Business Organizations Course Outline James Sinton 7/11/2023 BUSINESS ORGANIZATIONS Agency ................................................................................................................................................................................................... 9 A. Creation of the agency relationship ........................................................................................................................................... 9 1. Defining agency. ...................................................................................................................................................................... 9 a. Consent................................................................................................................................................................................ 9 b. On behalf of ........................................................................................................................................................................ 9 c. Control................................................................................................................................................................................. 9 2. Distinguishing agency from other relationships. ................................................................................................................... 9 a. Agency v. Gratuitous Bailment ........................................................................................................................................... 9 b. Agency v. Creditor-Debtor relationship ............................................................................................................................. 9 C. Liability from the agency relationship ....................................................................................................................................... 9 1. Tort liability from the agency relationship. .......................................................................................................................... 10 a. Distinguishing between servants and independent contractors. ..................................................................................... 10 b. Liability for the torts of servants. ...................................................................................................................................... 10 c. Liability for the torts of independent contractors. ........................................................................................................... 10 2. Contract liability from the agency relationship. ................................................................................................................... 10 a. Liability of the principal to the third party ....................................................................................................................... 10 (1) Actual authority ........................................................................................................................................................... 11 (2) Apparent authority ...................................................................................................................................................... 11 (3) Inherent authority ....................................................................................................................................................... 11 (4) Estoppel ........................................................................................................................................................................ 12 (5) Ratification................................................................................................................................................................... 12 (6) Summary ...................................................................................................................................................................... 12 b. Liability of the third party to the principal ...................................................................................................................... 12 c. Liability of the agent to the third party ............................................................................................................................. 12 D. Duties of the agent and the principal to each other ............................................................................................................... 13 1. The agent’s duties to the principal. ...................................................................................................................................... 13 2. The principal’s duties to the agent. ...................................................................................................................................... 13 E. Termination of the agent’s power ............................................................................................................................................ 14 The Partnership .................................................................................................................................................................................. 15 Choice of law .................................................................................................................................................................................. 15 A. Formation.................................................................................................................................................................................. 15 1. Partnership v. Other relationships........................................................................................................................................ 15 Martin v. Peyton ..................................................................................................................................................................... 15 Lupien v. Malsbenden ............................................................................................................................................................ 15 Elements of a partnership ...................................................................................................................................................... 15 2. Liability of Purported Partner ............................................................................................................................................... 15 3. Aggregate v. Entity Status ...................................................................................................................................................... 16 Fairway Development Co. ...................................................................................................................................................... 16 4. Federal Tax Consequences ................................................................................................................................................... 16 B. Management and Control ........................................................................................................................................................ 16 Internal conflict on ordinary business matters .......................................................................................................................... 16 Summers v. Dooley................................................................................................................................................................. 17 National Biscuit Co. v. Stroud ............................................................................................................................................... 17 C. Financial rights and obligations ............................................................................................................................................... 17 1. Partnership accounting ......................................................................................................................................................... 17 Capital accounts. .................................................................................................................................................................... 17 Draw........................................................................................................................................................................................ 18 Capital account and interest in partnership. ........................................................................................................................ 18 2. Sharing profits and losses ...................................................................................................................................................... 18 a. Contributions, profits, losses ............................................................................................................................................ 18 Schymanski ............................................................................................................................................................................. 18 -1- Business Organizations Course Outline James Sinton 7/11/2023 Kessler ..................................................................................................................................................................................... 18 b. Not entitled to remuneration for services ........................................................................................................................ 19 c. Indemnification ................................................................................................................................................................. 19 3. Liability to third parties......................................................................................................................................................... 19 a. Liability in Contract .......................................................................................................................................................... 19 b. Liability in Tort ................................................................................................................................................................. 20 Sheridan v. Desmond 188................................................................................................................................................ 20 c. Enforcing partnership liabilities against partners ............................................................................................................. 20 4. Indemnity and contribution ................................................................................................................................................. 20 D. Ownership interests and transferability ................................................................................................................................... 21 1. Partnership property............................................................................................................................................................... 21 2. Admitting versus Assigning ................................................................................................................................................... 21 3. The rights of a partner’s creditors .......................................................................................................................................... 21 Step 1: Charging order .......................................................................................................................................................... 22 Step 2: Foreclosure ................................................................................................................................................................ 22 Arguments against foreclosure 210................................................................................................................................... 22 E. Fiduciary Duties ........................................................................................................................................................................ 22 1. The common law ................................................................................................................................................................... 22 Meinhard v. Salmon 216 ................................................................................................................................................. 22 2. Fiduciary duty and contractual waiver .................................................................................................................................. 23 Eliminating or modifying the duties ...................................................................................................................................... 23 Singer v. Singer 227 ....................................................................................................................................................... 23 Modifying the duties: §103(b) .......................................................................................................................................... 23 3. The Duty of Loyalty ............................................................................................................................................................... 23 Enea v. Superior Court 233 ............................................................................................................................................ 23 Relaxing the strictures on self-dealing ................................................................................................................................... 23 Fairness defense ...................................................................................................................................................................... 24 4. The Duty of Disclosure ......................................................................................................................................................... 