golf course.
That business is dependent on having sufficient land for the course itself and ensuring
that the activity of golf is not hindered or affected by development of adjacent and
surrounding property. The Club had frequently discussed developing some of its own
land and on one occasion talked about the possibility of purchasing and developing
adjacent land.
Thus, the business opportunity was sufficiently related to the Club’s business.
It doesn’t matter that Harris received the information by playing golf with someone who offered
the information (in the case of the Smallidge property). The fact that she is a director and that
the property was adjacent to the golf course is enough to satisfy the test.
NOTE: Fairness and the Doctrine of Waste
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Under the ALI approach, a fiduciary may take advantage of a corporate opportunity if
such taking either is fair to the corporation, or is authorized in advance by disinterested
directors “in a manner that satisfies the standards of the business judgment rule,” or is
authorized by an informed vote of disinterested shareholders, so long as the
shareholders’ rejection of the opportunity “is not equivalent to a waste of corporate
assets.” (§5.05(a)).
The ALI defines “waste” as”
o “A transaction constitutes a “waste of corporate assets” if it involves an
expenditure of corporate funds or a disposition of corporate assets for which no
consideration is received in exchange and for which there is no rational business
purpose, or, if consideration is received in exchange, the consideration the
corporation receives is so inadequate in value that no person of ordinary sound
business judgment would deem it worth that which the corporation has paid.” ALI
Principles of Corporate Governance §1.42.
o A rejection of a corporate opportunity would constitute a waste of corporation
assets only if it was akin to a “gift” of corporate assets that no person of ordinary
business judgment would have authorized.
o Waste is treated as a void rather than voidable act
If rejection of a corporate opportunity constitutes a waste of corporate assets, the
rejection cannot be “fair” to the corporation. Likewise, if a corporate opportunity has been
rejected by the directors, a finding that such rejection is akin to waste would preclude a
finding that the directors’ actions are entitled to busines judgment rule presumptions. A
finding of waste with respect to a director-approved action necessarily constitutes a
finding that the directors acted in violation of their fiduciary duties and that the
corporation has been damaged by that action. Thus, the doctrine of waste serves to
define the outer boundary of judicial respect for, and deference to, the directors’
business judgment
Problem 4-3
(a) ALI §5.05(a) – none of the criteria are satisfied by the scenario (the criteria under (a) all
contemplate rejection, and there was none here)
(b) ALI §5.05 – opportunity wasn’t presented
(c)
(d)
The Delaware Approach
Delaware G.C.L. §122(17)
Facts
Broz v. Cellular Information Systems, Inc.
Robert Broz is the President and sole stockholder of RFB Cellular, Inc., a
Delaware corporation engaged in the business of providing cellular telephone
service in the Midwestern United States. Broz was also a board member of
Cellular Information Systems. CIS is a competitor of RFBC. CIS was fully aware of
Broz’s relationship with RFBC and the obligations incumbent on him from that
position. In 1994, Mackinac sought to divest itself of Michigan-2 and sought a
brokerage firm, Daniels, to seek potential purchasers. Daniels contacted Broz and
offered the possible acquisition to RFBC, and Broz signed a confidentiality
agreement at Mackinac’s request. The license was not offered to CIS (Daniels
didn’t consider CIS to be a viable purchaser). At the time that Michigan-2 was
offered to Broz, CIS had financial troubles and entered into Chapter 11
proceedings. As part of a restructuring plan, CIS entered into a loan that
substantially impaired its ability to undertake new acquisitions or incur new debt.
In June 1994, Broz approached most of the directors and the CEO of CIS about
his interest in acquiring Michigan-2, and all indicated that CIS had no interest or
financial ability to purchase the Michigan-2 license; the rest of the directors also
testified that had Broz approached them at the time, they would have said the
same thing. One director, who was also counsel for CIS, agreed to represent
RFBC (at Broz’s request) in the purchase of Michigan-2. Later in June, PriCellular
made a tender offer to purchase the shares of CIS board members. The Board
members entered into a “standstill” agreement which prevented the directors from
engaging in any transaction outside the regular course of CIS’ business or
incurring new liabilities until the close of the tender offer. PriCellular had issues
with financing the acquisition and had to delay the purchase. In the meantime,
Broz and PriCellular were also in a bidding war over Michigan-2. PriCellular
eventually reached an agreement with Mackinac on an option to purchase, but the
option provided that if anyone outbid PriCellular’s bid by $500,000, it would go to
that purchaser. Broz agreed to pay $500,000 over PriCellular’s price and executed
the purchase agreement with Mackinac on behalf of RFBC on November 14,
1994. After this, PriCellular’s tender offer for CIS shares closed on November 23,
and CIS’ board members, including Broz, were discharged and replaced by
PriCellular’s nominees. CIS commenced this action afterwards.
CIS brought an action against Broz and RFBC for equitable relief, contending that
the purchase of this license by Broz constituted a usurpation of a corporate
opportunity properly belonging to CIS, irrespective of whether or not CIS was
interested in the Michigan-2 opportunity at the time it was offered to Broz. The
Court of Chancery concluded that the Michigan-2 opportunity was well within the
core business interests of CIS at the relevant time. Thus, Broz violated his
fiduciary duty by not formally informing the board of the opportunity and the facts
surrounding it and by proceeding to acquire rights for his benefit without consent
of the corporation.
Issue
Whether Broz violated his fiduciary duty to CIS by purchasing the Michigan-2
license after his disclosure and discussion with CIS board members and
PriCellular’s tender offer.
Holding The Court of Chancery erred as a matter of law in concluding that Broz had a duty
formally to present the Michigan-2 opportunity to the CIS board. Is also erred in its
application of the corporate opportunity doctrine.
Although a corporate director may be shielded from liability by offering to the
corporation an opportunity which has come to the director independently and
individually, the failure of the director to present the opportunity does not
necessarily result in the improper usurpation of a corporate opportunity.
If the corporation is a target or potential target of an acquisition by another
company which has an interest and ability to entertain the opportunity, the director
of the target company does not have a fiduciary duty to present the opportunity to
the target company.
Analysis Application of the Corporate Opportunity Doctrine
The corporate opportunity doctrine, as delineated in Guth and its progeny, holds
that a corporate officer or director may not take a business opportunity for his
own if:
1) The corporation is financially able to exploit the opportunity;
2) The opportunity is within the corporation’s line of business;
3) The corporation has an interest or expectancy in the opportunity; and
4) By taking the opportunity for his own, the corporate fiduciary will thereby
be placed in a position inimicable to his duties to the corporation.
The Court is Guth also derived a corollary which states that a director or officer
may take a corporate opportunity if:
1) The opportunity is presented to the director or officer in his individual and
not his corporate capacity;
2) The opportunity is not essential to the corporation;
3) The corporation holds no interest or expectancy in the opportunity; and
4) The director or officer has not wrongfully employed the resources of the
corporation in pursuing or exploiting the opportunity.
No one factor is dispositive and all factors must be taken into account insofar as
they are applicable.
The determination of “[w]hether or not a director has appropriated for himself
something that in fairness should belong to the corporation is ‘a factual question to
be decided by reasonable inference from objective facts.’” (Johnston v. Greene)
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In the instant case, the facts do not support the conclusion that Broz
misappropriated a corporate opportunity.
Analyzing the facts:
- Broz became aware of the Michigan-2 opportunity in his individual
and not his corporate capacity.
- Mackinac did not think CIS was a viable candidate for Michigan-2 and
therefore did not offer it – this makes many of the fundamental concerns
undergirding the law of corporate opportunity not present; thus, the burden
imposed on Broz to show adherence to his fiduciary duties to CIS is
lessened to some extent. Nevertheless, this is not dispositive.
- CIS was not financially capable of exploiting the Michigan-2
opportunity. The record shows that CIS was in a precarious financial
position at the time Mackinac presented the Michigan-2 opportunity to
Broz, exacerbated by the Chapter 11 proceedings and the loan
arrangement, etc.
- Even considering PriCellular’s ability to exercise the option to acquire CIS’
bank debt, PriCellular’s own financial situation was not particularly stable.
Also, at the time Broz was required to decide whether to purchase
Michigan-2, PriCelluar had not yet acquired CIS and any plans to do so
were wholly speculative.
- While it may be said with some certainty that the Michigan-2
opportunity was within CIS’ line of business, it is not equally clear
that CIS had a cognizable interest or expectancy in the license.
- Under the third factor in Guth, for an opportunity to be deemed to belong to
the fiduciary’s corporation, the corporation must have an interest or
expectancy in that opportunity. Despite the fact that the nature of the
Michigan-2 opportunity was historically close to the core operations of CIS,
changes were in process. CIS was actively engaged in the process of
divesting its cellular licensing holdings. CIS’ articulated business plan did
not involve any new acquisitions. Also, the testimony of the board
members indicates that the Michigan-2 would not have been of interest to
CIS even if it had been in good financial health.
- Broz’s interest in acquiring and profiting from Michigan-2 created no
duties that were inimicable to his obligations to CIS
- CIS was well aware that Broz was the party in interest in RFBC. CIS was
fully aware of Broz’s potentially conflicting duties. Broz comported himself
in a manner that was wholly in accord with his obligations to CIS. Broz was
not obligated to refrain from competition with PriCellular.
The totality of the circumstances indicates that Broz did not usurp an
opportunity that properly belonged to CIS.
Presentation to the Board issue:
- The trial court placed great emphasis on the fact that Broz had not formally
presented the matter to the CIS board.
- In doing so, the court erroneously grafted a new requirement onto the law
of corporate opportunity, viz., the requirement of formal presentations
under circumstances where the corporation does not have an interest,
expectancy or financial ability.
- Presenting the opportunity to the board creates a kind of “safe
harbor” for the director, which removes the specter of a post hoc
judicial determination that the director or officer has improperly
usurped a corporate opportunity. But it is not the law of Delaware
Ratio
that presentation to the board is a necessary prerequisite to a finding
that a corporate opportunity has not been usurped.
- Thus, Broz was not required to make formal presentation of the
Michigan-2 opportunity to the CIS board prior to taking the
opportunity for his own.
- Broz was also very honest with all of the board members that he discussed
the opportunity throughout the course of these events.
Alignment of interests between CIS and PriCellular issue:
- The trial court concluded that since CIS’s interests with respect to the
Mackinac transaction merged with PriCellular’s even prior to its closing of
tender offer for CIS stock and that therefore Broz was required to consider
PriCellular’s interest in the transaction
- Broz was under no duty to consider the interest of PriCellular when
he chose to purchase Michigan-2. As stated in Guth, a director’s right to
“appropriate [an]… opportunity depends on the circumstances existing at
the time it presented itself to him without regard to subsequent events.”
- At the time Broz purchased Michigan-2, PriCellular had not yet acquired
CIS. Any plans to do so still would have been wholly speculative.
Broz, as an active participant in the cellular telephone industry, was entitled to
proceed in his own economic interest in the absence of any countervailing duty.
The right of a director or officer to engage in business affairs outside of his or her
fiduciary capacity would be illusory if these individuals were required to consider
every potential, future occurrence in determining whether a particular business
strategy would implicate fiduciary duty concerns.
There is no requirement that a director take into consideration the future
interests of a corporation that is a third-party at the time of the opportunity.
There is also no requirement the director in question formally present an
opportunity to directors if the corporation has no interest and doesn’t have
the financial ability to undertake the opportunity.
Conflicting Interest Transactions
At Common Law
Conflicting Interest Transaction: A transaction in which a director has an interest.
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MBCA Subchapter F, note 4
o Details specifically what the statutory rules cover as “conflicting interest
transactions”
In the nineteenth century, common law courts were in substantial agreement that transactions
between a corporation and one or more of its directors were void or voidable simply because a
conflict of interest existed.
As the complexity and interconnection of American business increased, conflicting interest
transactions became an accepted business reality. Judicial views evolved accordingly. By the
twentieth century, most common law courts no longer viewed conflict of interest transactions as
automatically void or voidable. However, courts were quick to void a conflicting interest
transaction if the substantive terms of the transaction were found unfair, or, even if such terms
were found fair, if the benefiting directorzas had in any way breached their obligation to disclose
fully all relevant facts to the corporation, including, of course, the fact of their interest in the
subject matter.
Globe Woolen Co. v. Utica Gas & Electric Co.
Plaintiff corporation is the owner of two mills in Utica. One is for the manufacture
of worsteds and the other for that of woolens. The defendant generates and sells
electricity for light and power. John Maynard has been the chief stockholder,
president, and member of the board of Globe Woolen Co for many years. He has
also been a director of the defendant and chairman of its executive committee. His
property interest in the plaintiff is large and in the defendant he has none.
In 1903, the general manager of Utica’s electric department (Greenidge)
suggested to Maynard that Globe Woolen convert the mills from steam power to
electric power. Maynard was concerned that the cost of conversion would be too
high. Greenidge, engaged in negotiations with Maynard that resulted in two
contracts to provide electricity to the mills. The contracts included a guarantee that
the monthly cost of electricity would be at least $300 less than Globe’s prior steam
expenses. After Greenidge and Maynard had agreed to the terms, the contracts
were presented to Utica’s board for ratification in December 1906 and February
1907. Greenidge presented the contracts and vouched for them. Maynard was
silent at the meetings and did not vote on either contract. They were both
approved by the board. Afterwards, it soon became clear that Greenidge had
miscalculated and that the contracts would generate huge losses for Utica. Globe
increased production and power usage significantly, but Utica was still required to
provide cost savings based on prior production levels. Maynard had not warned of
the changes. Predicting losses up to $300,000 if it held to the terms, Utica gave
notice of rescission in February 1911. Globe sued for specific performance. The
trial court ruled for Utica, finding the contracts unenforceable because they were
unfair, oppressive, and made under the dominating influence of a common
director. The appellate court affirmed. Globe appealed to this court, arguing that
since Maynard had abstained from voting on the contracts, he and Globe were
shielded from these claims.
Issue
Whether Maynard’s silence absolved him of undue influence or enrichment in the
contracts for power to the two mills.
Holding The refusal to vote does not nullify as of course an influence and
predominance exerted without a vote. The constant duty rests on a trustee
to seek no harsh advantage to the detriment of his trust, but rather to
protest and renounce if through the blindness of those who treat with him
he gains what is unfair. Because there is evidence that in the making of these
contracts that duty was ignored, the power of equity was fittingly exercised to
bring them to an end.
Analysis The “great rule of law” which holds a trustee to the duty of constant and
unqualified fidelity is not a thing of forms and phrases. A dominating influence may
be exerted in other ways than by a vote. A beneficiary, about to plunge into a
ruinous course of dealing, may be betrayed by silence as well as by the
spoken word.
- The trustee is free to stand aloof, while others act, if all is equitable and
fair. He cannot rid himself of the duty to warn and to denounce, if there is
improvidence or oppression, either apparent on the surface, or lurking
beneath the surface, but visible to his practiced eye.
There was an influence here, dominating, perhaps, and surely potent and
persuasive, which was exerted by Maynard from the beginning to the end. In all
Facts
Ratio
stages of preliminary treaty he dealt with a subordinate, who looked up to him as a
superior, and was alert to serve his pleasure.
- No label identified the request of Maynard, the plaintiff’s president, as
something separate from the advice of Maynard, the defendant’s
chairman.
- Superior and subordinate together framed a contract, and together closed
it. It came to the executive committee as an accomplished fact. The letters
had been signed and delivered. Work had been begun. All that remained
was a ratification, which may have been needless, and which, even if
needful, took the aspect of a mere formality.
There was then, a relation of trust reposed, of influence exerted, of superior
knowledge on the one side and legitimate dependence on the other. At least a
finding that there was this relation has evidence to sustain it. A trustee may not
cling to contracts thus won, unless their terms are fair and just. His dealings with
his beneficiary are “viewed with jealousy by the courts, and may be set aside on
slight grounds.” He takes the risk of an enforced surrender of his bargain if it turns
out to be improvident. There must be candor and equity in the transaction, and
some reasonable proportion between benefits and burdens.
- The contracts before us do not survive these tests. The unfairness is
startling, and the consequences have been disastrous.
- The mischief consists of this: that the guaranty has not been limited by a
statement of the conditions under which the mills are to be run.
Maynard must have known of the elements of unfairness. He may have trusted
Greenidge to compute with approximate accuracy, but he cannot have failed to
know that he held a one-sided contract which left the defendant at his mercy. He
was not blind to the likelihood that in a term of ten years there would be changes
in the business. The swiftness with which some of the changes followed permits
the inference that they were premeditated. With that recognition, no word of
warning was uttered to Greenidge or to any of the defendant’s officers.
- It is no answer to say that this potency, if obvious to Maynard, ought also
to have been obvious to other members of the committee. They did not
know, as he did, the likelihood or the significance of changes in the
business.
For the man who framed the contracts, there was opportunity to consider and to
judge. His fellow members, hearing them for the first time, and trustful of his
loyalty, would have no thought of latent peril.
- There was inequality, therefore, both in knowledge and in the opportunity
for knowledge.
As a fiduciary, a director has a duty to deal fairly with the corporation and
not to permit the corporation to suffer losses at his expense. Abstaining to
vote is NOT enough.
The director has a duty to fully inform the other directors about potential
risks and losses of the transaction. If the director fails to do so, and
unfairness exists, the contract is voidable at the corporations’ election.
The Intersection of the Common Law and Conflicting Interest Statutes
Delaware G.C.L. §144
MBCA §§1.43, 8.60-8.63
State legislatures enacted conflicting-interest-transaction statutes which sought to further
insulate corporations from shareholder litigation aimed at rescinding conflict-tainted
transactions.
Delaware G.C.L. §144 provides that no conflicting interest transaction shall be void or voidable
solely by reason of the conflict if the transaction is:
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(1) authorized by a majority of the disinterested directors, or
(2) approved in good faith by the shareholders, or
(3) fair to the corporation at the time authorized.
Delaware G.C.L. §144
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(a) No contract or transaction between a corporation and 1 or more of its directors or
officers, or between a corporation and any other corporation, partnership, association, or
other organization in which 1 or more of its directors or officers, are directors or officers,
or have a financial interest, shall be void or voidable solely for this reason, or solely
because the director or officer is present at or participates in the meeting of the board or
committee which authorizes the contract or transaction, or solely because any such
director's or officer's votes are counted for such purpose, if:
o (1) The material facts as to the director's or officer's relationship or interest and
as to the contract or transaction are disclosed or are known to the board of
directors or the committee, and the board or committee in good faith authorizes
the contract or transaction by the affirmative votes of a majority of the
disinterested directors, even though the disinterested directors be less than a
quorum; or
o (2) The material facts as to the director's or officer's relationship or interest and
as to the contract or transaction are disclosed or are known to the stockholders
entitled to vote thereon, and the contract or transaction is specifically approved in
good faith by vote of the stockholders; or
o (3) The contract or transaction is fair as to the corporation as of the time it is
authorized, approved or ratified, by the board of directors, a committee or the
stockholders.
The Delaware Statutory approach seems to be much more forgiving and flexible
In addition, §144 codifies the common law requirement of complete candor and fair dealing by
making director or shareholder approval effective only if the interested director has disclosed all
material facts.
Delaware §144 and similar statutes leave significant gaps – e.g., burden of proof, interests that
constitute a conflict, standard of judicial review, and what constitutes disinterestedness – that
must be filled by courts.