24 Common law .......................................................................................................................................................................... 24 An affirmative obligation to disclose (without demand) ...................................................................................................... 24 Obligation to disclose (with demand) .................................................................................................................................... 24 Texas ....................................................................................................................................................................................... 24 5. The Duty of Care .................................................................................................................................................................. 24 6. A partner’s remedies against other partners ......................................................................................................................... 24 Can a partner sue the partnership before dissolution? ......................................................................................................... 24 Accounting action .................................................................................................................................................................. 24 F. Dissociation and Dissolution .................................................................................................................................................... 25 1. Partner Dissociation .............................................................................................................................................................. 25 Step 1: Has the partner dissociated? ................................................................................................................................ 25 Step 2: Was the dissociation wrongful? Is it a partnership at will or for term? ............................................................ 25 Step 3: Does the dissociation result in a buyout or dissolution? .................................................................................... 25 Events that result in dissociation ........................................................................................................................................... 25 Wrongful dissociation ............................................................................................................................................................ 25 Does the dissociation cause dissolution? ............................................................................................................................... 25 2. Buying out dissociated partners ............................................................................................................................................ 26 3. Partnership Dissolution ........................................................................................................................................................ 26 Partnerships at will ................................................................................................................................................................. 26 Partnerships at term ............................................................................................................................................................... 26 Other events that can dissolve the partnership ..................................................................................................................... 26 Unlawful to continue the partnership business .................................................................................................................... 27 Partner seeks judicial dissolution ........................................................................................................................................... 27 Transferee seeks judicial dissolution ..................................................................................................................................... 27 Drashner v. Sorenson 279 ................................................................................................................................................ 27 4. Consequences of dissolution ................................................................................................................................................ 27 -2- Business Organizations Course Outline James Sinton 7/11/2023 The Corporation ................................................................................................................................................................................. 29 A. Introduction .............................................................................................................................................................................. 29 1. Comparing it with the partnership ....................................................................................................................................... 29 2. Choosing a state of incorporation ........................................................................................................................................ 29 The Internal Affairs Doctrine (Choice of law rule) ............................................................................................................. 30 B. Formation .................................................................................................................................................................................. 30 1. Incorporation and its aftermath ........................................................................................................................................... 30 Articles of incorporation ........................................................................................................................................................ 30 Organizational meeting .......................................................................................................................................................... 30 Bylaws...................................................................................................................................................................................... 30 Annual meeting of shareholders ............................................................................................................................................ 31 2. Financing the corporation .................................................................................................................................................... 31 Subscription agreement .......................................................................................................................................................... 31 Common shares ..................................................................................................................................................................... 31 Preferred shares ...................................................................................................................................................................... 31 Mandatory .......................................................................................................................................................................... 31 Cumulative ......................................................................................................................................................................... 31 Participating........................................................................................................................................................................ 31 Convertible ......................................................................................................................................................................... 31 Debt ........................................................................................................................................................................................ 32 Priority of corporate finance .................................................................................................................................................. 32 3. Preemptive rights ................................................................................................................................................................... 32 Opt-in preemptive rights ........................................................................................................................................................ 32 Opt-out preemptive rights ...................................................................................................................................................... 32 4. Promoters’ contracts .............................................................................................................................................................. 32 5. Defective incorporation ........................................................................................................................................................ 32 a. De jure corporation ........................................................................................................................................................... 32 b. De facto corporation ......................................................................................................................................................... 32 Cantor v. Sunshine Greenery, Inc. 306............................................................................................................................. 32 De facto corporation test. .................................................................................................................................................. 33 Argument against finding a de fact corporation. .............................................................................................................. 33 d. Corporations by estoppel (Purported corporation) ......................................................................................................... 33 e. Comparing the protections of each .................................................................................................................................. 33 f. Statutory protections .......................................................................................................................................................... 33 6. Ultra Vires Doctrine ............................................................................................................................................................. 34 C. Management and Operation .................................................................................................................................................... 34 1. Allocation of Power ............................................................................................................................................................... 34 Directors ................................................................................................................................................................................. 34 Charlestown Boot & Shoe Co. v. Dunsmore 327 ............................................................................................................... 34 A director’s informational rights ....................................................................................................................................... 34 Special meeting ....................................................................................................................................................................... 34 Shareholder action without a meeting .................................................................................................................................. 34 Shareholder quorum .............................................................................................................................................................. 35 Removal of Directors ............................................................................................................................................................. 35 Vacancies on the board .......................................................................................................................................................... 35 2. Interference with the Shareholder Franchise ....................................................................................................................... 35 3. Formalities required for board action .................................................................................................................................. 35 Board vote without quorum .................................................................................................................................................. 36 Gearing v. Kelly 342 ......................................................................................................................................................... 36 Tomlinson .............................................................................................................................................................................. 36 Deadlocked board .................................................................................................................................................................. 36 4. Authority of officers .............................................................................................................................................................. 36 President ................................................................................................................................................................................. 36 Lee v. Jenkins Brothers 345 ............................................................................................................................................ 36 Vice president ......................................................................................................................................................................... 36 -3- Business Organizations Course Outline James Sinton 7/11/2023 Secretary .................................................................................................................................................................................. 36 Treasurer ................................................................................................................................................................................. 37 5. Shareholder action ................................................................................................................................................................ 37 a. Formalities required for shareholder action ..................................................................................................................... 37 b. Straight v. Cumulative Voting .......................................................................................................................................... 37 Straight voting .................................................................................................................................................................... 37 Cumulative voting .............................................................................................................................................................. 37 Number of shares needed .................................................................................................................................................. 38 Number of directors ........................................................................................................................................................... 38 Classified board. §141(d) ................................................................................................................................................... 38 c. Informational rights .......................................................................................................................................................... 38 Getting access to the books and records ........................................................................................................................... 38 Proper purpose ................................................................................................................................................................... 39 Skouras v. Admiralty Enterprises, Inc. 359 ....................................................................................................................... 39 Alternative .......................................................................................................................................................................... 39 D. Altering corporate norms by contract ...................................................................................................................................... 39 1. Voting agreements ................................................................................................................................................................. 39 Ringling Bros. v. Ringling 366........................................................................................................................................ 39 2. Self-enforcing voting mechanisms ........................................................................................................................................ 39 a. Irrevocable proxies ............................................................................................................................................................. 39 b. Voting trusts ...................................................................................................................................................................... 40 c. Classified voting................................................................................................................................................................. 40 3. Controlling the board’s discretion ....................................................................................................................................... 41 a. Statutory requirements ...................................................................................................................................................... 41 b. Common-law summary ..................................................................................................................................................... 41 McQuade v. Stoneham 380 ........................................................................................................................................... 41 Clark v. Dodge 384........................................................................................................................................................ 41 Galler ................................................................................................................................................................................... 41 Long Park ............................................................................................................................................................................. 42 4. Voting requirements ............................................................................................................................................................. 42 Supporting supermajority or unanimous vote: ..................................................................................................................... 42 Opposing supermajority or unanimous vote: ........................................................................................................................ 42 Frankino v. Gleason 388 .................................................................................................................................................. 42 5. Share transfer restrictions ..................................................................................................................................................... 42 Allen v. Biltmore Tissue Corp. 392 ................................................................................................................................. 42 (1) First-option agreements ................................................................................................................................................... 42 (2) First-refusal agreements.................................................................................................................................................... 43 (3) Consent agreements......................................................................................................................................................... 43 (4) Buy-sell agreements .......................................................................................................................................................... 43 (5) Prohibiting transfers to designated persons .................................................................................................................... 43 (6) Preserving a legal advantage ............................................................................................................................................. 43 5. Statutory Close Corporations ............................................................................................................................................... 43 Formation ............................................................................................................................................................................... 43 Special rules ............................................................................................................................................................................ 43 E. Limited liability and piercing the corporate veil ...................................................................................................................... 43 Justifications for limited liability ................................................................................................................................................ 43 The piercing veil factors ............................................................................................................................................................. 44 (1) Inadequate economic capitalization ................................................................................................................................ 44 How do you measure the inadequacy of economic capitalization? .................................................................................. 44 When to measure? .............................................................................................................................................................. 44 (2) Siphoning off profits ........................................................................................................................................................ 44 (3) Corporate formalities ....................................................................................................................................................... 44 (4) Unfairness or injustice ..................................................................................................................................................... 45 Horizontal piercing theory ..................................................................................................................................................... 45 Vertical piercing ..................................................................................................................................................................... 45 -4- Business Organizations Course Outline James Sinton 7/11/2023 1. 2. 3. 4. 5. Tort cases ............................................................................................................................................................................... 45 Contract cases ........................................................................................................................................................................ 45 Fraudulent transfers 419 .................................................................................................................................................. 46 Parent-subsidiary cases ........................................................................................................................................................... 46 Reverse piercing ..................................................................................................................................................................... 46 Judgment against the shareholder ......................................................................................................................................... 46 Reverse piercing defined. ....................................................................................................................................................... 46 F. Fiduciary duty ............................................................................................................................................................................ 47 The Business Judgment Rule ..................................................................................................................................................... 47 Litigation roadmap ................................................................................................................................................................. 47 Standards of review ................................................................................................................................................................ 47 Justifications for the BJR ........................................................................................................................................................ 48 (1) Good faith ........................................................................................................................................................................ 48 (2) Reasonable business process ............................................................................................................................................ 48 Standard of Care ................................................................................................................................................................ 48 Smith v. Van Gorkom 475 ............................................................................................................................................. 48 §144(e) Statutory protection .............................................................................................................................................. 48 Shareholder voting protection ........................................................................................................................................... 49 (3) Conflict of interest transactions ....................................................................................................................................... 49 Who is an interested party? ................................................................................................................................................ 49 Cookies Food Products, Inc. 498 .................................................................................................................................... 49 Marciano v. Nakash 507 ............................................................................................................................................... 49 The corporate opportunity doctrine .................................................................................................................................. 49 Northeast Harbor Golf Club, Inc. v. Harris 517................................................................................................................ 49 ALI § 5.05........................................................................................................................................................................... 