Notes:
-
Supreme Court of Delaware: The enactment of §144 limited the stockholders’ power in
two ways:
o 1) Section 144 allows a committee of disinterested directors to approve a
transaction and bring it within the scope of the business judgment rule
o
-
2) Where an independent committee is not available, the stockholders may either
ratify the transaction or challenge its fairness in a judicial forum, but they lack the
power automatically to nullify it.
There is scant case law on the meaning of “good faith” in Delaware G.C.L. §144.
Consider this:
o “The inside transaction is valid where the independent and disinterested (loyal)
directors understood that the transaction would benefit a colleague (factor 1), but
they considered the transaction in light of the material facts (factor 2 – due care)
mindful of their duty to act in the interests of the corporation, unswayed by loyalty
to the interests of their colleagues or cronies (factor 3 – good faith). On the other
hand, where the evidence shows that a majority of the independent directors
were aware of the conflict and all material facts, in satisfaction of factors 1 and 2
(as well as other duties of loyalty and care), but acted to reward a colleague
rather than for the benefit of the shareholders, the Court will find that the
directors failed to act in good faith and, thus, that the transaction is voidable…”
The MBCA provisions take a different approach, emphasizing certainty and predictability
rather than judicial oversight, which comprise the entirety of Subchapter F of Chapter 8
addressing directors and officers.
-
-
First, MBCA §8.60 defines conflicting interest transactions with substantially greater
precision than previous provisions
Second, MBCA §8.61(a) instructs courts that transactions falling outside of the statutory
definition “may not be enjoined, set aside, or give rise to an award of damages or other
sanctions… because a director of the corporation, or any person with whom or which he
has a personal, economic, or other association, has an interest in the transaction.”
o In other words, transactions falling outside of the statutory definition of MBCA
§8.61 do not expose an “interested” director to any special duty of candor or fair
dealing, and therefore courts cannot grant relief based on an alleged violation of
those duties
Finally, MBCA §§8.61(b), 8.62, and 8.63 provide that a conflicting interest transaction
may not be voided as a result of such conflict if the transaction is ratified by “qualified
directors,” or by the vote of “qualified shares,” or is fair to the corporation.
MBCA §§8.60-8.63
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Defines when a director is in a conflict of interest transaction (§8.60)
Prescribes when a court may grant a remedy in response to conflict of interest (§8.61)
Prescribes procedures for action by the board or committees regarding a director’s
conflict of interest transactions (§8.62)
Prescribes corresponding procedures for shareholders (§8.63)
Prescribes which directors and shareholders qualify to participate in ratifying a conflict of
interest transaction (§§8.62; 8.63)
MBCA §8.61. Judicial Action
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(b) A director’s conflict of interest transaction may not be the subject of equitable
relief or give rise to an award of damages or other sanctions against a director…
The Subchapter F conflicting interest provisions, while seeking to provide greater certainty, still
leave substantial room for application of judicial doctrine and, thus, substantial room for
continuing certainty.
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MBCA §8.61(b) describes the circumstances under which a court will not grant relief
solely on the grounds that a conflict of interest taints the transaction.
Official Comment to §8.61 emphasizes, “if the transaction is vulnerable on some other
ground, Subchapter F does not make it less so for having passed through the
procedures of Subchapter F.”
Self-Dealing
The common law viewed all conflicting interest transactions with suspicion, but particularly those
between a corporation and a person in control of the corporation. In circumstances constituting
“self-dealing,” transactions between the corporation and the controlling person were subject to
heightened judicial scrutiny to protect the interests of the corporation and its non-controlling
shareholders.
The term “self-dealing” is not a statutory term or doctrine and is often used colloquially by
judges or advocates to include any transaction in which an officer or director has an interest in
conflict with that of the corporation. Delaware courts have usually been much more precise in
distinguishing between:
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(1) transactions involving merely a conflict of interest and (2) transactions in which a
person (whether officer, director, or shareholder) both has a conflicting interest and
controls the decision for both parties to the transaction. The latter type constituting
classic self-dealing.
In classic self-dealing, the courts forego their normal deference to the judgment of the directors
because the key presumption underlying the business judgment rule – that directors are acting
independently in what they honestly believe to be in the corporation’s best interest – no longer
holds. Once the presumption of the business judgment rule are pierced, the defending directors
or controlling shareholder has the burden of either:
-
Facts
(1) proving the intrinsic or entire fairness of the challenged action, decision, or
transaction; or
(2) taking cleansing steps, such as those anticipated by Del. G.C.L. §144 or Subchapter
F of the MBCA, to change the burden of proof or standard of review.
Sinclair Oil Corp. v. Levien (Delaware)
Defendant, Sinclair Oil Corp was sued in a derivative action requiring Sinclair to
account for damages sustained by its subsidiary, Sinclair Venezuelan Oil
(Sinven), organized by Sinclair for the purpose of operating in Venezuela, as a
result of dividends paid for Sinven, the denial of Sinven of industrial development,
and a breach of contract between Sinclair’s wholly-owned subsidiary, Sinclair
International, and Sinven.
Sinclair, operating primarily as a holding company, is in the business of exploring
for oil and of producing and marketing crude oil and oil products. At all relevant
times, it owned 97% of Sinven’s stock. The plaintiff owns about 3000 of 120,000
publicly held shares of Sinven. Sinven, incorporated in 1922, has been engaged in
petroleum operations primarily in Venezuela and since 1959 has operated
exclusively in Venezuela. Sinclair nominates all members of Sinven’s board of
directors. The trial court found that the directors were not independent of Sinclair.
From 1960 to 1966, Sinclair caused Sinven to pay out $108 million in dividends,
which was $38 million 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 created Sinclair International
Oil Company (International), another Sinclair subsidiary created to coordinate
Sinclair’s foreign business, and Sinclair caused Sinven to contract with
International. 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.
Whether Sinclair, in any of its dealings with Sinven, engaged in self-dealing.
Issue
Holding
Analysis By reason of Sinclair’s domination, it is clear that Sinclair owed Sinven a fiduciary
duty. The trial court held that because of Sinclair’s fiduciary duty and its control
over Sinven, its relationship with Sinven must meet the test of intrinsic fairness.
The standard of intrinsic fairness involves both a high degree of fairness and a
shift in the burden of proof. Under this standard the burden is on Sinclar to prove,
subject to careful judicial scrutiny, that its transactions with Sinven were
objectively fair.
Regarding Sinclair’s argument that the transactions should be tested by the
business judgment rule:
- When the situation involves a parent and a subsidiary, with the
parent controlling the transaction and fixing of the terms, the test of
intrinsic fairness, with its resulting shifting of the burden of proof, is
applied.
- The basic situation for the application of the rule is the one in which the
parent has received a benefit to the exclusion and at the expense of the
subsidiary.
A parent does indeed owe a fiduciary duty to its subsidiary when there are
parent-subsidiary dealings. However, this alone will not evoke the intrinsic
fairness standard. 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.
Regarding whether the dividend payments were self-dealing:
The Court did not accept the argument that the intrinsic fairness test can never be
applied to a dividend declaration by a dominated board, although a dividend
declaration by a dominated board will not inevitably demand the application of the
intrinsic fairness standard.
- If such a dividend is in essence self-dealing by the parent, then the
intrinsic fairness standard is the proper standard.
-
The dividends resulted in great sums of money being transferred from
Sinven to Sinclair. However, a proportionate share of this money was
received by the minority shareholder of Sinven. Sinclair received nothing
from Sinven to the exclusion of its minority stockholders. As such, these
dividends were not self-dealing. Thus, the business judgment standard
should have been applied.
Regarding Sinclair’s expansion policies:
Even though Sinclair was expanding from 1960-1966, took the dividend payments
from Sinven, and had an expansion policy of developing through its subsidiaries
new sources of revenue, the plaintiff could not prove that any opportunities which
came to Sinven. Therefore, Sinclair usurped no business opportunity belonging to
Sinven. Since Sinclair received nothing from Sinven to the exclusion of and
detriment of Sinven’s minority stockholders, there was no self-dealing. Therefore,
business judgment is the proper standard by which to evaluate Sinclair’s
expansion policies.
- Accordingly, Sinclair’s decision, absent fraud or gross-overreaching, to
achieve expansion through the medium of its subsidiaries, other than
Sinven, must be upheld.
Regarding the contract with International:
- Clearly, Sinclair’s act of contracting with its dominated subsidiary was selfdealing. Under the contract Sinclair received the products produced by
Sinven, and of course, the minority shareholders of Sinven were not able
to share in the receipt of these products. If the contract was breached,
then Sinclair received these products to the detriment of Sinven’s minority
shareholders. We agree with the Chancellor’s finding that the contract was
breached by Sinclair, both as to the time of payments and the amounts
purchased.
- Under the intrinsic fairness standard, Sinclair must prove that its causing
Sinven not to enforce the contract was intrinsically fair to the minority
shareholders of Sinven. Sinclair has failed to meet this burden. Late
payments were clearly breaches for which Sinven should have sought and
received adequate damages.
The Court indicates that the actions at issue satisfy the entire fairness test.
When there is an issue of self-dealing, then the “intrinsic fairness” test kicks in. That is, the
directors are no longer entitled to the presumptions of the business judgment rule. The onus
then shifts to the directors to justify their actions.
Notes:
-
-
While the Court placed the burden of proving the “intrinsic fairness” of late invoice
payments and failure to purchase contractually-required minimum quantities on Sinclair,
it first determined that intrinsic fairness rather than the business judgment rule was the
proper standard of review. Modern courts would use the term “entire fairness” in
describing the appropriate standard of review.
o If the appropriate standard of review is “entire fairness”, then the burden of proof
will initially be placed on the defendant
Most jurisdictions follow the Delaware lead for “entire fairness”:
o Directors who stand on both sides of a transaction have “the burden of
establishing its entire fairness, sufficient to pass the test of careful scrutiny
by the courts.”
o
Entire fairness can be proved only where the directors “demonstrate their
utmost good faith and the most scrupulous inherent fairness of the
bargain.” Entire fairness has two components: fair dealing and fair price.
 They are not independent, but rather the fair dealing prong informs the
courts as to the fairness of the price obtained through that process.
 Fair dealing addresses the “questions of when the transaction was
timed, how it was initiated, structured, negotiated, disclosed to the
directors, and how the approvals of the directors and the stockholders
were obtained.”
 Fair price assures the transaction was substantively fair by examining
“the economic and financial considerations.”
Conflicting Interest Transactions
-
Examples from PowerPoint on March 25 class
…
It is important to realize that the label “Self-dealing does not necessarily mean the
transaction…”
Transactions between a parent (or holding corporation) and its subsidiary offer useful
examples of how courts interpret the concept of self-dealing. In Sinclair Oil Corp. v.
Levien…
The Role of the Business Judgment Rule in Circumstances where Director Independence and
Disinterestedness is lacking or in Doubt
Control of Derivative Litigation: The Role of the Special Litigation Committee and the
Demand Requirement
MBCA §§1.43, 7.42-7.44
Fiduciary Duties and the Business Judgment Rule
Three general premises to consider
-
-
First: Director’s fiduciary obligations are similar, but not identical…
o A
Second: Corporate law places centralized managerial authority within the functions of
directors, whose fiduciary obligations extend beyond a duty of loyalty to include the duty
of care
o Because corporate law presumes directors act in accordance with their fiduciary
duties of care, loyalty, and good faith, which means plaintiffs must rebut this
presumption when alleging a directors…
Third: The high evidentiary threshold required to prove breach of a director’s fiduciary
duty:
o Is consistent with the presumption that managerial prerogative rests with a
corporation’s directors and officers
o Is designed to protect the corporation’s management from frivolous litigation
o Saves judges from having to make pronouncements about business judgment
when it is exercised in good faith
What is a derivative action?
-
-
A lawsuit brought by one of the corporation’s shareholders
It is brought against the directors, management and/or other shareholders of the
corporation, for a failure by management
Such litigation is commenced…
…
Both the MBCA and Delaware models contemplate that the shareholders first make a
demand that the directors initiate a lawsuit
Under Delaware law, the common law doctrine of futility excuses shareholders from the
obligation to issue any kind of demand where doing so would be futile on the basis that
directors lack the requisite degree of independence and disinterestedness
By contrast, the MBCA is must more prescriptive, requiring that the demand be in
writing…
Non-conflicted vs Conflicted Litigation Decision
-
Business judgment rule is more likely to be pierced in a conflicted litigation scenario than
in a non-conflicted situation
It may be useful to think of shareholder derivative suits as responding to a particular type of
actual or potential directional self-dealing: if a majority of the board of directors are the target of
a non-frivolous potential lawsuit where (1) they will personally benefit from a decision not to
litigate and (2) they control the decision.
The issue is determining whether a particular litigation decision should be protected by the
business judgment rule and entrusted to the sole discretion of the directors, or instead, is akin to
self-dealing and should be the province of shareholder-controlled action. Delaware and the
MBCA take different approaches to this problem and the nature of the pre-suit demand
requirement.
It had been the rule in Delaware prior to Aronson that officers and directors under an influence
that sterilizes their discretion could not be considered proper persons to prosecute derivative
suits. New in the years immediately before Aronson was the effort to avoid such sterilization by
forming a special litigation committee (“SLC”) composed of board members who were not
named or implicated in the litigation matter to be considered and empowering the SLC to act for
the corporation in deciding how to proceed.
The Delaware Supreme Court took an intermediate approach to SLC involvement (Zapata v.
Maldonado):
-
“After an objective and thorough investigation of a derivative suit, an independent
committee may cause its corporations to file a pretrial motion to dismiss in the Court of
Chancery. The basis of the motion is the best interests of the corporation, as determined
by the committee. The motion should include a thorough written record of the
investigation and its findings and recommendations. Under appropriate Court
supervision, akin to proceedings on summary judgment, each side should have an
opportunity to make a record on the motion… the Court should apply a two step test to
the motion:
o First, the Court should inquire into the independence and good faith of the
committee and the bases supporting its conclusions… The corporation should
have the burden of proving independence, good faith and a reasonable
-
-
investigation, rather than presuming independence, good faith and
reasonableness… (lack of reasonable bases should result in denial)
o Second, the Court should determine, applying its own independent business
judgment, whether the motion should be granted (the essential key in striking the
balance between legitimate corporate claims as expressed in a derivative
stockholder suit and a corporation’s best interests as expressed by an
independent investigating committee)
…If the Court’s independent business judgment is satisfied, the Court may proceed in
granting the motion, subject to any equitable terms or conditions the Court finds
necessary or desirable.”
From Aronson, discussing Zapata: the business judgment rule has no relevance to
corporate decision making until after a decision has been made. A shareholder does not
possess an independent individual right to continue a derivative action. Moreover, where
demand on a board has been made and refused, we apply the business judgment rule in
reviewing the board’s refusal to act pursuant to a stockholder’s demand. Unless the
business judgment rule does not protect the refusal to sue, the shareholder lacks the
legal managerial power to continue the derivative action, since that power is terminated
upon the exercise of applicable standards of business judgment
The following Aronson decision created a new demand futility framework that is substantially
more defendant-friendly, without actually overruling Zapata.
Facts
Aronson v. Lewis (Delaware)
Harry Lewis (Plaintiff) is a stockholder of Meyers Parking System. The defendants
are Meyers and its ten directors, some of whom are also officers.
This suit challenges certain transactions between Meyers and one of its directors,
Leo Fink, who owns 47% of outstanding stock. Plaintiff claims that these
transactions were approved only because Fink personally selected each director
and officer of Meyers.
In 1979, Prudential Building Maintenance spun off its shares of Meyers to
Prudential’s stockholders (Meyers was previously a wholly owned subsidiary).
Prior to 1981, Fink had an employment agreement with Prudential which provided
that upon retirement he was to become a consultant to that company for ten
years, which became operational when Fink retired in 1980. Thereafter, Meyers
agreed with Prudential to share Fink’s consulting services and reimburse
Prudential for 25% of the fees paid Fink. Under this arrangement, Meyers paid
Prudential $48,332 in 1980 and $45,832 in 1981. On January 1, 1981, the
defendants approved an employment agreement between Meyers and Fink for a
five-year term with provision for automatic renewal each year thereafter,
indefinitely. Meyers agreed to pay Fink $150,000 per year, plus a bonus of 5% of
its pre-tax profits. At termination, Fink was to become a consultant for Meyers and
be paid $150,000 for the first three years and $100,000 each year thereafter until
death. Fink agreed to devote his best and substantially his entire business time to
advancing Meyer’s interest. Fink was 75 years old when the agreement was
made. Additionally, the Meyers board approved interest-free loans to Fink totaling
$225,000. At oral arguments, defendant’s counsel represented that these loans
had been repaid.
The complaint alleges that these transactions had “no valid business purpose,”
and were a “waste of corporate assets” because the amounts to be paid are
“grossly excessive,” that Fink performs “no or little services,” and because of his
“advanced age” cannot be “expected to perform any such services.” Also, that the
Prudential consulting agreement prevents Fink from providing his “best efforts” on
Meyers’ behalf. Finally, that the loans represented “additional compensation”
without any “consideration” or “benefit” to Meyers.
The complaint alleged that no demand had been made on the Meyers board
because “such attempt would be futile,” since:
- All the directors are named as defendants and have participated in,
expressly approved and/or acquiesced in, and are personally liable for, the
wrongs complained of
- Defendant Fink, having selected each director, controls and dominates
every member of the Board and every officer of Meyers
- Institution of this action by present directors would require the defendantdirectors to sue themselves, thereby prevent effective prosecution
Relief sought: cancellation of Meyers-Fink employment agreement and accounting
by the directors, including Fink, for all damages sustained.
The trial court held that demand was excused as futile.
Issue
When is a stockholder’s demand upon a board of directors, to redress an alleged
wrong to the corporation, excused as futile prior to the filing of a derivative suit?
Holding Demand can only be excused where facts are alleged with particularity
which create a reasonable doubt that the directors’ action was entitled to
the protections of the business judgment rule. Because the plaintiff failed to
make a demand, and to allege facts with particularity indicating that such demand
would be futile, we reverse the Court of Chancery and remand with instructions
that plaintiff be granted leave to amend the complaint.
- Plaintiff failed to allege facts with particularity indicating that the Meyers
directors were tainted by interest, lacked independence, or took action
contrary to Meyers’ best interests in order to create a reasonable doubt as
to the applicability of the business judgment rule.
Analysis IV (A) – Legal Framework
- A cardinal precept of the Delaware GCL is that directors, rather than
shareholders, manage the business and affairs of the corporation (Section
141(a))
- However, a stockholder is not powerless to challenge director action which
results in harm to the corporation
- By its very nature the derivative action impinges on the managerial
freedom of directors. Hence, the demand requirement of Chancery Rule
23.1 exists at the threshold, first to insure that a stockholder exhausts his
intracorporate remedies, and then to provide a safeguard against strike
suits – thus this is a recognition of the fundamental precept that directors
manage the business and affairs of corporations.
- The entire question of demand futility is inextricably bound to issues of
business judgment and the standards of that doctrine’s applicability.
- The function of the business judgment rule is of paramount significance in
the context of a derivative action… there are certain common principles
governing the application and operation of the rule:
- First, its protections can only be claimed by disinterested directors whose
conduct otherwise meets the tests of business judgment… if such director
interest is present, and the transaction is not approved by a majority
consisting of the disinterested directors, then the business judgment rule
has no application whatever in determining demand futility
Second, to invoke the rule’s protection directors have a duty to inform
themselves, prior to making a business decision, of all material information
reasonably available to them. Having become so informed, they must then
act with requisite care in the discharge of their duties (this is predicated on
a standard of gross negligence)
- In determining demand futility, the Court of Chancery in the proper
exercise of its discretion must decide whether, under the
particularized facts alleged, a reasonable doubt is created that: (1)
the directors are disinterested and independent, and (2) the
challenged transaction was otherwise the product of a valid exercise
of business judgment.
- If this is an “interested” director transaction, such that the business
judgment rule is inapplicable to the board majority approving the
transaction, then the inquiry ceases. In that event, futility of demand has
been established by any objective or subjective standard.
- The mere threat of personal liability for approving a questioned
transaction, standing alone, is insufficient to challenge either the
independence or disinterestedness of directors, although in rare cases a
transaction may be so egregious on its face that board approval cannot
meet the test of business judgment, and a substantial likelihood of director
liability therefore exists.
- The entire review is factual in nature.
IV (B) – Plaintiff’s claim of futility
- The plaintiff’s contention that Fink dominated the board do not support any
claim under Delaware law that the directors lack independence – “stock
ownership alone, at least when it amounts to less than a majority, is not
sufficient proof of domination or control.” Even proof of majority ownership
does not strip the directors of the presumptions of independence, and that
their acts have been taken in good faith and in the best interests of the
corporation.
- Independence means that a director’s decision is based on the corporate
merits of the subject before the board rather than extraneous
considerations or influences.
- It is not enough to charge that a director was nominated by or elected at
the behest of those controlling the outcome of a corporate election.
- We conclude that in the demand-futile context, a plaintiff charging
domination and control of one or more directors must allege
particularized facts manifesting “a direction of corporate conduct in
such a way as to comport with the wishes or interest of the
corporation (or persons) doing the controlling.” – the plaintiff need
only allege specific facts; he need not plead evidence.
- Here, plaintiff has not alleged any facts sufficient to support a claim of
control. Cannot conclude that the complaint factually particularizes any
circumstances of control and domination to overcome the presumption of
board independence, and thus render the demand futile.
IV (C) – The board’s approval of the Meyers-Fink employment agreement
- In Delaware, mere directorial approval of a transaction, absent
particularized facts supporting a breach of fiduciary duty claim, or
otherwise establishing the lack of independence or disinterestedness of a
majority of the directors, is insufficient to excuse demand.
-
Plaintiff’s argument is premised on the notion that the Meyers-Fink
agreement was a waste of corporate assets and so, by approving such
waste the directors now face potential personal liability, thereby rendering
futile any demand on them to bring suit.
- The complaint does not allege particularized facts indicating that the
agreement is a waste of corporate assets. Indeed, the complaint as now
drafted may not even state a cause of action, given the directors’ broad
corporate power to fix the compensation of officers.
IV (D) – Plaintiff’s argument that demand is excused because directors
would otherwise have to sue themselves.
- Acceptance of this argument would abrogate Rule 23.1 and weaken the
managerial power of directors. Unless facts are alleged with particularity to
overcome the presumptions of independence and a proper exercise of
business judgment, in which case the directors could not be expected to
sue themselves, a bare claim of this sort raises no legally cognizable
issue.
The proper test for demand futility is whether, under the facts alleged, there
is reasonable doubt as to whether:
(1) The directors making the decision were disinterested and
independent, or
(2) The transaction at issue was otherwise the product of valid business
judgment.
- If there is a reasonable doubt as to either, the demand requirement is
excused
- To show a demand is futile, a plaintiff alleging domination and control over
the directors must allege facts demonstrating the directors are beholden to
the controlling person, either through personal or other relationships
-
Ratio
Notes:
-
-
The independence inquiry under the Zapata standard
o Unlike a board in the pre-suit demand context, SLC members are not given the
benefit of the doubt as to their impartiality and objectivity. They, rather than
plaintiffs, bear the burden of proving that there is no material question of fact
about their independence. The composition of an SLC must be such that it fully
convinces the Court that the SLC can act with integrity and objectivity, because
the situation is typically one in which the board as a whole is incapable of
impartially considering the merits of the suit.
o Thus, it is conceivable that a curt might find a director to be independent in the
pre-suit demand context not independent in the Zapata context based on the
same set of factual allegations made by the two parties.
The MBCA was amended in 1990 to require that a shareholder make a pre-suit demand
on the board of directors in virtually every circumstance – so-called “universal demand” –
and to give the corporation up to 90 days to respond before a derivative suit can be filed.
The demand, which must be in writing (and is commonly called a “demand letter”),
usually sets forth the claims that the shareholder wishes investigated and remedied
(MBCA §7.42).
o
-
-
In cases where some or all of the board members appear conflicted, it has
become standard operating practice for the board to appoint an SLC composed
of directors who will not appear conflicted.
o MBCA §7.44(a) provides that “a derivative proceeding shall be dismissed… if [a
SLC composed of two or more independent and disinterested directors (“qualified
directors”) or alternatively a majority vote of the qualified directors on the board
itself in certain circumstances] has determined in good faith, after conducting a
reasonable inquiry upon which its conclusion are based, that the maintenance of
the derivative proceeding is not in the best interests of the corporation.”
o There will be judicial review of director action as opposed to Delaware’s focus as
to whether demand would be futile.
o The judicial review process in this procedural setting different from the Delaware
context in the requirements of §7.44(d).
o MBCA Subchapter D
 Requirements…
The Aronson test does not apply to every demand futility motion. Instead, the following
Rales test comes into play in certain circumstances:
o A court should not apply the Aronson test for demand futility where the board that
would be considering the demand did not make a business decision which is
being challenged in the derivative suit. The situation would arise in three principle
scenarios:
 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, as here, the decision being challenged was made by the board
of a different corporation.
o The Rales test essentially drops the second component of the initial Aronson test
o It is appropriate in these circumstances to examine whether the board would be
addressing the demand can impartially consider its merits without being
influenced by improper considerations. Thus, a court must consider whether
or not the particularized factual allegations create a reasonable doubt that,
as of the time the complaint is filed, the board of directors could have
properly exercised its independent and disinterested business judgment in
responding to a demand (The Rales test).
In Delaware, if a shareholder makes pre-suit demand, there is a judicially created
expectation that the board will respond (Kaplan v. Peat, Marwick, Mitchell & Co.)
In Delaware, if demand is made, the shareholder-plaintiff is admitting that it is unable to
prove demand futility. However, the plaintiff has not waived the right to raise a challenge
to the manner in which the board responds to the demand, which is successful will
empower the shareholder to commence a derivative action.
Aronson in Action
Facts
In re The Limited, Inc. (Delaware)
Common stockholder plaintiffs Rochelle Phillips, Miriam Shapiro and Peter
Sullivan brought a derivative action on behalf of The Limited, against the
Company and each of its directors.
The Limited is a specialty retailer. Mr. Wexner was one of the individual
defendant-directors and the company’s largest shareholder, owning or controlling
approx. 25% of outstanding stock at the time of the challenged transaction.
On May 3, 1999, The Limited announced that the Board authorized a self-tender
of 15 million shares. Under the terms of the tender offer, the Company agreed to
repurchase those shares at a premium over their pre-announcement closing price.
Mr. Wexner agreed that neither he nor any of his affiliates would participate in the
tender. This decision, according to the Company, was based in large part the
Company’s large amount of excess cash ($660 million) and that it would
demonstrate to stockholders how much confidence it had in The Limited’s
business. After completing the self-tender, the Company announced that it had
acquired the 15 million shares for $750 million (which was $90 million more than
the excess cash). At the same time of the self-tender, the Company announced
that it had agreed to rescind the Redemption Agreement, which was an
agreement between The Limited and Mr. Wexner (in both his individual capacity
and trustee of The Wexner Children’s Trust). Under the Redemption Agreement,
the Children’s Trust acquired the right to redeem all or a portion of the 18.75
million shares it held at $18.75 per share (a put option) as well as providing the
Company a six-month window commencing July 2006 to redeem all or part of the
remaining shares still held by the Children’s Trust at $25.07 per share (a call
option). The Redemption Agreement also obliged The Limited to retain $350
million in a restricted cash account. The complaint alleges that the Company’s
directors committed corporate waste and breached their fiduciary duties of loyalty
and due care by rescinding the Redemption Agreement and funding in part with
monies made available as a result of the rescission, a self-tender offer that also
resulted in no consideration to the Company. Plaintiffs allege that the only reason
for structuring the transaction in this manner was to enable Mr. Wexner to avoid
the terms of the Redemption Agreement, which, they assert, had become
particularly unfavorable to him. Further, they allege that at least half of the board
had a disqualifying self-interest or lack of independence in approving the
transaction due to their personal or professional relationships with Mr. Wexner.
Issue
Holding
The plaintiffs have alleged sufficient particularized facts to raise a reasonable
doubt as to the disinterestedness or independence of at least six of The Limited’s
twelve directors.
The Complaint states a claim for breach of the duty of loyalty. The challenged
transactions were approved by a unanimous board of twelve; six of those directors
were either interested or subject to disqualifying doubts about their independence.
The challenged transaction, while perhaps not constituting corporate waste,
appear unfair to the stockholders.
Even after accepting of the plaintiffs well-pled factual allegations and according
them the benefit of all reasonable inferences, the Complaint does not state a claim
for corporate waste
Analysis Demand Futility
- “Directorial interest exists whenever divided loyalties are present, or a
director either has received, or is entitled to receive, a personal financial
benefit from the challenged transaction which is not equally shared by the
stockholders.”
- Because Mr. Wexner, in his individual capacity as trustee for the Trust,
negotiated the Redemption Agreement at its creation, the Complaint has
alleged sufficiently particularized facts creating a reasonable doubt as to
his disinterestedness in connection with the Company’s rescission of that
agreement. Mrs. Wexner (wife and another director) similarly stood to
benefit from the rescission, thereby creating a reasonable doubt as to her
disinterestedness as a director in the approval of the rescission.
Director Independence
- To establish lack of independence, a plaintiff meets his burden by showing
that the directors are either beholden to the controlling shareholder or so
under its influence that their discretion is sterilized.
- The Court must apply a “subjective ‘actual person’ test to determine
whether a particular director… lacks independence because he is
controlled by another.” (i.e., need to evaluate each director independently)
- The plaintiffs have not met their burden of raising, through allegations of
particularized facts, a reasonably doubt as to the independence of
Zimmerman, Tessler, Malone, or Freedman – Shackleford and Kollat.
- Gilman has served as a director since 1990. Since 1997, his principal
employment has been as vice chairman and chief administrative officer of
The Limited for which, during the years 1996-1998, he averaged $1.8
million in salary and bonuses. It is reasonable to infer that compensation of
this magnitude is material to him… Because of Mr. Wexner’s holdings of
The Limited and his positions as chairman, CEO, and director, these
allegations of particularized facts raise a reasonable doubt as to Gilman’s
independence from Mr. Wexner’s will.
- The same can be said of Trust, as Gilman, as Trust’s principal
employment was president and CEO of a wholly-owned subsidiary of The
Limited (with similar salary)
- Schlesinger provided consulting services to The Limited from 1996-1998
with an annual compensation of $150,000. It is reasonable to infer that
continued annual compensation in excess of $150,000 would be material
to Schlesinger. Thus, plaintiff’s have met their burden for raising a
reasonable doubt as to Schlesinger’s independence, as well.
- Gee was former president of Ohio State and successfully solicited $25
million from Wexner. Further, Gee as later president of Brown University,
is alleged to have continued to solicit Mr. Wexner for donations. Gee and
Wexner are not alleged to have had lengthy political and financial dealings
and they do not serve together on multiple boards (as in previous case
law). However, it may reasonably be inferred that Mr. Wexner’s gift of $25
million to Ohio State was a significant gift, even if not to Gee personally – it
was still a positive reflection on Gee and his fundraising efforts. One may
feel beholden to someone even for past acts. Thus, there is reasonable
doubt as to Gee’s independence from Wexner.
- Thus, six of the twelve directors of The Limited are either interested
(Mr. & Mrs. Wexner) in the challenged transactions or subject to a
reasonable doubt about their independence (Gilman, Trust,
Schlesinger, and Gee) from Wexner’s domination.
- Where the challenged actions are those of a board consisting of an
even number of directors, plaintiffs meet their burden of
demonstrating the futility of making demand on the board by
showing that half of the board was either interested or not
independent.
Duty of Loyalty
-
The complaint states a claim for breach of the duty of loyalty. The
challenged transactions were approved by a unanimous board of twelve;
six of those directors were either interested or subject to disqualifying
doubts about their independence. The challenged transactions, while
perhaps not constituting corporate waste, appear unfair to the
stockholders. Thus, because the challenged transactions were not
approved by a majority of independent and disinterested directors, the
complaint states a loyalty claim that survives a challenge under Court of
Chancery Rule 12(b)(6).
Corporate Waste
For plaintiff’s waste claim to survive, the complaint must show that the
transactions were “effected on terms ‘that no person of ordinary, sound business
judgment could conclude represent a fair exchange.’” Plaintiff’s burden has also
been described as requiring a showing that “the [transactions] in question either
served not corporate purpose or [were] so completely bereft of consideration that
[they] effectively consisted a gift.”
- Rescission of the Redemption Agreement – the Company was not able
to exercise the call option in the agreement until 2006, at which point the
stock price could have been any price. The Company also alleged that
rescinding the agreement freed up the $350 million it was required to set
aside. It is well settled that courts are ill equipped to attempt to weight the
adequacy of consideration under the waste standard or to judge
appropriate degrees of risk. Accordingly, the plaintiffs have failed to allege
facts supporting a claim that rescission served no corporate purpose or
was so completely bereft of consideration that it effectively constituted a
gift.
- The Self-Tender Offer – plaintiff alleges that the company could have
used its excess cash in other ways to benefit the company (e.g., payment
of dividends) and that rescinding the contract resulted in a buyback of
shares at a premium that corresponded to $90 million… “Directors are
guilty of corporate waste, only when they authorize an exchange that is so
one sided that no business person or ordinary, sound judgment could
conclude that the corporation has received adequate consideration.” That
the Complaint identifies viable alternatives to the Board’s decision is not
enough – it is precisely this kind of judicial after-the-fact evaluation that the
business judgment rule seeks to prevent. Accordingly, there is no viable
corporate waste claim.
- Rescission and Self-Tender Offer Together – The plaintiffs have failed
to demonstrate that the Company received no benefit in exchange from
these two transactions or that these transactions, taken together, served
no corporate purpose. For one, Mr. Wexner promised not to participate in
the self-tender (thereby forfeiting a 15% premium offered for his shares).
Moreover, rescinding the Redemption Agreement allowed the Company to
manage the otherwise untouchable $350 million that would have been
locked up by the terms of that agreement for another 6 to 7 years. Also
rescinding the agreement protected the Company from a potentially costly
liability if the shares had declined in value in the future.
The Fiduciary Duty of Care
The Interaction of Statutory and Common Law
MBCA §8.30(b); 8.31
In some states, including Delaware, the fiduciary duty of care is defined solely by judicial
doctrine. In many other states, however, the common law definition is supplemented or replaced
by statutory formulations.
The most widely adopted definition is modeled after the pre-1998 version of MBCA §8.30(a)(2),
and requires a director to carry out her duties “with the care an ordinarily prudent person in a
like position would exercise under similar circumstances.”
The use of tort-like phraseology by courts and corporation codes to described directors’ duty of
care was misleading. In reality, liability for breach of duty of care has always been rare, and has
occurred in circumstances where the director’s conduct was egregious. Courts universally
recognize that directors are presumptively not liable for breach of duty of care by applying the
business judgment rule.
In 1998, MBCA §8.30(b) was amended to provide that “when becoming informed in connection
with their decision-making function or devoting attention to their oversight function, [directors]
shall discharge their duties with the care that a person in a like position would reasonably
believe appropriate under the circumstances.”
-
Official Comment to §8.30 makes clear that one important purpose of the 1998
amendments was to signal to courts in states following the MBCA that directors’ duty of
care should not be conceptualized or enforced under tort principles, but rather under
principles developed specifically for corporations and their directors.
Background for Van Gorkom;
-
Facts
Most tax credits are nonrefundable, which means that any unused credit excess amount
expires the year in which it is used and is not refunded to you. For example, if you have
$5,000 tax credit and only have a $3,000 tax bill, the remaining $2,000 worth of unused
tax credit is considered non-refundable.
However, some tax credits are refundable and can actually increase your tax refund. For
example, if the amount of a refundable tax credit is $2,000 and you have a $1,000 tax
bill, the difference will be given back to you as a tax refund.
Smith v Van Gorkom (Delaware)
Appeal consisting of a class action brought by shareholders of the defendant
Trans Union Corporation seeking rescission of a cash-out merger of Trans Union
into the defendant New T Company, a wholly-owned subsidiary of the defendant,
Marmon Group, Inc.
Trans Union was a publicly traded holding company, with its principal earnings
generated by its railcar leasing business. It had hundreds of millions of dollars in
cash flow annually, but had difficulty generating sufficient taxable income to offset
increasingly large investment tax credits. In the 1970/80s, Trans Union, including
the CEO Jerome Van Gorkom, lobbied in Congress for the ITCs to be refundable
in cash to companies that couldn’t use them all, but eventually believed that their
efforts would be unsuccessful. The company had been acquiring smaller
companies since the 1960s to increase available taxable income. Eventually the
Chief Financial Officer, Donald Romans, suggested that Trans Union should
Issue
Holding
undergo a leveraged buyout to an entity that could offset the ITCs. At a
subsequent meeting on September 5, Romans against brought up the idea of a
leveraged buyout. The suggestion came without any substantial research, but
Romans thought that a $50-60 share price (on stock currently valued at a high of
$39½) would be acceptable. These computations were not considered extensive
and no conclusion was reached. Van Gorkom did not demonstrate any interest in
the suggestion, but shortly thereafter pursued the idea with a takeover specialist,
Jay Pritzker. Van Gorkom had Carl Peterson, Trans Union’s Controller calculate
the feasibility of a buyout at $55 per share, but told him not to tell anyone else. On
September 13, using this valuation, Van Gorkom discussed with Pritzker the
opportunity to sell Trans Union shares at $55 per share to Pritzker. Van Gorkom
also agreed to sell Pritzker one million shares of Trans Union at $39 per share if
Pritzker was outbid. Van Gorkom also agreed not to solicit other bids and agreed
not to provide proprietary information to other bidders. Van Gorkom, Chelberg,
and Prtizker consulted with Trans Union’s lead bank regarding the financing of
Pritzker’s purchase of Trans Union, where it indicated that it could finance the
transaction.
Van Gorkom called a special meeting of the Trans Union Board for September 20,
with the knowledge that Prtizker had indicated that they would need to accept by
September 21. He also called a meeting of the Company’s Senior Management
for an hour before the meeting. Only Peterson and Chelberg (members of the
Senior Management) were aware of the negotiations with Pritzker and the
purpose of the meeting. The rest of the senior management and the Board of
Directors found out about the deal on the day they had to vote to approve the
deal. Van Gorkom did not provide any copies of the proposed Merger Agreement.
The Senior Management’s reaction to the proposal was completely negative.