49 Executive compensation..................................................................................................................................................... 50 Wilderman v. Wilderman 541 ........................................................................................................................................ 50 De facto dividends.............................................................................................................................................................. 50 §144(a) Statutory Curative Measures ................................................................................................................................ 51 (4) Rational business purpose ............................................................................................................................................... 51 (5) Entire Fairness Standard ................................................................................................................................................. 51 Fair dealing ......................................................................................................................................................................... 51 Fair price ............................................................................................................................................................................. 51 (6) Duty to disclose ................................................................................................................................................................ 51 1. Duty of Care .......................................................................................................................................................................... 52 a. Oversight context................................................................................................................................................................ 52 Standard of care ................................................................................................................................................................. 52 Subjective standard ............................................................................................................................................................ 52 Inside versus outside directors ........................................................................................................................................... 52 Causation............................................................................................................................................................................ 52 Francis v. United Jersey Bank 451 ................................................................................................................................... 52 b. Decision-making context ................................................................................................................................................... 52 2. Duty of Loyalty ...................................................................................................................................................................... 52 Waste Doctrine....................................................................................................................................................................... 53 3. Duties of controlling shareholders ....................................................................................................................................... 53 Who is a controlling shareholder? ......................................................................................................................................... 53 4. Protections available to D/Os ............................................................................................................................................... 53 a. Exculpation statutes........................................................................................................................................................... 53 (1) DGCL charter option statutes .................................................................................................................................... 53 (2) Self-executing statutes .................................................................................................................................................. 53 (3) Cap on money damages ............................................................................................................................................... 54 b. Indemnification .................................................................................................................................................................. 54 c. Insurance............................................................................................................................................................................ 54 G. Dissension in the closely held corporation.............................................................................................................................. 54 1. Deadlock ................................................................................................................................................................................ 54 -5- Business Organizations Course Outline James Sinton 7/11/2023 2. Oppression ............................................................................................................................................................................ 54 a. Protection through Contract ............................................................................................................................................ 55 Does a contract eliminate or alter the oppression doctrines? ........................................................................................... 55 Does the suit for dissolution represent a stock buy-back?................................................................................................. 55 b. Protection in the absence of Contract.............................................................................................................................. 55 (1) Breach of fiduciary duty ................................................................................................................................................... 55 Wilkes Litigation Roadmap ................................................................................................................................................ 55 Checklist ............................................................................................................................................................................. 56 Defining Wilkes’s litigation roadmap ................................................................................................................................. 56 Traditional/General rights of a shareholder ..................................................................................................................... 56 Non-traditional/Specific rights of a shareholder .............................................................................................................. 56 Employment-at-will doctrine .............................................................................................................................................. 57 Cases ....................................................................................................................................................................................... 57 Donahue v. Rodd Electrotype Co. Supp 15 ........................................................................................................................ 57 Wilkes v. Springside Nursing Home, Inc. Supp 31 ............................................................................................................... 57 Merola v. Exergen Corp. Supp 40 .................................................................................................................................... 57 Economic theory on dividends .............................................................................................................................................. 58 (2) Dissolution for Oppressive conduct................................................................................................................................ 58 Kemp Litigation Roadmap ................................................................................................................................................. 58 Checklist ............................................................................................................................................................................. 58 Defining Kemp’s dissolution for oppression...................................................................................................................... 58 Reasonable expectations .................................................................................................................................................... 59 50% ownership................................................................................................................................................................... 59 In re Kemp & Beatley, Inc. Supp 44 ............................................................................................................................... 59 De facto dividends .................................................................................................................................................................. 59 (3) No special rules ................................................................................................................................................................ 60 Rationales for not adopting special rules ........................................................................................................................... 60 Rationales for adopting special rules ................................................................................................................................. 60 Nixon v. Blackwell Supp 56 ........................................................................................................................................... 60 3. Dissolution in general ........................................................................................................................................................... 60 Voluntary dissolution ............................................................................................................................................................. 60 Involuntary dissolution .......................................................................................................................................................... 60 Administrative dissolution ..................................................................................................................................................... 60 Common-law powers to dissolve............................................................................................................................................ 60 The Limited Partnership .................................................................................................................................................................... 62 Linkage. ........................................................................................................................................................................................... 62 A. Formation.................................................................................................................................................................................. 62 B. Management and Operation .................................................................................................................................................... 62 General partners ......................................................................................................................................................................... 62 Limited partners ......................................................................................................................................................................... 62 Management rights ................................................................................................................................................................. 62 Agency authority ..................................................................................................................................................................... 62 Voting rights ........................................................................................................................................................................... 63 Removing a partner ................................................................................................................................................................ 63 Equitable power to remove a general partner ....................................................................................................................... 63 Inspection and information rights ......................................................................................................................................... 63 C. Financial Rights and Obligations ............................................................................................................................................. 63 Distributions, profits, and losses ................................................................................................................................................ 63 Creditors ..................................................................................................................................................................................... 63 Winding up................................................................................................................................................................................. 63 D. Entity Status .............................................................................................................................................................................. 