Nevertheless, Van Gorkom proceeded with the Board meeting as scheduled. Of
the ten directors of the Trans Union Board, all were present except one. All
members of the Board were well informed about the Company and its operations
as a going concern. They were familiar with its current financial condition. Van
Gorkom gave a 20 minute oral presentation outlining the terms of the Prtizker
offer, but copies of the Merger Agreement were delivered too late for study before
or during the meeting, so the Board had only the word of Van Gorkom, the word of
the President of Trans Union (who was privy to the earlier discussions with
Pritzker), advice from an attorney who suggested that the Board might be sued if
they voted against the merger, and vague advice from Romans who told them that
the $55 was in the beginning end of the range he calculated. Van Gorkom did not
disclose how he came to the $55 amount. On the terms of the offer, he informed
the board that Trans Union could not actively solicit other bids but could consider
other offers for a period of 90 days; it could furnish published information, but not
proprietary information to those bidders. The meeting lasted only two hours. On
Van Gorkom’s advice, the Board approved the merger. Van Gorkom signed the
Merger Agreement at a social event without reading the agreement (none of the
Board members had read the agreement prior to signing it, either). On February
10, it was approved by the shareholders with 69.9% voting in favor, 7.25%
against, and 22.85% of shares not voted.
Whether the manner in which the Board analyzed the agreement was reckless.
The Directors of Trans Union breached their fiduciary duty to their
stockholders: (1) by their failure to inform themselves of all information
reasonably available to them and relevant to their decision to recommend
the Pritzker merger; and (2) by their failure to disclose all material
information such as a reasonable stockholder would consider important in
deciding whether to approve the Pritzker offer.
- The Court concluded that Trans Union’s Board was grossly negligent in
that it failed to act with informed deliberation in agreeing to the Pritzker
merger proposal on September 20, and further concluded that the Trial
Court erred as a matter of law in failing t address that question before
determining whether the directors’ later conduct was sufficient to cure its
initial error.
Analysis Board Meeting and the Business Judgment Rule
- In carrying out their managerial roles, directors are charged with an
unyielding fiduciary duty to the corporation and its shareholders. The
business judgment rule exists to protect and promote the full and free
exercise of the managerial power granted to Delaware directors.
- 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.”
- A director’s duty to inform himself in preparation for a decision derives
from the fiduciary capacity in which he serves the corporation and its
stockholders.
- Fulfillment of the fiduciary function requires more than the mere absence
of bad faith or fraud. Representation of the financial interests of others
imposes on a director an affirmative duty to protect those interests and to
proceed with a critical eye in assessing information of the type and under
the circumstances present here.
- In the specific context of a proposed merger of domestic
corporations, a director has a duty under DGCL s.251(b), along with
his fellow directors, to act in an informed and deliberate manner in
determining whether to approve an agreement of merger before
submitting the proposal to the stockholders. In the merger context, a
director may not abdicate that duty by leaving to the shareholders
alone the decision to approve or disapprove the agreement.
Whether the directors reached an informed decision to “sell”
- This issue must be determined only upon the basis of the information then
reasonably available to the directors and relevant to their decision to
accept the Pritzker merger proposal.
- The question of whether the directors reached an informed business
judgment in agreeing to sell the Company, pursuant to the terms the
September 20 Agreement presents two questions: (A) whether the
directors reached an informed business judgment on September 20, and
(B) if they did not, whether the directors’ actions taken subsequent to
September 20 were adequate to cure any infirmity in their action taken.
(A)
- The Board of Directors did not reach an informed business judgment
on September 20, in voting to “sell” the Company for $55 per share
pursuant to the Prtizker Merger Agreement.
- The Directors (1) did not adequately inform themselves as to Van
Gorkom’s role in forcing the “sale” of the Company and in
establishing the per share purchase price; (2) were uninformed as to
the intrinsic value of the Company; and (3) given these
circumstances, at a minimum, were grossly negligent in approving
the “sale” of the Company upon two hours’ consideration, without
prior notice, and without the exigency of a crisis or emergency.
- The Board based its September 20 decision on Van Gorkom’s
representations, since there were no reports or summaries available to
qualify any of what Van Gorkom was proposing – instead, they only had
Van Gorkom’s oral presentation and assertions of his understanding of the
agreement (which he had not even seen). Nothing provided at the meeting
amounted to what would qualify as a “report”, which directors are entitled
to rely upon in good faith under §141(e).
- Considering all the circumstances – hastily calling the meeting without
prior notice of its subject matter, the proposed sale of the Company
without any prior consideration of the issue or necessity therefor, the
urgent time constraints imposed by Pritzker, and the total absence of any
documentation whatsoever – the directors were duty bound to make
reasonably inquiry of Van Gorkom and Romans, and if they had done so,
the inadequacy of that upon which they now claim to have relied would
have been apparent.
The defendants rely on the following factors: (1) the magnitude of the premium or
spread between the $55 Pritzker offering price and Trans Union’s current market
price of $38 per share; (2) the amendment of the Agreement as submitted on
September 20 to permit the Board to accept any better offer during the “market
test” period; (3) the collective experience and expertise of the Board’s “inside” and
“outside” directors; and (4) their reliance on Brennan’s legal advice that the
directors might be sued if they rejected the Pritzker proposal.
- (1) A substantial premium may provide one reason to recommend a
merger, but in the absence of other sound valuation information, the fact of
a premium alone does not provide an adequate basis upon which to
assess the fairness of an offering price. Additionally, the record is clear
that before September 20, Van Gorkom and others knew that the market
had consistently undervalued the worth of Trans Union’s stock. At no time
did the Board call for a valuation study of Trans Union’s major asset: its
cash flow. Further, no Board member probed Romans, the CFO, regarding
his response that the $55 figure was at the bottom of a “fair price range”,
or anything about the details of how he arrived at that figure. Had they
done so, Romans would presumable have responded that this was based
on rough figures and was preliminary. By neglecting to probe further, the
Board also failed to discover that Van Gorkom had suggested the $55
figure and arrived at the figure based on calculations designed solely to
determine the feasibility of a leveraged buy-out. Thus, the record
compels the conclusion that on September 20, the Board lacked
valuation information adequate to reach an informed business
judgment as to the fairness of $55 per share for sale of the Company.
- (2) There is no evidence: (a) that the Merger Agreement was effectively
amended to give the Board freedom to put Trans Union up for auction sale
to the highest bidder; or (b) that a public auction was in fact permitted to
occur.
- (3) The directors’ unfounded reliance on both the premium and the market
test as the basis for accepting the Pritzker proposal undermines the
defendants’ remaining contention that the Board’s collective experience
and sophistication was a sufficient basis for finding that it reached its
September 20 decision with informed, reasonable deliberation.
-
(4) Unless the directors had before them adequate information regarding
the intrinsic value of the Company, upon which a proper exercise of
business judgment could be made, mere advice of this type is
meaningless; and given this record of the defendant’s failures, it
constitutes no defense here.
Whether the directors should be treated as one or individual in terms of invoking
the business judgment rule:
- (1) since all of the defendant directors, outside as well as inside, take a
unified position, we are required to treat all of the directors as one as to
whether they are entitled to the protection of the business judgment rule;
and (2) that considerations of good faith, including the presumption that
directors acted in good faith, are irrelevant in determining the threshold
issue of whether the directors as a Board exercised an informed business
judgment.
The Stockholder Vote of February 10:
- Defendants rely on this for exoneration, given the “overwhelming” vote
approving the merger agreement. The parties tacitly agree that a
discovered failure of the Board to reach an informed business judgment in
approving the merger constitutes a voidable, rather than a void, act.
- The settled rule in Delaware is that “where a majority of fully informed
stockholders ratify action of even interested directors, an attack on the
ratification transaction normally must fail.”
- However, Trans Union’s stockholders were not fully informed, due to
deficiencies in the proxy materials:
- (1) The Board had no reasonably adequate information indicative of the
intrinsic valuation of the Company, other than a concededly depressed
market price, and this lack of valuation information should have been
disclosed.
- (2) the Board’s characterization of the Romans report in the Supplemental
Proxy statement was false and misleading, because it failed to disclose the
basis for his calculations
- (3) The Board’s references to the “substantial” premium were misleading,
since it did not disclose its failure to assess the premium offered in terms
of other relevant valuation techniques
Dissent:
- The Majority failed to take into account the experience and expertise of the
directors. The five “inside” directors had extensive experience with Trans
Union and even the five “outside” directors were highly experienced in or
qualified to take on business transactions of this sort. Thus, this caliber of
directors are not ordinarily taken in by a “fast shuffle” (as the Majority
suggests the Merger Agreement was). The directors knew the inner
workings of Trans Union like the “back of their hands”.
Notes:
-
Delaware G.C.L. §141(e) was amended in the wake of Smith v. Van Gorkom, to provide
that directors could rely on opinions by a corporation’s officers, even if not expressed in
the form of a “report.”
-
The part of the opinion indicating that an informed shareholder vote to approve the
merger would have ratified and cured any breach of duty by the directors in failing to
make an informed business judgment is no longer good law. Now (Gantler v. Stephens):
o The scope of the shareholder ratification doctrine must be limited to its so-called
“classic” form: that is, to circumstances where a fully informed shareholder vote
approves director action that does not legally require shareholder approval in
order to become legally effective. The only director action or conduct that can be
ratified is that which the shareholders are specifically asked to approve. With one
exception, the “cleansing” effect of such a ratifying shareholder vote is to subject
the challenged director action to business judgment review, as opposed to
“extinguishing” the claim altogether (i.e., obviating all judicial review of the
challenged action).
Statutorily Authorized Exculpation Provisions – Contracting to Eliminate Shareholder Litigation
as a Mechanism to Enforce the Duty of Care
MBCA §2.02(b)(4)
Delaware G.C.L. §102(b)(7)
The business judgment rule lessens the risk of unnecessary judicial interference with, or
second-guessing of, directors’ judgments. However, the decision in Smith v. Van Gorkom made
it clear that directors could incur substantial liability even when acting loyally. Directors lacking
protection against such risks could be expected to respond in either of two ways: (1) become
overly cautious in carrying out their duties or (2) refuse to serve at all. Neither response would
be in the shareholders’ best interest, particularly if as a result, corporations were unable to
attract qualified “outside” directors.
Beginning in Delaware in 1986, approximately 40 states have now enacted legislation allowing
corporations to limit or eliminate directors’ liability for breach of fiduciary duty.
Exculpation clauses limit directors’ liability specifically for breaches of the duty of care.
Both the MBCA and Delaware system permit contracting to limit liability, so long as the
language does not attempt to insulate the directors from knowing violations of the law, selfdealing, etc.
Facts
MBCA §8.32 – can’t contract out for unlawful distributions
Malpiede v. Townson (Delaware)
Frederick’s of Hollywood is a retailer of women’s lingerie and apparel in LA,
California. On June 14, 1996, the Frederick’s board announced its decision to
retain an investment bank, JMS, to advise the board in its search for a suitable
buyer for the company. In January 1997, JMS initiated talks with Knightsbridge. In
June 1997, the Frederick’s board approved an offer from Knightsbridge to
purchase all of Frederick’s outstanding Class A and Class B shares for
$6.14/share. The terms of the merger agreement signed by the board prohibited
the board from soliciting additional bids from third parties, but permitted the board
to negotiate with third party bidders when the board’s fiduciary duty required it. On
August 21, Frederick’s received a fully financed, unsolicited cash offer of
$7.00/share from Milton Partners. On August 27, they received another unsolicited
offer of $7.75/share from Veritas Capital Fund. The Board postponed the merger
with Knightsbridge in light of these new offers. Milton eventually pulled out, but
Veritas did not. On September 3, the board met with representatives from Veritas
to discuss its offer. On September 4, Knightsbridge informed the board that it now
owned 41% of Frederick’s common stock and intended to vote the shares against
any competing third-party bids. On September 6, Knightsbridge increased its bid
to $7.75/share to match Veritas’ offer, but on the condition that the board accept
additional terms, including a “no-talk” provision which prohibited any Frederick’s
representative from speaking to third party bidders concerning the acquisition of
the company. The Frederick’s board approved this agreement on the same day.
Two days later, Knightsbridge purchased additional Class A shares on the open
market at an average of $8.21/share, thereby acquiring a majority of both classes
of Fredrick’s shares. On September 11, Veritas increased its cash offer to
$9.00/share – however, relying on the “no talk” provision, Knightsbridge’s intention
to vote against the bid, and Veritas’ request for an option to dilute Knightsbridge’s
interest, the board rejected the revised bid.
Before the close of the merger, the plaintiff filed this complaint, which the Court of
Chancery dismissed due to the exculpatory provision in the Frederick’s charter
regarding any breaches of the board’s duty of care.
Issue
Whether the complaint may be dismissed by reason of the existence and the legal
effect of the exculpatory provision of Article TWELFTH of Frederick’s certificate of
incorporation.
Holding Affirm Court of Chancery’s grant of motion to dismiss the plaintiff’s due care claim
on the ground that the exculpatory provision in the charter of the target
corporation authorized by Delaware G.C.L. §102(b)(7), bars any claim for money
damages against the director defendants based solely on the board’s alleged
breach of its duty of care.
Analysis Article TWELFTH of Frederick’s certificate of incorporation, adopted pursuant to
D.G.C.L. §102(b)(7), read:
- “A director of this Corporation shall not be personally liable to the
Corporation or its shareholders for monetary damages for breach of
fiduciary duty as a director, except for liability [for (i) breach of duty of
loyalty, (ii) acts or omissions not in good faith or which involve intentional
misconduct or knowing violation of law, (iii) under section 174 of Delaware
GCL, or (iv) for any transaction for which the director derived an improper
personal benefit.]”
Plaintiffs allege:
- Had the directors implemented a routine poison pill strategy to ward of
Knightsbridge’s advances, it would have preserved the appropriate options
for an auction process
- The Board was grossly negligent in immediately accepting the
Knightsbridge offer and agreeing to various restrictions on further
negotiations without first determining whether Veritas would issue a
counteroffer to achieve a higher share value, which was also impacted by
its acceptance of the extreme contractual restrictions
The Court of Chancery Properly Dismissed Claims based solely on Duty of Care
- If a complaint unambiguously and solely asserts only a due care claim, the
complaint is dismissible once the corporation’s Section 102(b)(7) provision
is invoked. This is in line with this Court’s previous decision in Emerald
Partners, which said that:
“The shield from liability provided by a certificate of incorporation
provision adopted pursuant to [§102(b)(7)] is in the nature of an
affirmative defense.”, and
o “Where the factual basis for a claim solely implicates a violation of
the duty of care… the protections of such a charter provision may
properly be invoked and applied.”
- The plaintiffs allege that their claim is so intertwined with loyalty and bad
faith claims that Section 102(b)(7) is not a bar to recovery. However, the
court determined that the complaint failed properly to invoke loyalty and
bad faith claims, and the court only determined, without deciding, that the
complaint alleged a claim for due care that shouldn’t be dismissed under
12(b)(6), leaving that as the only remaining basis for the claim.
- Defendants had the obligation to raise the bar of Section 102(b)(7) as a
defense and they did. Accordingly, the lower court did not err in dismissing
the plaintiff’s due care claim.
The Court of Chancery Correctly Applied the Parties’ Respective Burdens of Proof
- Plaintiffs asserted that the trial court incorrectly placed on plaintiffs the
pleadings burden to negate the elements of the §102(b)(7) charter
provision.
- Because the court assumed that the amended complaint did state a due
care claim, the exculpation afforded by the statute must affirmatively be
raised by the defendant directors. The directors have done so in this case,
and the trial court properly applied the Frederick’s charter provision to
dismiss the plaintiff’s due care claim.
Important distinction between this case and Van Gorkom – there is an outside firm
informing the decision of the board regarding the sale/merger
o
-
Directors’ Oversight Responsibilities: The Duty of Good Faith and the Caremark Cause of
Action
It has long been “black letter” law that “the business and affairs of the corporation shall be
managed by or under the direction of, and subject to the oversight of, its board of directors.”
MBCA §8.01(b).
Caremark claim: “Generally where a claim of directorial liability for corporate loss is predicated
upon ignorance of liability creating activities within the corporation… only a sustained or
systematic failure of the board to exercise oversight – such as utter failure to attempt to assure
a reasonable information and reporting system exists – will establish the lack of good faith that
is a necessary condition to liability.”
Facts
Stone v. Ritter (Delaware)
Appeal from a final judgment of the Court of Chancery dismissing a derivative
complaint against fifteen present and former directors of AmSouth Bancorporation
(“AmSouth”), a Delaware corporation. The plaintiffs, William and Sandra Stone,
are AmSouth shareholders and filed their derivative complaint without making a
pre-suit demand on AmSouth’s board of directors.
AmSouth Bank, a wholly owned AmSouth subsidiary, operated around 600
commercial banking branches in six states through the southeastern U.S. In 2004,
AmSouth and AmSouth Bank paid $40 million in fines and $10 million in civil
penalties for failure by bank employees to file Suspicious Activity Reports, as
required by the Bank Secrecy and various Anti-Money Laundering regulations. No
fines or penalties were imposed on AmSouth’s directors.
The government investigations were conducted by the U.S. Attorney’s Office
(USAO), the Federal Reserve, FinCEN and the Alabama Banking Department.
They arose as a result of a “Ponzi” scheme operated by Louis Hamric and Victor
Nance. In August 2000, Hamric and Nance, an attorney and investment advisor,
respectively, contacted an AmSouth branch bank in Tennessee to arrange for
custodial accounts to be created for “investors” in a “business venture.” The
venture consisted of taking investment payments with a return in the form of
interest payments guaranteed by promissory notes. This was a misrepresentation.
The scheme was discovered in March 2002, when the investors did not receive
their monthly interest payments and sued Hamric and Nance. The authorities
examined AmSouth’s compliance with its reporting and other obligations under the
BSA and on November 17, 2003 the USAO advised AmSouth that it was the
subject of criminal investigation. The USAO concluded that in 2000 “at least one”
AmSouth employee suspected that Hamric was involved in a possible illegal
scheme, but AmSouth failed to file SARs in a timely manner. AmSouth was
required to pay a $40 million fine, but the USAO did not ascribe any blame to the
Board or to any individual director.
On October 12, 2004, the Federal Reserve and Alabama Banking Department
issued a cease and desist order against AmSouth, requiring it, for the first time, to
improve its BSA/AML program. KPMG was the independent consultant creating a
report on their compliance. FinCEN and the Federal Reserve assessed a $10
million civil penalty against AmSouth for operating an inadequate anti-money
laundering program and failing to file SARs. They also concluded that AmSouth
had been in violation of the AML program requirements of the BSA since April
2002 – concluding that the AML program lacked adequate board and
management oversight.
Issue
Holding
The Court of Chancery properly applied Caremark and dismissed the
plaintiff’s derivative complaint for failure to excuse demand by alleging
particularized facts that created reason to doubt whether the directors had
acted in good faith in exercising their oversight responsibilities.
Analysis Demand Futility and Director Independence
The plaintiffs attempt to satisfy the Rales test in this proceeding by asserting that
the incumbent defendant directors “face a substantial likelihood of liability” that
renders them “personally interested in the outcome of the decision on whether the
pursue the claims asserted in the complaint,” and are therefore not disinterested
or independent.
- Central to this demand excused argument is whether or not the directors
conduct can be exculpated by the section 102(b)(7) provision contained in
the AmSouth certificate of incorporation.
- Such a provision can exculpate directors from monetary liability for a
breach of the duty of care, but not for conduct that is not in good faith or a
breach of the duty of loyalty.
Graham and Caremark
- In Graham, the Court held that “absent cause for suspicion there is no duty
upon the directors to install and operate a corporate system of espionage
to ferret out wrongdoing which they have no reason to suspect exists.”
- This holding was subsequently narrowly construed in Caremark, where the
court said Graham stood “for the proposition that, absent grounds to
suspect deception, neither corporate boards nor senior officers can be
charged with wrongdoing simply for assuming the integrity of employees
and the honesty of their dealings on the company’s behalf.” Further, “it is
important that the board exercise a good faith judgment that the
corporation’s information and reporting system is in concept and design
adequate to assure the board that appropriate information will come to its
attention in a timely manner as a matter of ordinary operations, so that it
may satisfy its responsibility.” Nevertheless, the Caremark court
recognized that, “the duty to act in good faith to be informed cannot be
though to require directors to possess detailed information about all
aspects of the operation of the enterprise.”
- Thus, the Caremark standard for so-called “oversight” liability draws
heavily upon the concept of director failure to act in good faith. That is
consistent with the definition(s) of bad faith recently approved by this Court
in Disney, where the Court held that 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 (i.e., gross
negligence).
- The failure to act in good faith is not conduct that results, ipso facto, in the
direct imposition of fiduciary liability. The failure to act in good faith may
result in liability because the requirement to act in good faith “is a
subsidiary element[,]” i.e., a condition, “of the fundamental duty of loyalty.”
It follows that because a showing of bad faith conduct, in the sense
described in Disney and Caremark, is essential to establish director
oversight liability, the fiduciary duty violated by that conduct is the duty of
loyalty.
- Although good faith may be described colloquially as part of a “triad” of
fiduciary duties that includes the duties of care and loyalty, the obligation
to act in good faith does not establish an independent fiduciary duty that
stands on the same footing as the duties of care and loyalty. Only the latter
two duties, where violated, may directly result in liability, whereas a failure
to act in good faith may do so, but indirectly.
- Also, the fiduciary duty of loyalty is not limited to cases involving a financial
or other cognizable fiduciary conflict of interest. It also encompasses cases
where the fiduciary fails to act in good faith.
- Thus, Caremark articulates the necessary conditions predicate for
director oversight liability: (a) the directors utterly failed to implement
any reporting or information system or controls; or (b) having
implemented such a system or controls, consciously failed to
monitor or oversee its operations thus disabling themselves from
being informed of risks or problems requiring their attention.” In
either case, imposition of liability requires a showing that the directors
knew that they were not discharging their fiduciary obligations.
Reasonable Reporting System Existed
The KPMG Report reflects that AmSouth’s Board dedicated considerable
resources to the BSA/AML compliance program and put into place numerous
procedures and systems to attempt to ensure compliance (e.g., BSA Officer,
BSA/AML Compliance Department, Corporate Security Department, and
Suspicious Activity Oversight Committee).
- The Report reflects that the directors not only discharged their oversight
responsibility to establish an information and reporting system, but also
proved that the system was designed to permit the directors to periodically
monitor AmSouth’s compliance with BSA and AML regulations.
- The Report also shows that AmSouth’s Board at various times enacted
written policies and procedures designed to ensure compliance with the
BSA and AML regulations (e.g., the bank wide “BSA/AML Policy”)
Complaint Properly Dismissed
- Delaware Courts have recognized that “[m]ost of the decisions that a
corporation, acting through its human agents, makes are, of course, not
the subject of director attention.” Consequently, a claim that directors are
subject to personal liability for employee failures is “possibly the most
difficult theory in corporation law upon which a plaintiff might hope to win a
judgment.”
- For the plaintiff’s derivative complaint to withstand a motion to dismiss,
“only a sustained or systematic failure of the board to exercise oversight –
such as an utter failure to attempt to assure a reasonable information and
reporting system exists – will establish the lack of good faith that is a
necessary condition to liability.”
- KPMG’s findings reflect that the Board received and approved relevant
policies and procedures, delegated to certain employees and departments
the responsibility for filing SARs and monitoring compliance, and exercised
oversight by relying on periodic reports from them.
- The plaintiff’s complaint seeks to equate a bad outcome with bad 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 be second-guessing after the
occurrence of employee conduct that results in an unintended adverse
outcome.
Problem 4-13
-
Directors were on notice since 2010 (along with evidence suggesting that they might
have been on notice prior to this) that there was fraudulent activity going on.
Protecting Participants’ Expectations in Closely Held Corporations
Closely held business are fundamentally different from those that are publicly held in various
ways:
-
First, closely held businesses are more intimate enterprises, lacking the separate of
function that the corporate form permits with its distinct roles for shareholders, officers,
and directors.
o Usually, a small number of participants are actively involved in the business with
no rigid division between those contributing money capital and those putting in
human capital.
o The business relationships often overlap family or other close personal ties,
adding another layer of expectations and creating various means of interactions
beyond those provided by the structure of entity law
-
Second, no market exists for the ownership interests of these enterprises. Thus, there is
no liquidity for one’s investments and also no check on those in control that markets
sometimes provide in a publicly held corporation.
o Most participants in a closely held business expect eventually to sell their
ownership interests back to the entity or to fellow investors, or expect to pass
their interests on to a son or daughter
The close corporation has long been a principal legal vehicle for closely held business; in recent
years, the limited liability company (LLC) has become the more frequently used form for nonpublicly traded firms.
Traditional Corporation
Entity Status
Liability
Tax
Control
Transferability
Entity separateness from
shareholders; asset
partitioning protects
entity creditors’ claims to
entity assets
Limited liability of
shareholders for debts of
corporation (limited to
the amount invested in
shares)
Corporation taxed as
separate entity, and
shareholders taxed
separately on receipt of
dividends or sale of
shares
Centralized control and
separation of function
(e.g., financial capital
from shareholders &
human capital from
managers)
Free transferability of
shares
Close
Corporations
Same as
corporation
Traditional
Partnerships
No entity; no partition
Same as
corporation
Personal liability –
unlimited liability (except
for in limited liability
partnerships)
Earnings pass
through via S
corp. election and
only taxed to
shareholders
Partnership not treated
as separate taxable
entity; all partnership
income passed-through
and taxed directly to
partners
Each partner has an
equal right to participate
in management and to
use partnership property
Legal separation
of function
coexists with
practical
unification of
function as most
or all
shareholders are
also officers and
directors. Until
breakdown in
relations, legal
majority rule
unneeded as
parties act in
harmony and by
consensus
Contract (share
transfer
agreement)
Transfer only by
member consent
Permanence/Exit Enduring entity (exit only
if available through
market)
regularly used to
limit transfer and
provide buyout
Enduring entity;
exit via sale of
shares often
contractually
restricted and
liquidity generally
available only
from the
corporation itself
via private
contract (share
purchases
agreement) or by
judicial
intervention
(oppression
remedy in most
states)
Easy exit (e.g.,
automatic dissociation)
In a close corporation, the corporate statutory norms of centralized control and majority rule,
when combined with the lack of public market for shares, leave a minority shareholder
vulnerable in a way that is distinct from risks faced by investors in public corporations.
The potential for majority opportunism inherent in corporate form can be described as a function
of majority rule, separation of function, lack of guaranteed employment and dividend rights for
shareholders, and denial of unilateral dissolution rights to minority shareholders. In other words,
the norms that both ensure the firm’s adaptability and protect the firm from minority opportunism
create the risk of majority opportunism.
Contracting as a Device to Limit the Majority’s Discretion
As to Director Decisions
MBCA §§7.32, 8.01, 8.24(c)
Delaware G.C.L. §§144(a) and (b), 350-354
Clark v. Dodge allowed shareholders to fix contractually their respective rights and to agree that
such rights could be abrogated by the directors only when required by the corporation’s best
interests.
The immutability of majority rule by directors was reaffirmed in Benintendi v. Kenton Hotel, Inc.
However, this no longer has statutory support, as many statutory provisions granting
management power to directors (such as D. G.C.L. §141(a) or MBCA §8.01) are now cast as
default rues in almost every state, specifically permitting shareholders to restrict or eliminate the
directors’ discretion.
More recent statutes have extended this contractual freedom in two additional ways. Most
states now have statutes like MBCA §7.32 that permit shareholders to vary norms not only be
provisions in the articles of incorporation (and sometimes the bylaws), but also in separate
shareholders’ agreements.
-
MBCA §7.32 specifically authorizes agreements that establish who will be the officers or
directors and even permits elimination of the board or transfer of corporate power to one
or more shareholders.
In a few states, the additional contractual freedom is offered only to statutory close corporations
– those enterprises that meet a statutory definition (such as, no more than 30 shareholders and
shares not publicly traded) and have designated the corporation as coming with special
provisions (e.g., Delaware subchapter XIV (§§341-356).
Thus, the modern statutes substantially increase shareholders’ “freedom of contract.”
Facts
Zion v. Kurtz (New York, 1980)
Zion and Kurtz were the only shareholders of Lombard-Wall Group, Inc. As part of
the transactions surrounding Zion’s purchase of a minority interest in LombardWall, Zion and Kurtz entered into a shareholders’ agreement providing that
Lombard-Wall would not engage in any business or activities without Zion’s
consent. Despite this agreement, Kurtz caused the corporation to take certain
actions without Zion’s consent. Zion then sought declaratory relief and injunctive
relief.
Issue
Holding
Analysis The general rule is found in Delaware G.C.L. §141(a), and the rest follows:
The stockholders’ agreement expressly provided that it should be “governed by
and construed and enforced in accordance with the laws of the State of Delaware
as to matters governed by the G.C.L. of that State,” and that is the generally
accepted choice-of-law rule with respect to such “internal affairs” as the
relationship between shareholders and directors.
Included in the Delaware G.C.L. are provisions relating to close corporations,
which explicitly state that a written agreement between the holders of a majority of
such a corporation’s stock “is not invalid, as between the parties to the agreement,
on the ground that it relates to the conduct of the business and affairs of the
corporation as to restrict or interfere with the discretion or powers of the board of
directors” (§350) or “on the ground that it is an attempt by the parties to the
agreement or by the stockholders of the corporation to treat the corporation as if it
were a partnership” (§354) and further provides that “[t]he certificate of
incorporation of a close corporation may provide that the business of the
corporation shall be managed by the stockholders of the corporation rather than
the board of directors” and that such provision may be inserted in the certificate by
amendment if “all holders of record of all of the outstanding stock” so authorize
(§351)
Any Delaware corporation can elect to become a close corporation by filing
an appropriate certificate of amendment (D.G.C.L. §344) and by such
amendment approved by the holders of all of its outstanding stock may
include in its certificate provisions restricting directors’ authority (§351).
- Kurtz agreed to this here.
Freedom of contract governs, and the parties executed this agreement.
Dissent:
- This contractual provision, if enforced, would effectively shift the authority
to manage every aspect of corporate affairs from the board to plaintiff, a
minority shareholder who has no fiduciary obligations with respect to either
the corporation or its other shareholders. As such, the provision represents
a blatant effort to “sterilize” the board of directors in contravention of the
statutory and decisional law of both Delaware and New York.
Notes:
-
Freedom to contract now underlies much of close corporation law and is a key
foundation of LLC law.
States differ as to whether unanimity is required for shareholders’ agreements changing
statutory norms.
o MBCA §7.32 sanctions only unanimous shareholders’ agreements.
o Delaware G.C.L. §350 provides that an agreement made by the owners of at
least a majority of the corporation’s stock is “not invalid as between the parties to
the agreement” on the ground that the agreement sterilizes directors.
Problem 5-1
-
(a)
o
Under Delaware: D.G.C.L. §§141(a), 350, 351, 354
 Section 141(a) would allow this restriction on director management power
MBCA: §7.32(a)(1)
o
o
Delaware: likely not allowed, because requirement that agreement be in writing
MBCA: 7.32(b)(1) – imposes writing requirement, so not permissible
o
o
Delaware: §350 does not have a unanimity requirement, so a vote by a majority
would allow this to survive
MBCA: §7.32(b)(1) – requires unanimity, so likely void
o
o
Delaware: §354 – could potentially violate public policy, so may be void
MBCA: §7.32(b)(1) – requires unanimity, so likely void
o
-
-
-
(b)
(c)
(d)
Voting Agreements as to Shareholder Decisions
MBCA §§7.22, 7.30, 7.31
Delaware G.C.L. §§212, 218(a) and (c)
The court in McQuade v. Stoneham indicated that the common law distinguished presumptively
invalid shareholder’s agreements designed to control the contracting parties’ future discretion to
act as directors from presumptively valid vote-pooling agreements whereby shareholders simply
agreed in advance as to how they would exercise their rights as shareholders, such as voting
for directors. Corporate codes provide and regulate several mechanisms by which shareholders
enter into agreements to affect their actions as shareholders. These include:
-
Voting trusts (MBCA §7.30, Delaware G.C.L. §218(a))
Irrevocable proxies (MBCA §7.22, Delaware G.C.L. §212)
-
Shareholder pooling agreements (MBCA §7.31, Delaware G.C.L. §218(c))
These shareholder agreements remain useful when the agreement is made by fewer than all of
the corporation’s shareholders or when shareholders desire to agree with creditors as to who
will be the corporation’s directors during the term of an outstanding loan.
A corporation in which the shareholders who together own a majority of shares wish to have
decisions made within their majority group (majority of the majority) and to exclude any possible
future realignment with those outside groups takes a different approach. Consider Ringling v.
Ringling Bros.-Barnum & Bailey Combined Shows Inc.:
-
-
-
Facts
A corporation owned the Ringling circus. Discord arose after the deaths of the brothers
who had owned and run the circus. Two shareholders, each owning about 30 percent
(one the widow of one brother and the other a daughter-in-law or a second brother),
entered into a vote-pooling agreement to oust the remaining shareholder (the son of the
Ringling sister) from control of the corporation. The agreement provided that the two
shareholders would act jointly in exercising their voting rights and that if the parties failed
to agree they would submit the disagreement to arbitration by a party named in the
agreement. The majority stockholders shared control of the corporation harmoniously
until a dramatic and fatal circus fire led to criminal charges against the husband of one of
the parties to the vote-pooling agreement, The criminal defendant’s wife subsequently
refused to vote her shares in accordance with the agreement. A suit to enforce the
agreement, and the defendant’s assertion that the agreement was illegal and
against public policy, led the court to discuss why the law would want to limit
what shareholders can agree to in actions taken as shareholders.
The Court: by adhering to strict literalism, it can be said that the present Agreement does
not separate voting rights from ownership because the arbitrator only directs the parties
as to how they shall vote in case of disagreement. However, recognizing substance
rather than form, it is apparent that the arbitrator has voting control of the shares in the
instances when he directs the parties as to how they shall vote since, if the Agreement is
to be binding, they are also bound by his direction.
The parties obviously decided to contract with respect to this very situation and to
appoint as arbitrator one in whom both had confidence. The cases which strike down
agreements on the ground that some public policy prohibits the severance of ownership
and voting control argue that there is something very wrong about a person “who has no
beneficial interest or title in or to the stock” directing how it shall be voted. Such a
person, according to these cases, has “no interest in the general prosperity of the
corporation” and moreover, the stockholder himself has a duty to vote. Such reasons
ignore the realities because obviously the person designated to determine how the
shares shall be voted has the confidence of such shareholders. Quite naturally, they
would not want to place such power over their investment in the hands of one whom
they felt would not be concerned with the welfare of the corporation. The objection based
on the so-called duty of the stockholders to vote, presumably in person, is ludicrous
when considered in light of present day corporate practice.
Ramos v. Estrada (California, 1992)
Plaintiffs Ramos et al. formed Broadcast Corporation for the purpose of obtaining
an FCC construction permit to build a Spanish language television station. Ramos
and his wife held 50% of Broadcast Corp. stock and the remaining 50% was
issued in equal amounts to five other couples. The Estradas were one of the
couples with a 10% share in Broadcast. In 1986, Broadcast merged with Ventura
41 for form Costa del Oro Television Inc. The merger authorized the issuance of
10,002 shares for Television Inc. voting stock, with 5000 going to Broadcast Corp.
and 5000 to Ventura 41. Each group would have the right to elect half of an 8
member board. The two remaining shares were to be issued to Broadcast Corp.
after 6 months, where Television Inc.’s board would increase to 9 members and
Broadcast would elect 5. The merger agreement contained restrictions on the
transfer of stock, and the FCC gave approval for the Television Inc. stock to be
issued directly to the respective owners of the merged entities. In part, Broadcast
Corp. agreed to this change in exchange for Ventura 41’s approval of the June
Broadcast Agreement, at issue here. Among other things, the June Broadcast
Agreement provided for block voting for directors by the Broadcast group
shareholders according to their ownership. Further, failure to adhere to the
agreement constitutes an election by the shareholder to sell their shares pursuant
to buy/sell provisions of the agreement. At the close of the transaction, Leopoldo
Ramos was elected president and Tila Estrada as one of the directors. Later, at a
special meeting on October 8, 1988, Tila Estrada voted with the Ventura 41 group
block to remove Ramos as president and replace him with someone from Ventura
41. On October 15, 1988 the Broadcast Group noticed another meeting to decide
how its members should vote for directors at the annual meeting, but the Estradas
did not attend and unilaterally declared the agreement null and void in a letter. Tila
Estrada refused to recognize the vote of the majority of the Broadcast Group to
replace her as director of Television, Inc. and Ramos et al. sued for breach of the
June Broadcast Agreement. The trial court found in favor of Ramos and Estrada
appealed on the grounds that the agreement constituted a proxy, which expired
when Estrada revoked it.
Issue
Holding
A corporate shareholders’ voting agreement may be valid even though the
corporation is not technically a close corporation.
The Estradas breached the agreement by their written repudiation of it. Their
breach constituted an election to sell their Television Inc. shares in
accordance with the terms of the buy/sell provisions in the agreement. This
election does not constitute a forfeiture – they violated the agreement
voluntarily, aware of the consequences of their acts and they are provided
full compensation, per their agreement.
Analysis The June Broadcast Agreements details the voting arrangement among the
shareholders. It stated, in pertinent part: “The Stockholders agree that they shall
consult with each other prior to voting their shares in the Company. They shall
attempt in good faith to reach a consensus as to the outcome of any such
vote…In the case of all votes of Stockholders they agree that, following
consultation and compliance with the other provisions of this paragraph they will
all vote their stock in the manner voted by a majority of the Stockholders.”
- Key California statutory provision: 706(a)… an agreement between two or
more shareholders of a close corporation, if in writing and signed by the
parties thereto, may provide that in exercising any voting rights the shares
held by them shall be voted as provided by the agreement, or as the
parties may agree or as determined in accordance with the procedures
agreed upon by them.
- Key contractual provision: “in the case of all votes of stockholders they
agree that, following consultation and compliance with the other provisions
of this paragraph, they will al vote their stock in the manner voted by a
majority of the Stockholders.”
- No proxies are created by this agreement. The agreement has the
characteristics of a shareholders’ voting agreement expressly authorized
by statute for close corporations.
- The members of this corporation executed a written agreement providing
that they shall try to reach a consensus on all votes and that they shall
consult with one another and vote their own stock in accordance with the
majority of the stockholders.
- Even though this corporation does not qualify as a close corporation,
this agreement is valid and binding on the Estradas. Section 706,
subdivision (d) of the California statute states: “This section shall not
invalidate any voting or other agreement among shareholders… which
agreement… is not otherwise illegal.”