63 E. Limited Liability ........................................................................................................................................................................ 64 Name in the partnership! ........................................................................................................................................................... 64 1. The control rule..................................................................................................................................................................... 64 -6- Business Organizations Course Outline James Sinton 7/11/2023 What amounts to taking part in the control of the business? .............................................................................................. 64 ULPA (1916) §7 ..................................................................................................................................................................... 64 RULPA (1976) §303(a) .......................................................................................................................................................... 64 RULPA (1985) §303(a) .......................................................................................................................................................... 64 Statutory safe-harbors ............................................................................................................................................................. 65 Holzman v. De Escamilla 799 ......................................................................................................................................... 65 2. Control of the entity general partner ................................................................................................................................... 67 Corporate general partners of limited partnerships .............................................................................................................. 67 Liability of limited partners.................................................................................................................................................... 67 Defense as a limited partner in RULPA ................................................................................................................................ 67 Initial concerns ....................................................................................................................................................................... 67 F. Fiduciary Duties ......................................................................................................................................................................... 68 1. General partners .................................................................................................................................................................... 68 2. Limited Partners .................................................................................................................................................................... 68 RULPA ................................................................................................................................................................................... 68 Partnership agreement creates a fiduciary duty ................................................................................................................. 68 Confidential relationship creates a fiduciary duty ............................................................................................................ 68 ULPA ...................................................................................................................................................................................... 68 G. Exit rights: Dissociation and dissolution ................................................................................................................................ 69 1. Dissociation ........................................................................................................................................................................... 69 RULPA ................................................................................................................................................................................... 69 ULPA ...................................................................................................................................................................................... 69 2. Dissolution ............................................................................................................................................................................ 69 The Limited Liability Partnership ...................................................................................................................................................... 70 A. Formation.................................................................................................................................................................................. 70 Capital contribution or Liability insurance ............................................................................................................................... 70 Converting General Partnership to LLP ................................................................................................................................... 70 Registration fees.......................................................................................................................................................................... 70 B. Limited Liability ........................................................................................................................................................................ 70 Approaches to limited liability ................................................................................................................................................... 70 Supervisory liability ................................................................................................................................................................ 70 RUPA §306(c) ........................................................................................................................................................................ 71 Utah’s approach ..................................................................................................................................................................... 71 Comparing the LLP to other organizations ............................................................................................................................... 71 Piercing theories ......................................................................................................................................................................... 71 Partnership default rules and Limited liability .......................................................................................................................... 71 Management rights ................................................................................................................................................................. 71 Profit sharing .......................................................................................................................................................................... 71 Admitting new partners ......................................................................................................................................................... 72 Kus v. Irving Supp 80............................................................................................................................................................ 72 The Limited Liability Limited Partnership ............................................................................................................................................ 73 General partner............................................................................................................................................................................... 73 Limited partner ............................................................................................................................................................................... 73 Control Rule ............................................................................................................................................................................... 73 The Limited Liability Company ......................................................................................................................................................... 74 Judicial interpretation ..................................................................................................................................................................... 74 Formation ....................................................................................................................................................................................... 74 Operating agreement .................................................................................................................................................................. 74 Role of Contract ......................................................................................................................................................................... 74 Management and operation ........................................................................................................................................................... 74 General governance .................................................................................................................................................................... 74 Removing a manager .............................................................................................................................................................. 75 Agency authority ......................................................................................................................................................................... 75 -7- Business Organizations Course Outline James Sinton 7/11/2023 Apparent Authority ................................................................................................................................................................ 75 Information and Inspection rights............................................................................................................................................. 75 Financial Rights and Obligations ................................................................................................................................................... 75 Classes of ownership .................................................................................................................................................................. 75 Entity Status .................................................................................................................................................................................... 75 Limited Liability.............................................................................................................................................................................. 75 Piercing the veil .......................................................................................................................................................................... 76 Fiduciary duties ............................................................................................................................................................................... 76 -8- Business Organizations Agency James Sinton 7/11/2023 1. Doty volunteered the use of her car for transporting some of the football players on the condition that Russell Garst drive the car. 2. Garst got into an accident. He was killed, and Richard Gorton was injured. 3. Gorton sued Doty to recover for his son’s injuries. Gorton said that Garst was acting as Doty’s agent when the accident happened. 4. The jury return a verdict for Gorton. Analysis of Gorton: 1. Consent? Yes, Doty volunteered the car and Garst drove it. 2. Control? Yes, Doty instructed Garst to be the sole driver of her car. 3. On behalf of Doty? No, volunteering her car benefited the school, Garst, and the players. It provided no tangible benefit to Doty. The dissent relied on this aspect of Gorton to say that it was a gratuitous bailment. Agency A. Creation of the agency relationship 1. Defining agency. R 2d of Agency § 1, defines agency as Fiduciary relationship which results from the manifestation of consent by one person to another that the other shall act on his behalf and subject to his control, and consent by the other so to act. The fiduciary duty is the highest duty the law can impose Agent: person who is acting for another Principal: person for whom the agent is acting Elements of agency relationship) 1. Consent by the principal and the agent 2. Action by the agent on behalf of the principal 3. Control by the principal b. Agency v. Creditor-Debtor relationship a. Consent 1. both the principal and the agent must consent to the agent acting on the principal’s behalf and subject to the principal’s control 2. the consent must be manifested in writing, orally, or by implication. 3. Technically you need consent to have the other two elements. b. On behalf of 1. the agent must be acting primarily for the benefit of the principal 2. the agent does not have to be acting exclusively for the principal c. Control 1. the agent must act subject to the principal’s control 2. the degree of control does not have to be significant 3. Hair-trigger It may be found simply by the principal specifying the task the agent should perform. A. Gay Jenson Farms Co. v. Cargill, Inc. A lender was deemed to be the principal and the borrower as the agent. The lender was responsible for all the debts of the borrower. Defining a creditor: A creditor who assumes control of his debtor’s business for the mutual benefit of himself and his debtor, may become a principal, with liability for the acts and transactions of the debtor in connection with the business. Affirmative control: transactions. the power to initiate or direct Negative or Passive control: the power to limit, block, or veto conduct that is initiated by others. When a debtor is attempting to generate income for itself, it is primarily operating for its own benefit rather than for the benefit of another. 