To the Estradas’ argument that the agreement constituted a proxy:
- A key distinction between the cases (e.g., Smith) the Estradas relied on
and this case is that here, the shareholders chose to vote their stock
themselves, and not by proxy. What the Smith court held is that voting
agreements, like the one here, are valid.
- The instant agreement is valid, enforceable and supported by
consideration. It states, in pertinent part, that the stockholders entered into
the agreement for the purposes of “limiting the transferability of… stock in
the Company, ensuring that the Company does not pass into the control of
persons whose interests might be incompatible with the interests of the
Company and of the Stockholders, establishing their mutual rights and
obligations in the event of death, and establishing a mechanism for
determining how the Stockholders’ voting rights… shall be exercised.”
- Section 7.2 of the agreement states that “… in the event that a Stockholder
fails to abide by this arrangement for whatever reason, that failure shall
constitute an irrevocable election by the Stockholder to sell his stock in the
Company, triggering the same rights of purchase provided” above in the
agreement.
Notes:
-
In both Ringling and Ramos, the voting agreements were used to create and preserve a
majority. In other situations, voting agreements can be used to ensure participation of
shareholders on boards of directors, as with venture capitalists providing funds to hightech startup companies. The venture capitalists do not necessarily want control, but they
want to make sure that they are in a position to monitor what is going on and to protect
their investment if the venture does not work out. Cumulative voting may be used to
create such arrangements, as may class voting.
Fiduciary Duty and Threat of Dissolution as a Check on Opportunistic Majority Action
Traditional Judicial Deference to Majority’s Discretion
Corporation law provides two principal avenues for minority shareholders’ suits – a petition for
involuntary dissolution and a direct or derivative suit for breach of fiduciary duty. An
alternative is a suit to compel the payment of dividends or to protect rights belonging directly to
shareholders.
-
It has long been recognized that shareholders may sue in their own right to challenge
unfair dividend policies, to protect voting or contractual rights, and to protect other rights
owed directly to them by the corporation. However, Zidell v. Zidell illustrates that
business judgment presumptions and the majoritarian-directorial bias of the traditional
norms still leave the majority with substantial discretion.
For most of this century, courts and statutes have applied the same equitable doctrines for
closely held and publicly held corporations. Such interpretations have the effect of granting
majority shareholders substantial discretion to take actions that displease minority shareholders.
Corporation statutes and the common law have long recognized that courts may dissolve a
corporation if such action would be equitable. However, more recently, corporate norms treats
involuntary dissolution as a drastic remedy, to be granted only if the complaining shareholder
proved both wrongful conduct by those in control and that dissolution was the only way to
prevent irreparable harm to the corporation.
Under traditional norms, a complaining minority shareholder must pursue most fiduciary
litigation via a derivative suit, with the attendant possibility that the majority may be able to take
control of the litigation. In any event, the minority shareholder is generally interested in
remedying the harm done not to the corporation itself but to herself, a goal that is more easily
accomplished through direct enforcement of shareholders’ rights.
Facts
Zidell v. Zidell (Oregon, 1977)
The defendants are directors of four different Zidell family corporations, engaged
in scrapping shipping vessels, building and selling barges, buying and selling
scrap metal, and marketing industrial valves. The family business began as a
partnership and was later incorporated. By 1966, Emery Zidell and Arnold Zidell
each owned 37.5% of stock, and Jack Rosenfeld owned 25%. In the meantime,
three of the defendant corporations had been organized to carry on separate
aspects of the family business. Their stock was held by the three partners in
proportion to their partnership interests. The partners also served as directors and
Emery acted as CEO. In 1972, Jack Rosenfeld sold all of his stock in 1 of the four
companies and a portion of his stock in the other 3 to Jay Zidell, the son of Emery.
This effectively gave Emery and his son Jay a majority interest in each of the
family corporations. Arnold didn’t learn about the sale until after it was completed.
There had been some animosity between Arnold and Emery brewing, which
increased after Jay’s purchase of the stock. In 1973, at a special meeting of the
BOD, Arnold demanded a salary increase, or else he would resign. His request
was refused and he resigned his employment (but not his directorship – but when
his term expired, he was not reelected). Prior to Arnold’s resignation, the
customary practice was to retain all earnings of the business rather than distribute
them as dividends, since all significant stockholders were active in the business
and received adequate salaries. Following Arnold’s resignation, however, Arnold
demanded the corporations begin declaring dividends. Thereafter, a dividend was
declared and paid on the 1973 earnings of each corporation. Arnold contended
that these were unreasonably small. He also argued that after his resignation
corporate salaries and bonuses were increased substantially and that this change
is evidence of a concerted effort by the other shareholders to wrongfully deprive
him of his right to a fair proportion of the profits of the business. The trial court
declined to rule that defendants acted in bad faith, but ordered each defendant
corporation to declare additional dividends out of its earnings for 1973 and 1974.
Issue
Holding
Plaintiff did not carry his burden of proving a lack of good faith. Thus, the trial
court erred in decreeing the distribution of additional dividends.
Analysis Those in control of corporate affairs have fiduciary duties of good faith and faith
dealing toward the minority shareholders. Insofar as dividend policy is concerned,
that duty is discharged if the decision is made in good faith and reflects legitimate
business purposes rather than the private interests of those in control.
Reviewing Gay v. Gay’s Super Markets, Inc.:
- “To justify judicial intervention in cases of this nature, it must, as a general
proposition be shown that the decision not to declare a dividend amounted
to fraud, bad faith, or an abuse of discretion on the part of the corporate
officials authorized to make the determination…”
- “The burden of demonstrating bad faith, fraud, breach of fiduciary duty or
abuse of discretion on the part of the directors of a corporation rests on the
party seeking judicial mandatory relief respecting the declaration of
dividends…”
- Further, judicial review must be viewed in light of the business judgment
rule
- Thus, plaintiff had the burden of proving bad faith on the part of the
directors in determining the amount of corporate dividends.
Regarding the issue of bad faith, Gottfried v. Gottfried:
- There are no infallible distinguishing earmarks of bad faith. The following
facts are relevant to the issue of bad faith and are admissible in evidence:
Intense hostility of the controlling faction against the minority; exclusion of
the minority from employment by the corporation; high salaries, or bonuses
or corporate loans made to the officers in control; the fact that the majority
group may be subject to high personal income taxes if substantial
dividends are paid; the existence of a desire by the controlling directors to
acquire the minority stock interests as cheaply as possible. But if they are
not motivating causes they do not constitute “bad faith” as a matter of law.
The plaintiff showed that the corporations could have afford to pay additional
dividends, that he left the corporate payroll, that those remaining stockholders
working for the corporations are receiving generous salaries and bonuses, and
that there is hostility between him and the other major stockholders. While these
are factors often present in cases of oppression or attempted squeeze-out by
majority shareholders, they are not invariably signs of improper behavior.
- The Defendants also introduced a considerable amount of credible
evidence to explain their conservative dividend policy, including:
consideration of a future need for expensive physical improvements and
even possible relocation of a major plant; the need for cash to pay for large
inventory orders; the need for renovations; the need for short-term
financing.
- The plaintiff tried to counter, claiming that they did not actually rely
on these considerations. However, the court found that their
testimony was believable and the burden of proof was on the
plaintiff, not the defendants
Regarding the plaintiffs contention that the court should approve the forced
declaration of additional dividends to prevent a deliberate squeeze-out:
- Plaintiff left his employment position voluntarily; he was not forced out.
Although the dividends he received are modest, they are not unreasonable
in light of the corporation’s projected financial needs. Moreover, the court
was not persuaded that the directors were employing starvation
tactics to force the sale of plaintiff’s stock at an unreasonably low
price.
Notes:
-
-
-
Under traditional analysis, the complaining shareholder has the burden of providing that
the directors’ failure to issue a dividend is not the product of a good faith, informed
business decision. Merely proving that there is bad blood between the partis is
insufficient to establish that the directors were in fact improperly motivated. A critical
factor in dividend-related cases is the corporation’s accumulation of an unreasonably
large cash reserve – a reserve that can only be explained by the controlling majority’s
bad faith (e.g., Dodge v. Ford Motor Co.)
Under traditional doctrine, complaining minority shareholders face the same difficulty in
challenging a closely held corporation’s salary policies as do complaining shareholders
in a publicly held corporation.
Under traditional analysis, complaining minority shareholders in a successful corporation
often face an uphill fight even when the burden of proving fairness is placed on the
controlling shareholders.
The Partnership Analogy as a Basis for Enhancing Minority Shareholders’ Rights
The so-called partnership analogy is an early and recurring theme in judicial and academic
analysis of the close corporation puzzle. Analysis based on the partnership analogy asserts that
the expectations and internal governance needs of shareholders in typical closely held
corporations are similar to those of partners in a typical partnership. Accordingly, the partnership
analogy suggests that close corporation law should be based on, or draw heavily from,
partnership law.
-
Facts
However, the utility of the partnership analogy is disputed. Shareholders now have
freedom to contract around the majoritarian bias of traditional corporate norms.
Donahue v. Rodd Electrotype Co. (Massachusetts, 1975)
Harry Rodd and Joseph Donahue each owned shares of Rodd Electrotype Co. In
1955, Harry Rodd held 200 of Rodd Electrotype Co.’s 250 shares, representing an
80 percent stake in the company. Joseph Donahue owned the remaining 50
shares, which passed on his death to his wife Euphemia Donahue (plaintiff) and
his son. By 1965, Harry Rodd had ceded the management of the corporation to
his son Charles. Additionally, from 1959 to 1967, Harry gifted the majority of his
shares to his children (giving 39 shares to each of his two sons, Charles and
Frederick and daughter, Phyllis, and returning 2 shares to the corporate treasury).
In 1967, Harry resigned from the board and the remaining incumbent directors,
Charles and Harold Magnuson elected Frederick to replace him. Following this,
the three directors then authorized an agreement for the corporation to purchase
45 of Harry’s shares for $800 per share.
At a special meeting in 1971, after a report of an audit conducted of the company
events of the year, the Donahues learned of the purchase. They voted against a
resolution to approve the report, or the ratifying of the purchase of Harry’s shares.
A few weeks later, the Donahues offered to sell their shares on the same terms as
Harry’s, but the offer was rejected.
The plaintiff brought suit against the three current directors (Charles and Frederick
Rodd, and Harold Magnuson) and Harry Rodd, seeking to rescind Rodd
Electrotype’s purchase of Harry’s shares and to compel Harry to pay back the
purchase price. Plaintiff alleged that the directors caused the company to
purchase the shares in violation of their fiduciary duty to her, a minority
shareholder. The trial judge dismissed the action, finding that the purchase did not
prejudice the plaintiff and was carried out in good faith and with inherent fairness.
The Appeals Court affirmed.
Issue
Whether majority stockholders owe any standard of duty to minority stockholders.
Holding Reversed the lower courts, but limited the holding to “close corporations” for the
time being. The plaintiff is entitled to relief and have one hundred percent of her
forty five shares similarly purchased, as to Harry’s.
Because of the fundamental resemblance of the close corporation to the
partnership, the trust and confidence which are essential to this scale and
manner of enterprise, and the inherent danger to minority interests in the
close corporation, we hold that stockholders in the close corporation owe
one another substantially the same fiduciary duty in the operation of the
enterprise that partners owe to one another.
- Stockholders in close corporations must discharge their management and
stockholder responsibilities in conformity with “utmost good faith and
loyalty.” They may not act out of avarice, expediency or self-interest in
derogation of their duty of loyalty to the other stockholders and to the
corporation.
- (this stands in contrast to the less stringent standard of fiduciary duty to
which directors and stockholders of all corporations must adhere in the
discharge of their corporate responsibilities)
The strict standard of duty is plainly applicable to the stockholders in Rodd
Electrotype.
- On its face, the purchase of Harry Rodd’s shares by the corporation
is a breach of the duty, which the controlling stockholders, the
Rodds, owed to the minority stockholders, the Donahues. The
purchase distributed a portion of the corporate assets to Harry Rodd, a
member of the controlling group, in exchange for his shares. The
Donahues were not offered an equal opportunity to sell their shares
to the corporation. In fact, their efforts to obtain an equal opportunity
were rebuffed by the corporate representative.
Analysis Close Corporations
A close corporation is typified by: (1) a small number of stockholders; (2) no ready
market for the corporate stock; and (3) substantial majority stockholder
participation in the management, direction and operations of the corporation.
- As thus defined, the close corporation bears striking resemblance to a
partnership
- Although the corporate form provides advantages for the stockholders
(such as limited liability, perpetuity, etc.), it also supplies an opportunity for
the majority stockholders to oppress or disadvantage minority
stockholders. The minority is vulnerable to a variety of oppressive devices,
termed “freeze-outs,” which the majority may employ.
- A minority shareholder cannot easily reclaim his capital. In a large public
corporation, the oppressed or dissident minority shareholder could sell his
stock in order to extricate some of his invested capital. By definition, this
market is not available for shares in a close corporation. In a partnership,
a partner who feels abused by his fellow partners may cause dissolution
by his “express will… at any time” and recover his share of partnership
assets and accumulated profits. By contrast, the stockholder in the close
corporation or “incorporated partnership” may achieve dissolution and
recovery of his share of the enterprise assets only be compliance with the
rigorous terms of the applicable chapter of the General Laws.
- Thus, in a close corporation, the minority stockholder may be trapped in a
disadvantageous situation. To cut losses, the minority stockholder would
be compelled to deal with the majority (which may result in agreeing to sell
shares at least than fair value, in which case the majority ha won).
Equal Opportunity in a Close Corporation
In light of the above holding:
- When the corporation reacquiring its own stock is a close
corporation, the purchase is subject to the additional requirement
that the stockholders, who, as directors or controlling stockholders,
caused the corporation to enter into the stock purchase agreement,
must have acted with the utmost good faith and loyalty to the other
stockholders.
- To meet this test, if the stockholder whose shares were purchased
was a member of the controlling group, the controlling stockholders
must cause the corporation to offer each stockholder an equal
opportunity to sell a ratable number of his shares to the corporation
at an identical price.
The Modern Approach to Involuntary Dissolution
MBCA §§14.30, 14.34
Some states have enacted liberal involuntary dissolution provisions that instruct courts to take
into account shareholders’ reasonable expectations or interests in fashioning relief.
Under the evolving doctrine, courts view dissolution as a viable remedy for truly egregious
conduct and are increasingly willing to order corporations to repurchase the complaining
minority’s shares in order to protect shareholders’ reasonable expectations or to remedy
oppression.
MBCA §14.34 grants the defendant corporation the right to avoid a court-ordered involuntary
dissolution by electing to repurchase the complaining minority’s shares for fair value.
-
However, this section gives the majority rather than the minority the right to determine
whether buyout will occur.
Thompson, The Shareholder’s Cause of Action for Oppression
In response to a falling out among participants in a closely held corporation, in which a minority
shareholder may face an indefinite period with no return on his or her investment, legislatures
and courts have responded in two ways:
-
-
First, legislatures have broadened the grounds for judicial dissolution of a corporation at
the request of a minority shareholder and have provided additional remedies as
alternatives to involuntary dissolution.
Second, courts have expanded significantly the ability of shareholders in a close
corporation to bring a direct, individual cause of action based on a majority shareholder’s
breach of fiduciary duty. Courts have enhanced the duty owed to minority shareholders
in a close corporation and have allowed them to bring direct suit rather than just a
derivative suit brought in the name of the corporation.
Most American jurisdictions now permit a shareholder to petition for dissolution on a variety of
grounds. Illegality, fraud, misapplication of assets, and waste are listed as grounds for
dissolution in most state statutes, although these terms standing alone have not been cited
often as grounds for dissolution by courts.
-
Oppressive conduct by the majority or controlling shareholder now is listed widely in
most state dissolution statutes, and has become the principal vehicle used by
legislatures, courts, and litigants to address the particular needs of close corporations.
It is fair to say that the remedy has outgrown its dissolution origins and now is better described
as a general remedy for shareholder dissention within a close corporation that only rarely results
in the dissolution of a corporation.
-
Thus, it makes sense to view oppression not as a ground for dissolution, but as a
remedy for shareholder dissension
Hetherington and Dooley mandatory buyout provision – permits minority shareholders to force
a buyout with even fewer restrictions than in partnership law.
“[W]hen a shareholder presumes to exercise control over a corporation, to direct its actions, that
shareholder assumes a fiduciary duty of the same kind as that owed by a director.” Sterling v.
Mayflower Hotel, Corp., 93 A.2d 107, 109-10 (Del. 1952).
MBCA §14.30 GROUNDS FOR JUDICIAL DISSOLUTION
-
(a) The [name or describe court or courts] may dissolve a corporation…
…(2) in a proceeding by a shareholder if it is established that:
(i) the directors are deadlocked in the management of the corporate affairs, the
shareholders are unable to break the deadlock, and irreparable injury to the corporation
is threatened or being suffered, or the business and affairs of the corporation can no
longer be conducted to the advantage of the shareholders generally, because of the
deadlock;
(ii) the directors or those in control of the corporation have acted, are acting, or
will act in a manner that is illegal, oppressive, or fraudulent;
(iii) the shareholders are deadlocked in voting power and have failed, for a period
that includes at least two consecutive annual meeting dates, to elect successors to
directors whose terms have expired; or
(iv) the corporate assets are being misapplied or wasted;
Facts
Issue
Holding
In re Kemp & Beatley, Inc. (1984, New York)
Dissin and Gardstein each owned stock in Kemp & Beatley. Dissin was employed
by the company for 42 years before resigning in 1979 and currently owns 200
shares. Gardstein was employed with the company for 35 years before his
employment was terminated in 1980 and currently owns 105 shares. After each of
their employment’s ceased, both stopped receiving any distribution of the
company’s earnings. Prior to the end of their employment, it had been both of their
experiences when with the company to receive a distribution of the company’s
earnings according to their stockholdings, in the form of either dividends or extra
compensation. Since that distribution stopped, they considered themselves to be
“frozen out” of the company. Both petitioners (holding collectively 20.33% of
outstanding stock) brought an action seeking dissolution of Kemp & Beatley
pursuant to §1104-a of the Business Corporation Law (New York), alleging
“fraudulent and oppressive” conduct by the company’s board of directors such as
to render their stock “a virtually worthless asset.” The trial court found that the new
dividend policy had prevented the petitioners from receiving any return on their
investments, affirming a referee’s report requiring dissolution.
Whether the provision for involuntary dissolution when the “directors or those in
control of the corporation have been guilty of… oppressive actions towards the
complaining shareholders” was appropriate in this case? YES
Under the circumstances of this case, there was no error in determining that the
conduct (i.e., change in dividend policy shortly before or shortly after petitioners’
employment ended) constituted oppressive action within the meaning of the New
York law & the trial court did not abuse its discretion in ordering dissolution subject
to an opportunity for a buy-out of petitioners’ shares.
Utilizing a complaining shareholder’s “reasonable expectations” a means of
identifying and measuring conduct alleged to be oppressive is appropriate.
- A court considering a petition alleging oppressive conduct must
investigate what the majority shareholders knew, or should have
known, to be the petitioner’s expectations in entering the particular
enterprise. Majority conduct should not be deemed oppressive
simply because the petitioner’s subjective hopes and desires in
joining the venture are not fulfilled. Disappointment alone should not
necessarily be equated with oppression.