2. Distinguishing agency from other relationships. Agency is the relationship where one party tells another to act on his behalf and act subject to his control. a. Agency v. Gratuitous Bailment C. Liability from the agency relationship Gorton v. Doty -9- Business Organizations Agency James Sinton 7/11/2023 What liability is created when an agent interacts with a 3dparty? direction of the employer or by a specialist without supervision; 4. the skill required in the particular occupation; 5. whether the employer or the workman supplies the instrumentalities, tools, and the place of work for the person doing the work; 6. the length of time for which the person is employed; 7. the method of payment, whether by the time or by the job; 8. whether or not the work is a part of the regular business of the employer; 9. whether or not the parties believe they are creating the relation of master and servant; AND 10. whether the principal is or is not in business. 1. Tort liability from the agency relationship. General rule: The principal is liable for the agent’s torts while the agent is acting in the scope of employment a. Distinguishing between servants and independent contractors. Two defenses: 1. She was not an employee but an independent contractor 2. She was an employee but working outside of the scope of her employment Master: a principal who employs an agent to perform service in his affairs and who controls or has the right to control the physical conduct of the other in the performance of the service. b. Liability for the torts of servants. Servant: an agent employed by a master 3d R simply defines 1. agent as employee 2. independent contractor as nonemployee Principal’s liability only applies to actions within the scope of agent’s employment. Scope of employment A servant’s conduct is within the scope of employment “if, but only if 1. it is of the kind he is employed to perform; 2. it occurs substantially within the authorized time and space limits; 3. it is actuated, at least in part, by a purpose to serve the master, and 4. if force is intentionally used by the servant against another, the use of force is not unexpectable by the master. c. Liability for the torts of independent contractors. Principal is subject to liability for 1. non-delegable duties (strict liability, abnormally dangerous activities) 2. torts authorized by the principal 3. fraud or misrepresentation 2. Contract liability from the agency relationship. a. Liability of the principal to the third party Independent contractor: a person who contracts with another to do something for him but who is not controlled by the other nor subject to the other’s right to control his physical conduct in the performance of the undertaking. 1. Employee versus Independent Contractor Factors to consider in determining whether the individual is an agent or an independent contractor include: 1. the extent of control which, by the agreement, the master may exercise over the details of the work; 2. whether or not the one employed is engaged in a distinct occupation or business; 3. the kind of occupation, with reference to whether, in the locality, the work is usually done under the 2. - 10 - Disclosed principal: the 3d party has notice that the agent is acting for a principal and has notice of the principal’s identity a. 3d party knows two things: b. agent is acting for principal c. principal’s identity Partially disclosed principal: the 3d party has notice that the agent is or may be acting for a principal, but does not know the principal’s identity a. 3d party only knows one thing b. agent is acting for principal c. he does not know the principal’s identity Business Organizations Agency 3. James Sinton 7/11/2023 Undisclosed principal: the 3d party has no notice that the agent is acting for the principal a. 3d party doesn’t know a thing about the agency relationship b. He thinks the agent is acting on the agent’s own behalf. c. It’s not illegal to transact under an undisclosed principal 6. 7. Types of authority of the agent (1) Actual authority The principal manifests to the agent that the agent has power to deal with others as a representative of the principal. 1. 2. 3. 4. The power of position argument on authority: People with positions or titles might have authority to do things ordinarily associated with those positions or titles. 1. Title conveys authority. 2. It may establish actual authority. 3. It may establish apparent authority. 4. Words or conduct? Principal gives title or position to his agent. 5. Is it reasonable for the agent or the 3d party to believe? If the principal’s words or conduct would lead a reasonable person in the agent’s position to believe that the agent has authority to act for the principal, there is actual authority. It is created by the principal doing something. It stems from the principal’s words or conduct; the agent’s intent is not the focus of actual authority. Implied actual authority: words or conduct of the principal, prior relationship, or custom (3) Inherent authority The power of an agent which is derived not from authority, apparent authority or estoppel, but soley from the agency relation and exists for the protection of persons harmed by or dealing with a servant or other agent. 1. Normative authority, the court will extend the authority of the agent to what the 3d party would have reasonably believed the agent to have. 2. It was reasonable for third parties to believe that a person in that position had the customary authority of persons in the agent’s position. 3. A general agent for a disclosed or partially disclosed principal has inherent authority to bind the principal for acts done on his account which usually accompany or are incidental to transaction which the agent is authorized to conduct if, although they are forbidden by the principal, the other party reasonably believes that the agent is authorized to do them and has no notice that he is not so authorized. (2) Apparent authority The principal manifests to a 3d party that another person is authorized to act as an agent for the principal. Elements: 1. The principal manifests to a 3d party than an agent has authority; 2. It induces the 3d part to reasonably believe that the agent has authority; 3. That agent has apparent authority to bind the principal. 1. 2. 3. 4. 5. 3d party, the 3d party can hold the principal liable for the action of the agent. Apparent authority may be established through an agent’s title or position, but the agent’s actual authority still defines the scope of the agent’s role. Liability of the agent. The agent may be liable to the principal if he acts outside the scope of his actual authority. Apparent authority exists if the principal’s words or conduct leads a reasonable person in the 3d party’s position to believe that the agent had authority to act for the principal. It stems from principal’s words or conduct. In the 3d party’s mind that the agent has authority to act for the principal. If the 3d party does not realize there is an agency relationship, there is no basis for apparent authority. Liability of the principal. When the principal manifests apparent authority of the agent to the Third Restatement purports to throw out inherent authority. But it creeps back below: 3d R § 2.06(2): An undisclosed principal may not rely on instructions given an agent that qualify or reduce the agent’s authority to less than the authority a third party would reasonably believe the agent to have under the same circumstances if the principal had been disclosed. - 11 - Business Organizations Agency James Sinton 7/11/2023 (1) the agent purports to act on the principal’s behalf, and (2)(a) express ratification, the principal authorizes the agent’s act, or (2)(b) implied ratification, the principal engages in conduct that is justifiable only if the principal is treating the agent’s act as authorized. 1. Agent acts on the principal’s behalf, and the principal with full knowledge of the agent’s conduct treats the transaction as authorized. Most courts recognize that it is redundant with apparent authority. Undisclosed principal Inherent authority has independent significance in an undisclosed principal case. (4) Estoppel 1. The principal knew or should have known the agent was transacting with the 3d party; 2. The 3d party reasonably relied on his belief that the agent was acting on behalf of the principal; 3. The 3d party acted on that belief; and 4. The principal did not take reasonable steps to correct the 3d party’s belief about the agent’s authority. Two types of ratification: 2. Express ratification comes from written or oral statements. A board resolution that affirms the transaction made by the agent. 3. Implied ratification occurs when the principal knows of an unauthorized transaction purportedly made on his behalf, and the principal accepts that transaction. 4. Ratification arises when the principal objectively manifests his approval of the agent’s act, or treats the agent’s act as authorized. 5. Principal retains the benefits of the agent’s. 6. Frequently referred to as after-the-fact authority. 7. It is functionally equivalent to actual authority. A person who is not otherwise liable as a party to a transaction purported to be done on his account, is nevertheless subject to liability to persons who have changed their positions because of their belief that the transaction was entered into by or for him, if (a) he intentionally or carelessly caused that belief, or (b) knowing of that belief and that others might change their positions because of it, he did not take reasonable steps to notify them of the facts. 1. we are going to hold the principal responsible for the 3d party’s belief that the agent had authority because the principal did not correct that belief and he knew or should have known of that misbelief. 2. Estoppel is liability by omission. (6) Summary 1. 2. 3. 4. 5. Fake agents Koos Bros. subjects the principal to liability 1. when a fake agent acts on behalf of the principal and 2. it can be shown that the principal knew or should have known about the fake agent conducting business on his behalf. Estoppel applies when the principal does nothing Actual Authority: the principal does something to make the agent believe he has authority. Apparent Authority: the principal does something to make the 3d party believe the agent has authority Inherent Authority: not as important, but know it. Estoppel: liability of the principal by omission Ratification: actual authority after-the-fact, (a substitute for actual authority) the agent does something beyond his authority, and the principal accepts it later b. Liability of the third party to the principal If the principal is liable to the 3d party: 1. In general the 3d party is liable to the principal. 2. Estoppel does not apply symmetrically. It does not allow the third party to be liable to the principal Apparent authority applies when the principal does something (5) Ratification Even if an agent acts without authority, a principal will be liable to a 3d party if c. Liability of the agent to the third party 1. - 12 - Undisclosed P, A is liable. Business Organizations Agency 2. 3. James Sinton 7/11/2023 Partially disclosed P, A is liable. Disclosed P, A is not liable if P is bound to the transaction. Duty of loyalty: Your duty is to act solely in the other person’s interest. It must be ahead of your own. Duty of care: Your duty is to act with reasonable care given your assignment. You must act carefully. It is a question of reasonableness. If an agent contracts with a 3d party on behalf of a disclosed principal, the agent is not a party to the contract and is not liable to the 3d party. 1. Same view below, the 3d party had enough information to solely transact with the principal 2. For a disclosed principal, liability should not extend to the agent so long as the principal is bound. 3. Consider whether the P is bound under the 5 types of authority. Duty to disclose: Your duty is to give the principal material information that you know about the transaction. Breach of agent’s duty: When the agent has not actual authority but binds the principal with apparent authority, the agent is liable to the principal. An agent’s fiduciary duties require the agent to act loyally and carefully when acting within the scope of the agency. 1. An agent is accountable to the principal for any profits arising out of the transactions he is to conduct on the principal’s behalf. 2. An agent must act solely for the benefit of the principal and not to benefit himself or a 3d party. 3. An agent must refrain from dealing with his principal as an adverse party or from acting on behalf of an adverse party. 4. An agent may not compete with his principal in the scope of the agency. 5. An agent may not use the principal’s property for the agent’s own purposes or a 3d party’s purposes. If an agent contracts with a 3d party on behalf of a partially disclosed or undisclosed principal, the agent is a party to the contract and is liable to the third party. 1. For a partially disclosed principal, holding the agent responsible is premised on the notion that a 3d party normally would not agree to look solely to a person whose identity is unknown for performance of the contract. 2. For an undisclosed principal, the 3d party expected to only deal with the agent. 3. In both cases, the 3d party lacks information on the principal’s solvency and reliability. Implied warranty of authority An agent who purports to act on behalf of a principal makes an implied warranty of authority to a 3d party. 1. This is a breach of contract theory. 2. If the agent lacks the power to bind the principal, the agent is liable to the 3d party for breach of the implied warranty. 3. The agent may also be liable to the third party under a theory that he has tortiously misrepresented his authority. This is claim of tort law. The agent is bound by a strict rule of disgorgement of profits. 1. If the agent breaches his duty to the principal, the agent must disgorge all of his ill-gotten gains, even if the principal has been made whole. 2. This is to discourage the agent from advancing his own interest. An agent must act carefully. 1. He has a duty to the principal to act with the care, competence, and diligence normally exercised by agents in similar circumstances. 2. He has a duty to disclose information to the principal. D. Duties of the agent and the principal to each other 1. The agent’s duties to the principal. 2. The principal’s duties to the agent. Fiduciary duty: It is the highest duty imposed by law. The agent is to consider that principal’s interest above his own. The fiduciary duty runs only from the agent to the principal. - 13 - Business Organizations Agency James Sinton 7/11/2023 The principal does not owe a fiduciary duty to the agent! The principal is liable to the agent for expenses in carrying out the agency. A principal has obligation to an agent. 1. A principal must perform his contractual commitments to the agent. 2. It must not unreasonably interfere with the agent’s work. 3. It must generally act fairly and in good faith towards the agent. 4. It has a duty to indemnify the agent. 5. It will be inferred that it agreed to compensate the agent for his services. E. Termination of the agent’s power The principal always has the power to terminate the agency relationship although he may not have the right. 1. The principal has the power. 2. The agent may sue for breach if the relationship is terminated early. 3. Why should the principal always have the power to terminate the relationship? 4. The relationship derives from the principal. The principal’s liability stems from the relationship. You have to stop your exposure to liability for someone else’s acting on your behalf. Actual authority from the relationship terminates: 1. When the object of the relationship has been achieved, 2. When the principal or agent dies 3. When the principal revokes the authority, or the agent renounces it. - 14 - Business Organizations The Partnership James Sinton 7/11/2023 The Partnership Elements of a partnership Choice of law §202 Formation of a partnership. 1. Two or more persons 2. To carry on as co-owners 3. A business for profit 4. Whether or not the persons intend to form a partnership (subjective intent is irrelevant) UPA is silent on the choice of law. Choice of law principles suggest that a court will apply the law of the state with the most significant relationship to the partnership and transaction at issue. RUPA § 106(a) provides that the law of the state in which the partnership has its chief executive office governs internal partnership affairs. Factors Some courts consider the factors that strongly indicate that a partnership has been formed: 1. An agreement to share profits. This is most probative factor to demonstrate the existence of a partnership. A business for profit contemplates that the co-owners will share the profits among themselves. §202(3) treats shared profits as prima facie evidence of a partnership. 2. An agreement to share losses. It might be implied by co-owners sharing losses. Loss sharing is no longer required under RUPA. A business for profit contemplates that the co-owners will share the losses among themselves. 3. A mutual right of control or management of the enterprise. Control is the second most important element, but a partnership might exist with a passive partner. Co-owners contemplates affirmative control over the operations of the business. 4. A community of interest in the venture. §202 ignores the intent of the parties to form a partnership. A. Formation Practice Advice You always form a limited liability entity! It does not make sense to have the GP, which can amount to malpractice. 1. Partnership v. Other relationships What is a partnership? 1. An association of two or more persons to carry on as co-owners a business for profit. 2. UPA § 6(1); RUPA § 202(a) What is a joint venture? 1. The modern view tends to be that partnership rules govern the formation and operation of joint ventures. 2. RUPA § 202 cmt. 2 views that partnership rules apply to joint ventures if the venture fits the definition of a partnership. 3. There is no separate legal thing as a joint venture with special common law rules. 2. Liability of Purported Partner Martin v. Peyton Peyton said he was a lender and not a partner. The court said he was not a partner, but it was close. Lupien v. Malsbenden Facts Cragin sold Lupien a car. Cragin skipped town without building the car. Lupien sued Malsbenden. Malsbenden said he was Cragin’s banker. He did not charge interest and operated the business. Holding The court said Maslbendend was a partner. UPA § 16 RUPA § 308 UPA § 16 Partnership by estoppel RUPA § 308 Liability of purported partner 1. You are holding yourself out to the world that you are a partner. 2. The third party relied on you being a partner. I only did business with you because you were a partner. 3. That third party enters into a transaction on that belief. Consider the elements when trying to distinguish between a creditor and partner. §308 is the exclusive basis for imposing liability as a partner on persons who are not partners. - 15 - Business Organizations The Partnership James Sinton 7/11/2023 8. How can you be liable as a partner? 1. You are a partner under §202; OR 2. You allow someone to believe you are partner. How are partners taxed? 1. The corporation makes $100 of profit. Corporations are subject to a double tax. It has to pay an entity level tax at a separate rate. Assume it is taxed 35%. It has $65. The corporation distributes the earnings. The individual owner gets a dividend taxed at another rate. Assume the individual tax rate is 40%. So the tax bill is now $61. The corporation can hold onto the earnings to control when the double taxation occurs. 2. The partnership has pass-through taxation. The partnership makes $100 of profit. The profit and loss passes through the entity and goes to the partner. It will be subject to only the individual tax rate. 3. The partner is liable for profits of the partnership even if it is not distributed to that partner. The partners are each liable for the partnership profits regardless of whether the partnership distributed the earnings. 3. Aggregate v. Entity Status UPA §§ 6, 10, 18(g), 24, 26-27, 31-32, 41 Partnerships may elect to be taxed like a corporation. Treas. Reg. §§ 301.7701-1 et seq. RUPA §§ 201, 307, 801-802 Aggregate theory of partnership: a partnership is regarded as the sum of the partners who comprise the partnership. Legal entity theory of partnership: the partnership like a corporation is regarded as an entity in of itself. RUPA §201(a) A partnership is an entity distinct from its partners. 1. This alleviates the issue in Fairway. 2. A UPA partnership is the only organization that persists to apply the aggregate theory. B. Management and Control UPA §§ 9, 18 Fairway Development Co. Facts Wenger and Valentine, as the sole partners of Fairway, made a claim on their insurance policy. Title refused to pay Fairway. It said the policy was for a different partnership. Holding The court concluded that because Fairway was not the same partnership named in the policy, based on an aggregate theory, Fairway was not entitled to enforce that contract against Title. RUPA §§ 301, 303, 401 Internal conflict on ordinary business matters Default rule: One partner, one vote. Ordinary business decision: You need a majority vote. Extraordinary business decision: You need unanimity. Conflict: If the partners are equally divided, those who forbid the change must have their way. Alternatively If there is a tie among an equal number of partners, the partnership must stay within the status quo of its course of business. General rule: Any change in the personnel of a partnership will result in its dissolution. 4. Federal Tax Consequences Internal conflict RUPA § 401(j) 1. It implies that the voting rule is one partner, one vote. A partner’s share of capital contributions do not determine the partners’ voting rights. 2. It permits a majority of partners to decide a difference in the ordinary course of business among the partners. In a two-person partnership, you need two votes. 3. It requires a unanimous consent of the partners to amend the partnership agreement or to do an act outside of the ordinary course of business. Under Subchapter K of the Internal Revenue Code: 1. I.R.C. §§ 701-777 2. A partnership is taxed on a pass-through basis 3. The partnership is required to report the receipts and expenditures of the business. 4. The net income or loss from partnership operations is allocated among the partners and then carried over to each partner’s individual return. 5. Partnership profits are subject to double taxation. 6. Partnership losses are passed to the partners to shield other income on their individual returns. 7. Partners must pay tax on their share of the partnership’s income for the year whether or not the partnership distributes cash to the partners. - 16 - Business Organizations The Partnership James Sinton 7/11/2023 3. Summers v. Dooley Facts Summers asked Dooley if they could hire another employee. Dooley refused. Despite this refusal, Summers hired the man and paid him out of his own pocket. A third person must still be notified of the limited authority of a partner for transactions other than real property. C. Financial rights and obligations Dooley refused to pay for the new employee out of the partnership funds. 1. Partnership accounting Capital accounts. Summer says “You owe me for the other guy’s pay.” Holding The court held that Summers was not entitled to recover the costs incurred when Dooley continually objected to the hiring of the third man, because it would have violated the status quo of the partnership. Selling the partnership. In general, if the business is sold, each partner would be entitled to receive an amount equal to his capital account. Example of capital account Every partner has a capital account. If there is a negative balance, that is the amount owed by the partner to the partnership. National Biscuit Co. v. Stroud To determine what is forbidden, it asks what is the status quo of the partnership business. Suppose A, B, P, and Morris form a partnership. Alternative arguments available to Summers: 1. I had exclusive control of the management rights. 2. Dooley ratified my conduct, but ratification is an argument for claims against third parties. Capital contributions A $15,000 B 15,000 P 20,000 M 0 Total $50,000 Management rights Default Rule on management: Each partner has a say in management affairs of the business. M will contribute neither cash nor property but agrees to manage the store at slightly lower than market rate. RUPA §401(f) establishes that each partner has equal rights in the management and conduct of the partnership. 1. Exclusive control. Partners may agree that one or more can have exclusive control over the management of the business. 2. Exclusive control might be implied from the course of conduct of the partners! Suppose that all profits and losses are shared equally. The first year partnership has $20,000 of profits. Record this by adjusting the capital accounts: A $20,000 B 20,000 P 25,000 M 5,000 Total $70,000 RUPA § 301(1) Partner agent of partnership 1. Each partner is an agent of the partnership. 2. An act of a partner in the ordinary course of the business binds the partnership. 3. Exception: It does not bind the partnership, if the partner had no authority and the third person knew or had reason to believe that partner lacked authority. Suppose instead the firm experience a loss of $20,000 A $10,000 B 10,000 P 15,000 M (5,000) Total $30,000 RUPA § 303 Statement of partnership 1. This permits a partnership to file a statement of partnership authority providing the capacity of each partner. 2. It only is effective at establishing constructive knowledge of the authority of a partner for transactions in real property. If the business was sold, M would have to contribute $5,000. If losses are shared by the partners in accordance with their initial capital contributions. A $9,000 20*0.3 30% B 9,000 20*0.3 30% - 17 - Business Organizations The Partnership P M Total 12,000 0 $30,000 James Sinton 7/11/2023 20*0.4 0 40% 0 Assume the business takes a loss on the sale at $38,000. The loss would be shared among the partners equally. A $12,000 B 12,000 P 17,000 M (3,000) Total $38,00 Draw. Profits do not necessarily generate spare cash. Draw is the cash distributed to partners. Generally, the amount of the draw is determined by majority vote of the partners. M would be required to contribute $3,000. Suppose on the year that the firm generates an accounting profit of $20,000 that there is a draw and each partner is paid $3,000. A $17,000 $5,000 (profit) + ($3,000) (draw) B 17,000 P 22,000 M 2,000 Total $58,000 $8,000 UPA § 18(a), (b), (f) Suppose instead the firm had a loss of $20,000 and each partner still withdrew $3,000. A $7,000 ($5,000) (loss) + ($3,000) (draw) B 7,000 P 12,000 M (8,000) Total $18,000 ($32,000) Default Rule on losses: Losses are apportioned among the partners in the same manner as profits. Losses mirror profits, so if the partnership agreement modifies the default rule for profits, it might implicitly modify the rule on losses. RUPA §401(b). 