Analysis §1104-a provides a mechanism for the holders of at least 20% of the outstanding
shares of a corporation whose stock is not traded on a securities market to
petition for its dissolution “under special circumstances”
- §1104-a(a)(1) describes three types of proscribed activity: “illegal,”
“fraudulent,” and “oppressive” conduct.
Meaning of “Oppressive Actions”
- It is widely understood that, in addition to supplying capital to a
contemplated or ongoing enterprise and expecting a fair and equal return,
parties comprising the ownership of a close corporation may expect to be
actively involved in its management and operation
- As the stock of closely held corporations generally is not readily salable, a
minority shareholder at odds with management policies may be without
either a voice in protecting his or her interests or any reasonable means of
withdrawing his or her investment
-
Oppressive action is distinct from illegality and refers to conduct that
substantially defeats the “reasonable expectations” held by minority
shareholders in committing their capital to the particular enterprise.
o A shareholder who reasonably expected that ownership in the
corporation would entitle him or her to a job, a share of
corporate earnings, a place in corporate management, or
some other form of security, would be oppressed in a very real
sense when others in the corporation seek to defeat those
expectations and there exists no effective means of salvaging
the investment
- Oppression should be deemed to arise only when the majority
conduct substantially defeats expectations that, objectively viewed,
were both reasonable under the circumstances and were central to
the petitioner’s decision to join the venture. (this is a fact specific
inquiry)
Appropriateness of Dissolution
- Under the statute, Courts must consider whether “liquidation of the
corporation is the only feasible means” to protect the complaining
shareholder’s expectation of a fair return on his or her investment and
whether dissolution “is reasonably necessary” to protect “the rights or
interests of any substantial number of shareholders” not limited to those
complaining.
- Implicit in this, is that one oppressive conduct is found, consideration must
be given to the totality of the circumstances surrounding the current state
of corporate affairs and relations to determine whether some remedy short
of or other than dissolution constitutes a feasible means of satisfying both
the petitioner’s expectations and the rights and interests of any other
substantial group of shareholders.
- Every order of dissolution must be conditioned upon permitting any
shareholder of the corporation to elect to purchase the complaining
shareholder’s stock at fair value
There remains an obligation of good faith on behalf of the minority shareholder in
instituting this type of action and in their reasonable expectations
Distinction of involuntary dissolution for closely held corporation’s vs with partnerships (i.e.,
McCormick v. Brevig):
Facts
Gimpel v. Bolstein (1984, New York)
Gimpel Farms is a family corporation engaged in the dairy business. The stock of
the company is owned by David, Robert, Shirley, and George Gimbel, and Diane
Bolstein Kaufman – all the stocks of which has been passed down through two
generations of family members. The family members have each participated
actively in the management and daily operations of the company and have taken
their recompense in the form of salary and perquisites. It does not appear that
dividends have ever been paid Robert’s shares were gifted to him by his father
when he passed away. Robert was employed until 1974, when he was discharged
due to allegations of embezzlement. Robert denied these allegations, claiming
that he was never prosecuted for them, but the court deemed that in 1975, Robert
was, in fact, a thief who stole from the company and was discharged when the
theft became known. Since that time, Robert has received no benefits from his
ownership position in the company. The company continued to adhere to its policy
of not paying dividends, resulting in Roberts not receiving any return. After his
father’s death, the other shareholders offered to buy out Roberts’ shares, but he
rejected the offer as inadequate. Robert brought this petition to dissolve the
corporation pursuant to §1104-a claiming that he has been oppressed, along with
a derivative action.
Issue
Whether the conduct of the majority can be said to be “oppressive” within the
meaning of §1104-a.
Holding The conduct was not oppressive conduct. Nonetheless, Robert cannot be forever
compelled to remain an outcast. The other shareholders need not allow him to
return to employment with the corporation, but they must by some means allow
him to share in the profits.
- The court has discretion to fashion a proper remedy in these
circumstances.
- Thus, the court ordered; the corporation must immediately allow Robert full
access to corporate records, issued stock certificates, and elect between
either altering the corporate financial structure so as to commence
payment of dividends, or else make a reasonable effort to buy out Robert’s
interest.
- If the corporation chooses to commence payment of dividends, the
dividends must be substantial (consistent with sound business judgment)
and not a sham. To the extent that the salaries paid to majority
shareholders have been fixed so as to include amounts in lieu of
dividends, the salaries must be adjusted downward.
- If the election is made to buy out Robert’s shares, the offer again must be
substantial and made in good faith.
Analysis Dissolution under §1104-a is discretionary.
- It is a “drastic” remedy, and before ordering it, the court must consider
whether it is the only means by which the complaining shareholders can
reasonably expect to receive a fair return on their investment or whether it
is reasonably necessary to protect their rights and interests.
Robert alleged both “oppressive” actions under §1104-a(a)(1) and waste and
diversion of corporate assets under §1104-a(a)(2). He alleges numerous acts by
the majority which he claims constitute “oppressive” conduct: (1) he has been
excluded from “corporate participation”; (2) the profits of the corporation are
distributed to the majority interests in the form of salaries, benefits and
perquisites, with no dividends being declared, whereby Robert derives no benefit
whatsoever from his ownership interest; and (3) he has been excluded from
examination of the corporate books and records which he is entitled to examine,
completing his “freeze out” form the corporation.
Whether the majority’s conduct was oppressive:
- There are two definitions that are applicable but not mutually exclusive,
either of which may be more useful dependent on the facts of each case:
- First, “oppression” as a violation by the majority of the “reasonable
expectations” of the minority
- Second (derived from British Law), “oppressive conduct” as
burdensome, harsh and wrongful conduct; a lack of probity and fair
dealing in the affairs of a company to the prejudice of some of its
members; or a visible departure from the standards of fair dealing,
and a violation of fair place on which every shareholder who entrusts
his money to a company is entitled to rely.
- Here, the “reasonable expectations” test seems to be inappropriate, given
the corporation’s advanced stage of existence and the plaintiff’s place and
record (i.e., a family company that is 53 years old, which ownership has
been transferred between generations – all current holders of the voting
shares are two generations removed from the adoption of the corporate
form). While the manner of their dealing with each other may in some
respects resemble that of partners, it cannot fairly be said that they
entered into the busines with the same “reasonable expectations” as
partners do, since they all acquired shares by bequest or gift from other
parties.
- Unless there is an unmistakable expression of their intent to the
contrary, the agreement will not “run with the shares.” Hence, the
present shareholders are not bound by whatever unwritten
agreements may have existed between Louis, David and Moe, and did
not form any agreement among themselves which could inure to
Robert’s benefit.
- Where the question of oppressiveness cannot be resolved by comparing
the conduct of the majority to the “reasonable expectations” of the parties,
the court must look to the alternative test described above.
- Although a minority shareholder may be in the position of a stranger
to them, the majority must still act with “probity and fair dealing,”
and if their conduct becomes burdensome, harsh and wrongful,” they
may be found to have been guilty of oppression and the corporation
may be subject to dissolution.
Oppressiveness under the second definition:
- Under this test, Robert’s discharge, as well as his subsequent exclusion
from corporate management, were not oppressive. Thus, the only forms of
participation which may fairly be said to be open to Roberts are those open
to a shareholder in the position of a stranger: possible entitlement to
dividends, voting at shareholders’ meetings, and access to corporate
records.
- As to dividend policy: The corporation had never declared dividends from
its beginning even up until Robert’s discharge. The corporation had a
policy to buy back shares of original founder’s widows upon their death.
Thus, if the corporation were to begin paying out dividends now, the
remaining shares would receive a disproportionate share of income.
Therefore, this claim does not stand.
- Other allegations of oppression: the failures to hold shareholders’
meetings, to issue proper stock certificates reflecting his actual interest in
the corporation, or to allow him access to stock ledgers may all have been
improper, but do not, individually or collectively, constitute oppressive
conduct such as would justify dissolution.
Robert’s claims under §1104-a(b)(2):
- Robert’s derivative action, wherein the same allegations are made
regarding waste due to the salaries of majority shareholders being
excessive, provides sufficient remedy for any wrong that may have been
done by these acts. Since dissolution is not “reasonably necessary…”, it
will not be ordered on these grounds, either.
There are two definitions of “oppressive conduct” that the court accepted as valid,
both of which are not mutually exclusive, and either may be applicable to a set of
circumstances that is more conducive to that definition.
- Unless there is an unmistakable expression of their intent to the contrary,
the agreement will not “run with the shares,” and “reasonable
expectations” test may be inappropriate.
Ratio
Notes:
-
-
In more recent years, courts have been more willing to tailor relief to fit the
circumstances (as opposed to simply denying or granting dissolution). In this regard,
MBCA§ 14.34 will increase the resolution of these disputes via buyouts rather than
tailored relief because the defendant’s election to repurchase the complaining minority’s
shares for fair value will block a court’s ability to use its equitable discretion
For buyout remedies, court’s determine fair value based on the testimony of experts.
Reasonable expectations analysis supposedly differs from an attempt to determine what
parties would have agreed to had they bargained over the matter in question. Thus,
relief is to be fashioned based on the actual expectations of particular shareholders, not
the hypothetical expectations of similarly situated shareholders.
Problem 5-3
(a) (1)
(d) (1) 14.30(a)(2)(ii) seek dissolution – (2) seek dissolution as under (1), but remaining
shareholders may elect to buy out 14.34(a)
The Limited Liability Company
A limited liability company (LLC) is formed by filing a chartering document, usually termed
“articles of formation” or “articles of organization,” with the state.
A separately adopted and nonpublic agreement, commonly termed an “operating agreement,”
specifies in detail the ownership rights, duties, and obligations of those who will own and
manage the LLC.
To understand the nature of the LLC, it is instructive to consider how the LLC allocates among
joint owners the ownership and management functions that are united in one person in a sole
proprietorship. These functions are threefold:
-
(1) servings as the firm’s residual claimant and ultimate risks bearer;
(2) overseeing business affairs and determining business policies; and
(3) managing day-to-day affairs.
In the sole proprietorship, the firm’s entrepreneur, the sole proprietor, performs all three
functions. The general partnership default rules divide all three functions equally among the
general partners. Corporation law norms assign the sole proprietor’s first function to
shareholders, the second function to the board of directors, and the third to officers. The LLC
permits planners to choose either a partnership-like or corporation-like allocation of functions.
Members – the LLC allocates the residual claimant status to the firm’s “members.” Thus,
members, like shareholders in a corporation or general partners in a general partnership, share
ratably in the profits of the firm, but only after all other claimants and needs of the firm have
been satisfied. Most LLC statutes permit an LLC to be member managed or manager managed,
usually providing member management as the default rule if the operating agreement does not
provide otherwise.
Member-managed LLC – Under LLC statutory norms, members in a member-managed LLC
function similarly to general partners in a general partnership. Not only are members the firm’s
residual claimants, but they also, collectively, have authority to manage the LLC’s business and
affairs. Further, each member owes fiduciary and contractual duties to the LLC in the carrying
out of this management role.
Managers and manager-managed LLC – LLC statutes provide that the sole proprietor’s
ownership functions may be allocated to one or more “managers,” who may but need not be
members of the LLC. In order to take advantage of this specialization of management function,
the LLC is organized as a manager-managed LLC. In this structure, members, as members,
have no management authority or fiduciary responsibilities. Instead, the persons designated as
managers are responsible for managing the business and affairs of the LLC.
Limited Liability – Neither members nor managers are personally liable for the LLC’s
obligations (no one in the LLC is assigned the function of ultimate risk bearer)
Development of LLCs, as compared to partnerships & corporation on p.534.
Entity Status
Liability
Tax
Traditional
Corporation
Entity
separateness from
shareholders;
asset partitioning
protects entity
creditors’ claims to
entity assets
Limited liability of
shareholders for
debts of
corporation
(limited to the
amount invested in
shares)
Corporation taxed
as separate entity,
and shareholders
taxed separately
on receipt of
dividends or sale
of shares
Close
Corporations
Same as
corporation
LLC
Same as
corporation
Same as
corporation
Personal liability –
unlimited liability
(except for in limited
liability partnerships)
Earnings pass
through via S
corp. election and
only taxed to
shareholders
Pass through via
“check-the-box”
(IRS policy
whereby an
unincorporated firm
is permitted to elect
whichever tax
treatment it
preferred (e.g.,
partnership vs.
corporate))
Partnership not
treated as separate
taxable entity; all
partnership income
passed-through and
taxed directly to
partners
Same as
corporation
Traditional
Partnerships
No entity; no
partition
Control
Centralized control
and separation of
function (e.g.,
financial capital
from shareholders
& human capital
from managers)
Legal separation
of function
coexists with
practical
unification of
function as most
or all
shareholders are
also officers and
directors. Until
breakdown in
relations, legal
majority rule
unneeded as
parties act in
harmony and by
consensus
Transferability
Free transferability
of shares
Permanence/
Exit
Enduring entity
(exit only if
available through
market)
Contract (share
transfer
agreement)
regularly used to
limit transfer and
provide buyout
Enduring entity;
exit via sale of
shares often
contractually
restricted and
liquidity generally
available only
from the
corporation itself
via private
contract (share
purchases
agreement) or by
judicial
intervention
(oppression
remedy in most
states)
LLC statutes
support both
partnership-like and
corporate-like
governance
structures. In the
former, members
share management
power equally. In
the latter,
ownership
functions are split
into two realms –
members and
managers. Contract
(the Operating
Agreement)
regularly used to
provide detail in
either
Operating
Agreement
regularly used to
modify transfer
limits and provide
buyouts.
Enduring entity but
exit regularly
provided via
contract or by
statute (if judge
finds oppression –
in more than 40%
of states)
Each partner has an
equal right to
participate in
management and to
use partnership
property
Transfer only by
member consent
Easy exit (e.g.,
automatic
dissociation)
A key attribute of the LLC is its status as a contractual entity. Coming into being at a time when
contractarian analysis of the corporation dominated legal thinking, the LLC was seen as a
business entity intended for investors and business firms that preferred to design governance
systems for themselves, rather than using the default rules in the corporate statute and one or
more of the mandatory rules that went along with the corporate form.
Delaware LLC law not only provides a coherent and comprehensive set of rules, but also
imposes fewer restrictions on planners. The resulting combination of flexibility, predictability,
and certainty is attractive to planners and is decidedly less present in any other LLC jurisdiction.
-
E.g., Delaware’s greater willingness than other states in an LLC context to permit
members to contract around the fiduciary duty of loyalty and waive their right to petition a
court for dissolution.
Elf Atochem North America, Inc. v. Jaffari (Delaware, 1999)
Facts
Elf Atochem manufactured and distributed solvent-based maskants to the
aerospace and aviation industries throughout the world. Jaffari was the president
of Malek, Inc., and had developed an innovative, environmentally friendly
alternative to the solvent-based maskants. In order to stay compliant with EPA
regulations, Elf Atochem approached Jaffari with a proposal to invest in his
product, and both agreed to undertake a joint venture that was to be carried out
using a limited liability company as the vehicle. In October 1996, Malek, Inc filed a
Certificate of Formation in Delaware, which formed Malek LLC. In April 1998, Elf
sued Jaffari and Malek LLC individually and derivatively on behalf of Malek LLC.
Elf alleged that Jaffari breached his fiduciary duty to Malek LLC, pushed Malek
LLC to the brink of insolvency by withdrawing funds for personal use, interfered
with business opportunities, failed to make disclosures to Elf, and threatened to
make poor quality maskant and to violate environmental regulations. Elf also
alleged breach of contract, tortious interference with prospective business
relations, and (solely as to Jaffari) fraud. The trial court dismissed the action,
concluding, in part, that the Agreement governed the question of jurisdiction and
that only a court of law or arbitrator in California is empowered to decide these
claims.
Issue
(1) Whether the LLC Agreement is binding on its members and (2) whether the
forum selection provision is valid.
Holding (1) The Agreement is binding on the LLC as well as its members, and (2) since
the Act does not prohibit the members of the LLC from vesting exclusive subject
matter jurisdiction in arbitration proceedings (or court enforcement of arbitration) in
California to resolve disputes, the contractual forum selection provisions must
govern.
Analysis The Delaware LLC Act can be characterized as a “flexible statute” because it
generally permits members to engage in private ordering with substantial freedom
of contract to govern their relationship, provided they do not contravene any
mandatory provisions of the Act.
Freedom of Contract
- Section 18-1101(b) of the Act provides that “[i]t is the policy of [the Act] to
give the maximum effect to the principle of freedom of contract and to the
enforceability of limited liability company agreements.”
- In general, only where the agreement is inconsistent with mandatory
statutory provisions will the members’ agreement be invalidated
The Arbitration and Forum Selection Clauses in the Agreement
- In vesting the Court of Chancery with jurisdiction, the Act accomplished at
least three purposes: (1) it assured the Court of Chancery has jurisdiction
it might not otherwise have because it is a court of limited jurisdiction that
requires traditional equitable relief or specific legislation to act; (2) it
established the Court of Chancery as the default forum in the event the
members did not provide another choice of forum or dispute resolution
mechanism; and (3) it tends to center interpretive litigation in Delaware
courts with the expectation of uniformity.
-
Nevertheless, the arbitration provision of the Agreement in this case
fosters the Delaware policy favoring alternative dispute resolution
mechanisms, including arbitration.
Malek LLC’s Failure to Sign the Agreement
- Notwithstanding Malek LLC’s failure to sign the Agreement, Elf’s claims
are subject to the arbitration and forum selection clauses of the
Agreement. The Act is a statute designed to permit members flexibility in
entering into an agreement to govern their relationship. Therefore, Malek
LLC’s failure to sign the agreement does not affect the members’
agreement governing dispute resolution.
Elf’s Claims as Derivative Actions
- Although Delaware law allows for derivative suits against management of
an LLC, Elf contracted away its right to bring such an action in Delaware
and agreed instead to dispute resolution in California (per the forum
selection provision)
Elf also argues that the Act grants “special” jurisdiction to the Court of Chancery
over its claims for breach of fiduciary duty and removal of Jaffari, even though the
parties contracted to arbitrate all such claims in California.
- Elf is correct that §§18-110(a) and 18-111 vest jurisdiction with the Court
of Chancery in actions involving removal of managers and interpreting,
applying or enforcing LLC agreements respectively. Further, §18-1001
provides that a party may bring derivative actions in the Court of Chancery.
- Nevertheless, for the purpose of designating a more convenient forum, we
find no reason why the members cannot alter the default jurisdictional
provisions of the statute and contract away their right to file suit in
Delaware.
- Because the policy of the Act is to give maximum effect to the principle of
freedom of contract and to the enforceability of LLC agreements, the
parties may contract to avoid the applicability of §§18-110(a), 18-111, and
18-1001.
- Here, the parties contracted as clearly as practicable when they relegated
to California “any” dispute “arising out of, under or in connection with [the]
Agreement or the transactions contemplated by [the] Agreement.” And
Likewise, “n[o] action at law or in equity based upon any claim arising out
of or related to” the Agreement may be brought, except in California, and
then only to enforce arbitration in California.
- This conclusion is bolstered by the fact that Delaware recognizes strong
public policy in favor of arbitration.
Validity of Section 13.7 of the Agreement
- Elf argues that Section 13.7 of the Agreement violates §18-109(d).
- Assuming that, without deciding, that §18-109(d) relates to subject matter
jurisdiction and not merely in personam jurisdiction, it is permissive in that
it provides that the parties “may” agree to the non-exclusive jurisdiction of
the courts of a foreign jurisdiction or to submit to the exclusive jurisdiction
of Delaware. In general, the legislature’s use of “may” connotes the
voluntary, not mandatory or exclusive, set of options. The permissive
nature of §18-109(d) complements the overall policy of the Act to give
maximum effect to the parties’ freedom of contract.
- Although §18-109(d) fails to mention that the parties may agree to the
exclusive jurisdiction of a foreign jurisdiction, the Act clearly does not state
Ratio
that the parties must agree to either one of the delineated options for
subject matter jurisdiction.
Policy of the Delaware Act
- The basic approach of the Delaware Act is to provide members with
broad discretion in drafting the Agreement and to furnish default
provisions when the members’ agreement is silent
- The overall policy of the Act is to give maximum effect to the parties’
freedom of contract
Notes:
-
After Elf Atochem, Delaware amended Section 18-109(d).
Planning for the Limited Liability Company
Delaware LLCA §§101, 304, 306, 401-403, 503, 504, 505(c), 601-604, 1101, 1104
ULLCA §§110, 404, 407, 601
As noted in Elf Atochem, the Operating Agreement or Limited Liability Company Agreement is
the cornerstone of an LLC. At a minimum, the Operating Agreement should specify the basic
economic and management arrangements that will govern the firm. Additionally, the Operating
Agreement should specify the rules or processes that will determine how major changes in the
relationships between and among members and managers will take place and what rights exist
to exit from the relationship and withdraw invested capital. If the Operating Agreement is silent
on a key issue, then statutory default rules will govern.
Facts
Olson v. Halvorsen (Delaware 2009)
Olson was one of the founders of Viking Global, an investment management firm
and hedge fund. The defendants are the two other co-founders of Viking,
Halvorsen and Ott, and the various entities through which Viking conducted its
business.
Halvorsen, Olson and Ott all worked together at Tiger Management, a large hedge
fund. Eventually becoming dissatisfied with management, they left to form Viking.
In February 1999, the three met to discuss the formation of their new hedge fund
called Viking Global. At that meeting they orally agreed to the basic elements of
the business, including governance, investment strategy, compensation and
logistics. Specifically, regarding compensation, they agreed that the business
would pay out all profits annually (with Halvorsen receiving 55% and Olson and
Ott 22.5% each), and that if any member left Viking, they would be entitled only to
earned compensation and the balance of his capital account – rather than an
equity percentage of the total value of the business. Olson had created a
document summarizing these terms.
A few months later Viking was ultimately organized into three Delaware limited
liability companies (LLCs) (Performance, Investors, and Partners). Due to some
delays, the three founders in April 1999 signed only short-form agreements for
both Investors and Partners and later Performance, which were only skeletal and
did not contain all of the terms agreed upon at the February meeting (although,
they did include the agreed compensation issues). Olson continued to work with
counsel on the long-form agreements, but the drafting process eventually came to
a halt despite none of the founders signing any long-form agreements. As a result
of a potential dispute with an employee, the founders agreed to supersede the
shot-form agreement for Performance by signing a long-form LLC Agreement of
Viking Global LLC in September 1999, which provided that the Operating
Committed could remove members with or without cause while also reflecting the
same compensation provisions agreed to in the February meeting.
In mid-1999, Olson proposed a new compensation concept whereby upon
departure a founding member (or his estate) would be paid an earnout in addition
to the agreed-to compensation and capital account funds through another entity to
be called Founders. Halvorsen and Ott left the topic open to discussion but never
expressly agreed to the earnout compensation structure. Olsen instructed outside
counsel to draft an operating agreement for Founders including the earnout
arrangement. Various drafts were sent to Halverson and Ott, but they never read
or signed them. Olsen had the outside counsel file a certificate of formation for
Founders, and throughout several years funds were occasionally funneled through
the entity at Olsen’s direction. In 2001, Olson became dissatisfied with his
compensation and demanded that it be changed. After some negotiations, Olson,
Ott and Halvorsen came to a compromise whereby Halvorsen’s share decreased,
and the difference was reallocated to Olson. The founders did not discuss the
impact this change would have on the earnouts claims. However, both Ott and
Halvorsen testified that they agreed to increase Olson’s annual compensation only
and had no intention of altering his retirement benefits. The Court said that it was
logical to conclude that the original “cap and comp” agreement was still in place.
Founders was off the radar from 2001 to 2004, but Cahill, Viking’s president in
2003, discovered Founders in 2003 and placed the topic on the agenda for
management committee meetings from July 2004 to November 2004 (because he
was alarmed by and curious about the earnout provision). It was dismissed never
truly discussed at any meeting. In 2005, Olson decides to go on sabbatical, and
before returning to work he was officially dismissed from Viking. He was paid his
accrued compensation and his capital account balance, but he demanded in
addition that he receive an earnout (fair value for his ownership interest) as
provided in the Founders operating agreement. Halvorsen and Ott refused,
arguing that they had never agreed to that arrangement. Olsen sued Halverson,
Ott, and all the Viking entities, seeking the additional funds.
Issue
Whether Viking’s compensation policy was altered by the earnout policy that
Olson proposed for Founders.
Holding The evidence overwhelmingly shows that the three founders agreed that they
would each take only their accrued compensation and capital account balance
when they left Viking and that they never agreed to an alternative operating
agreement for Founders. Moreover, Investors and Partners were both governed
by signed short-form agreements that stated that a partner or member was
entitled only to his accrued compensation and capital upon departure. Thus,
Olson was only entitled to his accrued compensation and the balance of his
capital account.
Analysis Olson did not prove the existence of any superseding agreement that conflicted
with the defendants contention that they had agreed only to the compensation
policy of accrued compensation and remaining capital account balance.
Accordingly, Olson is not entitled to fair value for his ownership interest in any of
the Viking entities.
As set forth in the language of both statutes and in a number of Delaware cases,
Delaware law generally defers to the demonstrated agreement of the parties in the
limited partnership and limited liability company context.
-
Ratio
Both the DRULPA and the LLC Act expressly provde that it is the policy of
the act “to give the maximum effect to the principle of freedom of contract
and to the enforceability of [LLC/partnership] agreements.”
- Accordingly, if a valid enforceable agreement of the parties conflicts
with the fair value statute, the agreement of the parties will govern.
All the founders, including Olson, testified that they reached an oral agreement on
the core principles of Viking. These core principles, Olson admitted, included that
a departing member would take only his accrued compensation and capital
account balance when he left Viking – an agreement that conflicts with the fair
value statutes. The oral agreement as to Viking’s core principles was reached
before any of the Viking entities were formed and was intended to apply to Viking
as a whole. Thus, the original agreement governing the operation of each Viking
entity, including Founders, was the oral agreement regarding the company’s core
principles.
The Delaware Revised Uniform Limited Partnership Act (DRULPA) states that a
withdrawing partner is entitled to the fair value of his partnership interest “if not
otherwise provided in a partnership agreement.” Section 18-604 of the Delaware
LLC Act tracks this language and states that a resigning member is entitled to the
fair value of his membership interest “if not otherwise provided in a limited liability
company agreement.
Piercing the Veil
“Piercing the corporate veil” = imposing personal liability on shareholders
The “black letter” law of veil piercing is usually stated in broad generalities. However, most
courts would likely agree with the following:
-
“The separateness of the corporate entity is normally to be respected. However, a
corporation’s veil will be pierced whenever corporate form is employed to evade an
existing obligation, circumvent a statute, perpetuate fraud, commit a crime, or work an
injustice.”
The “Alter Ego” or “Instrumentality” Doctrine
-
-
-
Definition: a corporation, organization or other entity set up to provide a legal shield for
the party actually controlling the business activities under scrutiny
The alter ego doctrine is often called the instrumentality rule, which refers to situations
where the corporation is considered an instrument for the personal advantage of its
corporate affiliate, stockholders, directors, or officers.
When courts pierce the veil, they are ignoring the traditional separation of functions
carried out by a corporation’s shareholders, officers, and directors so as to hold them
personally liable for their actions.
Courts will also apply this remedy to LLCs in an attempt to reach members and
managers who might otherwise enjoy the protection that limited liability LLC structures
offer.
The Fletcher Test
Traditional factors determining when courts will pierce the veil (must find a combination of all 3
factors)
-
(1) The defendant shareholder dominated and controlled the corporation so that the
corporation had no mind of its own;
(2) The defendant used this control to commit fraud or wrong; and
(3) The control and breach of duty were the proximate cause of the plaintiff’s loss or
injury.
Courts are more likely to pierce the veil:
-
-
-
(1) Where the dispute involves the pursuit of tort claims as opposed to the enforcement
of contract rights
o Because contract claimants have an opportunity to bargaining with the
corporation, it has been asserted that courts should be more reluctant to pierce
the corporate veil in contract cases than in tort cases, where the injury party has
not consented to tortious conduct.
(2) Where the party hiding behind the veil is a corporation and not an individual
o Many commentators argue that courts should be more willing to pierce the
corporate veil to reach other corporations than to reach a real person
(3) Where the veil being pierced is that of a closely held corporation rather than one
whose shares are publicly traded
o Because most publicly held corporations are not effectively controlled by the
shareholders, it seems unlikely that courts would find it equitable or efficient to
hold such shareholders personally liable for a corporation’s debts.
Piercing the Corporate Veil to Reach Real Persons
Contract Cases
Facts
Consumer’s Co-op v. Olsen (Wisconsin, 1988)
ECO was incorporated by Chris Olsen in January 1980. There were 2200 shares
of common stock authorized, with 1,125 issued to Chris Olsen for $3,589 and the
remaining 1,075 to Jack and Nancy Olsen. Chris was the president and GM of
ECO. Jack was the treasurer and accountant, and Nancy was the secretary. Jack
and Chris both testified that the BOD met and conferred about 4 or 5 times a
week, but there existed a formal record only of the first meeting at which the
corporate officers were elected and another meeting where Chapter 11
bankruptcy reorganization was authorized. In 1977, Chris opened a personal
charge account with Consumer’s Co-op. This account was changed to a corporate
charge account shortly after ECO’s incorporation in 1980. Chris testified that no
personal charges were made on the corporate account and that abundant
measures were taken to assure that all corporate business was done in the
corporation’s name. By the end of 1981, ECO was in financial difficulties, with a
negative shareholder equity of $2,723.02. This grew to $62,815.60 at the end of
1982, $148,927.92 at the end of 1983, and finally to $189,362.26 at the end of
1984. No dividends were paid at any time. Throughout ECO’s existence,
Consumer’s Co-op had extended credit to ECO on an open account primarily for
the purchase of bulk fuel. Starting in June or July 1983, ECO failed to remain
current in the monthly payments. However, Consumer’s Co-op continued to
extend credit until March 1984, notwithstanding its policy to terminate credit after
sixty days and the fact that after charges become more than thirty days old, the
monthly statements of account explicitly stated that “additional credit cannot be
extended until your account is brought current.” There was no evidence that
corporate funds were used to pay persona expenses, but there was ample
evidence that substantial personal assets were used to subsidize the operation of
the corporation in the form of unprofitable leasing and foregone salaries and rent.
The trial court entered judgment for Co-op, finding this case to be an “appropriate
case to pierce the corporate veil.”
Issue
Whether ECO was adequately capitalized at its inception and whether Consumer
Co-op waived its right to challenge the sufficiency of its capitalization.
Holding In view of the fact that ECO commenced business as a part-time operation, the
initial stated capital was not “obviously insufficient.” Thus, to the extent that
“control” may have been exercised under the first prong of an instrumentality
analysis, because no “injustice” was created by an inadequacy of initial
capitalization, the corporate veil must not be pierced.
- Finally, the issue of whether the change in the size and nature of the
corporation was of such significant as to require an increase in
capitalization was not reached; Consumer Co-op is precluded from
asserting any claim as to subsequent undercapitalization as a factor
constituting an “injustice” justifying disregard of the separate legal entity of
the corporation on both the grounds of waiver and estoppel.
Analysis Fundamental premise implicated with respect to the imposition of personal liability
on shareholders for corporate debts: “By legal fiction the corporation is a separate
entity and is treated as such under all ordinary circumstances.”
- Notwithstanding the unwavering adherence to the general principle of
shareholder nonliability, there exists exceptions justifying, metaphorically,
the “piercing of the corporate veil” or, “disregarding the corporate fiction.”
Concept of minimally adequate level of capitalization:
- Inadequate capitalization may be a factor relevant to whether an injustice
is present sufficient to justify piercing the corporate veil in a contract case.
The volitional nature of a contractual relationship presents a cognizable
distinction between contract and tort cases; however, this distinction is
more appropriately recognized as one which may justify the application of
the doctrines of estoppel and waiver than as to preclude the invocation of
the equitable remedy of piercing the corporate veil in a contract case.
- Whether a contractual relationship is truly one in which a creditor
had the opportunity to investigate the capital structure of a debtor
and knowingly failed to exercise the right to investigate before
extending credit, such that the creditor should be precluded from
piercing the corporate veil, should be decided with respect to the
particular facts of each case rather than by the denial to all contract
creditors of resort to this equitable remedy by a presumption of an
“assumption of risk.”
- While significant, undercapitalization is not an independently
sufficient ground to pierce the corporate veil. In order for the
corporate veil to be pierced, in addition to undercapitalization,
additional evidence of failure to follow corporate formalities or other
evidence of pervasive control must be shown
- Both inadequate capitalization and disregard of corporate formalities
are significant to a determination of whether the corporation has a
separate existence such that shareholders can claim the
accoutrement of incorporation: nonliability for corporate debts.
Determination of piercing the corporate veil must be flexible: “it is a
combination of factors which, when taken together with an element
of injustice or abuse of corporate privilege, suggest that the
corporate entity attacked had “no separate mind, will or existence of
its own” and was therefore the “mere instrumentality or tool” of the
[shareholder].”
Facts at issue here:
- The respondent has failed to persuade the court that corporate formalities
were so egregiously ignored, or that control so pervasively exercised, such
as to constitute a situation where recognition of “the corporate fiction would
accomplish some fraudulent purpose, operate as a constructive fraud, or
defeat some strong equitable claim…”
- The initial capitalization of over $7,000 was not, and could not be
reasonably viewed as, an obvious inadequacy of capital as measured by
the slight size of the initial undertaking.
- Moreover, the circumstances were indicative of Consumer Co-op’s waiver
of its right: evidence indicating that commencing in June or July, ECO
failed to remain current in its monthly payments on its open account and
Consumer nevertheless continued to extend credit – this permitted ECO to
become further indebted, and no personal guarantee was requested.
Additionally, Consumer Co-op had the opportunity to investigate the capital
foundations of ECO but did not, and knew, given the delinquency of ECO’s
account, that ECO’s business was failing. Thus, by continuing to extend
credit, notwithstanding and in contravention of its own policy,
Consumer Co-op waived the right to claim inadequacy of
capitalization as a basis to pierce the corporate veil. The same case
can be made for estoppel.
The adequacy of capital is to be measured as of the time of formation of the
corporation. A corporation that was adequately capitalized when formed but
which subsequently suffers financial reverses is not undercapitalized.
However, inquiry may be made beyond that at inception when the
corporation distinctly changes the nature or magnitude of its business.
- Standard for sufficient capitalization: a corporation is undercapitalized
when there is an “obvious inadequacy of capital, ‘measured by the nature
and magnitude of the corporate undertaking.’”
-
Ratio
Facts
K.C. Roofing Center v. On Top Roofing, Inc. (Missouri 1991)
KCRC and Lumberman’s Mutual Wholesale filed suit against On Top Roofing and
Russell and Carol Nugent to recover damages for unpaid roofing supplies
delivered to On Top.
Russell and Carol Nugent were the sole shareholders, officers and directors of On
Top. The Nugent’s continued operation of On Top until it went out of business in
1987. At this point, they incorporated RNR, Inc., in which they were sole
shareholders, officers and directors. RNR went out of business in 1988 and the
Nugent’s incorporated RLN Construction, which again, they were sole
shareholders, directors and officers. RLN went out of business in 1989, and they
incorporated Russell Nugent, Inc. which is the current corporation owned by
Russell, who is the sole director. Each of the corporations had the same address
and telephone number. From April through August 1987, KCRC advanced
$45,000 in roofing supplies to On Top. When On Top failed to pay, KCRC sued
both On Top and the Nugents. On Top ordered 1,360 rolls of shakeliner from
Lumberman on November 25, 1987 at a cost of $7,367.77 and was unable to pay.
Lumberman got a default judgment. Unable to collect Lumberman also sued to
pierce the corporate veil. Russell testified that he defaulted against Lumberman as
On Top was no longer in business and the delivery was taken by his successor
corporation and the judgment was against the wrong corporation. Russell
admitted he was having trouble paying trade debts and only paid secured
creditors who had personal guarantees or loans against his house. The corporate
income tax return showed the Nugents’ getting $100,000 in salaries in 1986. The
Nugents’ also owned the building and made the corporations they owned pay rent
of $99,200 in 1986. The trial court found that On Top purchased supplies from
Plaintiffs knowing that it owed almost $100,000 to other suppliers that it could not
pay. Russell testified that he had five different roofing companies in five years and
that every time he needed a fresh start, he would close down one company and
open another. In October 1987, the Nugents sold all the assets of On Top to a
company they owned. Once On Top stopped doing business, Russell still used
the same phone and signs as late as of 1989 with very small d.b.a. designations
that could hardly be seen. The trial court found that Russell exercised total control
of On Top. The court found that Carol was not an active participant and that it
would be improper to pierce the veil for her personal assets. Plaintiffs prevailed
against Russell, who appealed.
Issue
Holding
There was substantial evidence that Russell Nugent was in control in the form of
complete domination; the evidence also suggested that Russel was operating an
intricate corporate shell game, using it for unfair or inequitable purpose of avoiding
debts to plaintiffs.
It would be unfair, unjust or inequitable to allow Nugent to hide behind the
corporate shield and avoid his legal obligations to plaintiffs. Accordingly, the trial
court did not err in piercing the corporate veil and holding Russell Nugent
personally liable for the debts owed to plaintiffs.
Analysis A court may pierce the corporate veil or disregard the separate legal entity of the
corporation and the individual where the separateness is used as a subterfuge to
defraud a creditor. But actual fraud is not necessarily a predicate for piercing the
corporate veil; it may also be pierced to prevent injustice or inequitable
consequences.
Ratio
Court will pierce the corporate veil or disregard the corporate entity once a plaintiff
shows:
- “(1) Control – not mere majority or complete stock control, but complete
domination, not only of finances, but of policy and business practice in
respect to the transaction attacked so that the corporate entity as to this
transaction had at the time no separate mind, will or existence of its own
- (2) Such control must have been used by the defendant to commit fraud or
wrong, to perpetrate the violation of a statutory or other positive legal duty,
or dishonest and unjust act in contravention of plaintiff’s legal rights;
- (3) The aforesaid control and breach of duty must proximately cause the
injury or unjust loss complained of.”
“Where a corporation is used for an improper purpose and to perpetrate injustice
by which it avoids its legal obligations, ‘equity will step in, pierce the corporate vail
and grant appropriate relief.’”
It's proper for a court to pierce the corporate veil of a corporation and hold
shareholders personally liable for injury caused to a plaintiff if the owners:
(1) Maintained complete control of the entity’s business practices so as to
render the corporation functionless; and
(2) Utilized their control over business functions in order to violate a plaintiff’s
legal rights.