2. Sharing profits and losses RUPA § 401(b), (c), (h) a. Contributions, profits, losses Default Rule on profits: Each partner has an equal share in the profits of the partnership regardless of how much capital is contributed. RUPA §401(b) Default Rule on services: Services do not count as capital. (In RUPA, this rule is implied. See the comments for §401) Note: The capital accounts merely reflect the claims each partner has to the assets of the firm. RUPA § 401(b) Each partner is entitled to an equal share of the partnership profits and is chargeable with a share of the partnership losses in proportion to the partner’s share of the profits. Capital account and interest in partnership. Suppose the partnership capital accounts stand: A $17,000 B 17,000 P 22,000 M 2,000 Total $58,000 Cases maneuvering around the default rule on services Schymanski The court said that services are treated as capital contributions. It arrived at this conclusion, because the partners agreed to share the profits equally and they must have agreed that their contributions were equal in value as well. The partnership might increase in value with the construction of a large housing development. The increase in value is not reflected by the capital accounts. Result of surplus Then the business is sold for $78,000. The business has a surplus of $20,000. A $22,000 B 22,000 P 27,000 M 7,000 Total $28,000 Kessler The court said that profits and losses are handled by parties that contributed money. The court found an implied contract between the partners that the servicespartner would not share in the losses. These cases show that the courts bend over backwards to find an implied agreement to dampen the effect of the Result of loss - 18 - Business Organizations The Partnership James Sinton 7/11/2023 default rule on the partner, who contributes to the partnership solely by way of services. 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. Example A contributes $100,000 to the business. B manages the business. His services are worth $30,000/year, and he works for 3 years. c. Indemnification Default rule for expenses incurred: A partner is entitled to be reimbursed by the partnership for expenses incurred in the ordinary course of the partnership business. Capital contributions A $100,000 B (services) 0 Total $100,000 RUPA § 401(c) A partnership shall reimburse a partner for payments made and indemnify a partner for liabilities incurred by the partner in the ordinary course of business of the partnership or for the preservation of its business or property. Suppose the business is sold for $400,000. $100,000 in capital is returned to A to reduce the profits to $300,000, which is split equally between both partners. Result A $250,000 B 150,000 Total $400,000 3. Liability to third parties UPA §§ 4(3), 9, 13-15, 17 Suppose B’s services are considered a capital contribution. See Schymanski. $100,000 in capital is returned to A; $90,000 in capital is returned to B. It reduces the profits to $210,000, and each partner receives another $105,000. Result A $205,000 B 195,000 Total $400,000 RUPA §§ 104(a), 201, 301, 305-307 UPA treats the partnership as an aggregate of the partners. 1. The partnership is liable for contracts entered into by partners acting with actual or apparent authority. § 9. 2. The partnership is liable to third parties for wrongful acts or omissions of partners acting with authority or in the ordinary course of the partnership business. § 13. 3. A single partner might be sued; he is jointly and severally liable for partnership obligations. 4. Partners are jointly liable for all other obligations. Suppose the business is sold for $50,000. The total capital was at $100,000 resulting in a loss of $50,000. Each partner loses $25,000. Result A $75,000 B (25,000) Total $50,000 RUPA treats the partnership as an entity. 1. RUPA permits the partnership to be sued in its own name. 2. RUPA creates a hurdle for partnership creditors. Suppose all the loss is shifted to A because he was the only partner to contribute. See Kessler. Result A $50,000 B 0 Total $50,000 a. Liability in Contract When is partnership liable in contract? 1. Actual authority. When are partners actually authorized to enter into a contract on the partnership’s behalf? a. §401(j) – A majority of the partners must vote that that partner has authority, when a difference arises between the partners; or b. They included authorization in the partnership agreement, or the authorization is implied. b. Not entitled to remuneration for services Default Rule on compensation: A partner is not entitled to compensation for his services. RUPA § 401(h) - 19 - Business Organizations The Partnership 2. 3. James Sinton 7/11/2023 Apparent authority. §103(b)(10) prohibits the partnership from restricting the rights of third parties under this Act. If there is no apparent authority, then the partner must have actual authority to bind the partnership. 2. 3. 4. § 301(1) Apparent authority: 1. Has P manifested to the bank that he has authority to bind the partnership? 2. Has P given the 3d party notice that he lacks that authority? 3. Was P’s actions in the ordinary course of the partnership business? Torts. The partnership is liable to third parties for wrongful actors or omissions of partners acting with authority or in the ordinary course of business. Partners are jointly and severally liable for torts. Partners are jointly liable for all other obligations. Joint liability means that, if feasible, all partners must be joined in the suit. RUPA (entity) Every partner has joint and several liability for the obligation born by the partnership. The creditor may sue any partner for the entirety of his judgment against the partnership! b. Liability in Tort A creditor may not collect his judgment against a partner unless he has a separate judgment against the partnership and 1. Exhaustion. He has attempted unsuccessfully to enforce the judgment against the partnership; 2. The partnership is in bankruptcy; 3. The partner has waived exhaustion by contract; 4. A court removes the exhaustion requirement; OR 5. The partner is independently liable to the claimant. When is a partner liable for tortious acts? §305(a) the partnership is only liable for the torts of the partners acting in the ordinary course of business of the partnership. Sheridan v. Desmond 188 The common law standard for a partner’s liability in tort asks whether the tortious conduct of a partner was within the ordinary scope of the partnership’s business. RUPA leveled the playing field. 1. Partners are jointly and severally liable for obligations of the partnership business. This is appropriate because partnerships have insurance to protect the partners. 2. §307(c) A judgment against a partnership is not by itself a judgment against a partner. 3. Exhaustion. §307(d)(1) A creditor of the partnership must first try to get the money from the partnership! The ordinary scope of a business. To hold the partnership liable for the actions of a partner, the partner’s acts must have: 1. Been the kind of thing a partner would do; 2. Occurred substantially within the authorized time and geographic limits of the partnership; 3. Been motivated at least in part by a purpose to serve the partnership. Does the tort victim have a prima facie case against the partnership? 1. Was this the kind of thing a partner would do? 2. Did it occur on the geographic limits of the partnership? 3. Was P motivated in part by a purpose to serve the partnership? 4. Indemnity and contribution UPA §§ 5, 18(a), (b), 40(b), (d) §401(b) Contribution 1. If the partnership is unable to satisfy its obligation to a partner, the other partners must contribute to their share of the losses. 2. The partners may also be required to contribute to satisfy creditors, even on dissolution. c. Enforcing partnership liabilities against partners Unlimited personal liability looms over the partners. UPA (aggregate) 1. RUPA §§ 104(a), 401(b), (c), 807(a), (b) Contracts. The partnership is liable for contracts entered into by partners acting with actual or apparent authority. §401(c) Indemnity 1. If a partner satisfies a partnership obligation, that partner is entitled to seek indemnification from the partnership. - 20 - Business Organizations The Partnership 2. James Sinton 7/11/2023 If the loss was caused by the wrongful act of one of the partners, the culpable partner ultimately bears the entire loss and must indemnify the partnership or partner who paid the claim. It consists of the partner’s transferable interest and all the management and other rights. What happens when the partner sells his transferable interest? 1. The partner can unilaterally sell his financial rights. 2. It does not dissolve the partnership. It does not transfer management rights or other rights. 3. The transferor still has his management and other rights. §503(d). 4. The transferee has the right to receive the distribution of the transferor’s share of profit and losses in the partnership. Comparison: 1. Contribution and indemnity permit the partner to sue another partner or the partnership. 2. Indemnification is the obligation of the partnership to reimburse a partner. 3. Contribution is the obligation of a partner to reimburse the partnership. D. Ownership interests and transferability Transferable interest (financial rights) is limited to: 1. Right to receive distributions to which the partner would have been entitled. 2. Right to seek judicial liquidation of the partnership 3. It may not be sold without the partner’s consent 1. Partnership property UPA §§ 8, 25 RUPA §§ 201(a), 203-204, 501 UPA created a new form of property ownership called tenants-in-partnership. Each partner owns the partnership property as tenants-in-partnership. Non-transferable interests (Management and other rights) 1. Right to participate in votes 2. Right to use partnership property 3. Right to access books and records RUPA says that the partnership owns the property. Transferee’s rights § 503(a)(3) A transfer, in whole or in part, of a partner’s transferable interest in the partnership does not, as against the other partners or the partnership, entitle the transferee, during the continuance of the partnership, 1. to participate in the management or conduct of the partnership business, 2. to require access to information concerning partnership transactions, or 3. to inspect or copy the partnership books or records What is a partnership interest? It consists of the partner’s transferable interest and all the management and other rights. What happens when the partner sells his transferable interest? 1. The partner can unilaterally sell his financial rights. 2. It does not dissolve the partnership. It does not transfer management rights or other rights. 3. The transferor still has his management and other rights. §503(d). 4. The transferee has the right to receive the distribution of the transferor’s share of profit and losses in the partnership. 3. The rights of a partner’s creditors 2. Admitting versus Assigning UPA §§ 28, 31(5), 32(2), 40(h) UPA §§ 18(g), 24, 26-28 The partnership interest is considered to be the personal property of the partner! See §502. RUPA §§ 401(i), 502-504 RUPA §§ 504, 601(6), 701, 801 Can one partner assign another to be a partner? No. A creditor may seek to satisfy the debt by seizing the property of the partner. Default rule on becoming a partner: The pick your partner rule. A person can become a partner only with the consent of all the partners. §401(i). Normally, as a judgment creditor, he can request the sheriff to seize the debtor’s personal property. RUPA displaces the state rights of a judgment creditor. The creditor may get a lien on the partner’s interest, which is called a charging order. Partner’s interest in the partnership What is a partnership interest? - 21 - Business Organizations The Partnership James Sinton 7/11/2023 4. Step 1: Charging order 5. § 504(a) A creditor of the partner can petition the court to enter a charging order against the partner’s transferable interest. 6. 7. The charging order permits the creditor to receive any partnership distributions to which the partner would otherwise be entitled. Costs of fiduciary duties 1. Fiduciaries have varying costs of forgoing opportunities outside the firm. 2. Firms and insiders have potential scope economies of information in buying from and selling to each other by reason of information acquired in their other dealings. 3. Fiduciary duties arise in relationships in which it is in the beneficiary’s interest to delegate open-ended decisionmaking power to the fiduciary. 4. Prohibiting waivers may preclude efficient compensation arrangements. 5. Fiduciary duties may be costly not only because of the potentially perverse impact of the duties themselves, but also because of the costs of enforcing them. However, the charging order does not transfer the tax liability of the partner’s interest to the creditor. §504(c) also allows the partnership to redeem the partnership interest before foreclosure. Step 2: Foreclosure § 504(b) The creditor may obtain foreclosure of the partner’s transferable interest in the partnership, which the allows the creditor himself to purchase that interest. As transferee, the creditor can seek judicial liquidation of the partnership, if the partnership refuses to satisfy the lien. §801. Arguments against foreclosure The beneficiary may be able to discipline the fiduciary through power to exit the relationship. The beneficiary may be able to remove the fiduciary. (Is this effective for partners?) The fiduciary may have reputational incentives to act in the beneficiary’s interests. Non-managerial owners of firms may choose to rely on 3d-party monitoring. 1. The common law 210 Meinhard v. Salmon 216 Partners owe the strictest of duties to the partnership and other partners. It is the duty of the finest loyalty, the punctilio of an honor the most sensitive. Many forms of conduct in the workday world are forbidden in the fiduciary relationship. Unanimous consent Crocker prohibits foreclosure unless the remaining partners unanimously consent to it and the creditor has been unable to satisfy the debt under the charging order. It is a flexible standard, which makes it unclear when a partner has adhered to his fiduciary duties. Would it unduly interfere with the partnership? Hellman instructs the courts to consider whether the foreclosure would unduly interfere with partnership business before ordering the foreclosure. Duty to disclose A partner has a duty to disclose information that is material to the partnership business. Crocker and Hellman rely on the view that the courts should avoid interfering with partnership business. Business opportunities An aspect of the fiduciary duty is the obligation not to usurp the business opportunities belonging to the partnership. E. Fiduciary Duties Default rule: A partner owes a fiduciary duty to the partnership and the other partners. Defense to taking business opportunity (a) Line of business. It was not a business opportunity of the partnership. Benefits of fiduciary duties 1. The amount of discretion delegated is proportional to the fiduciary duty owed to the principal. 2. The beneficiary can reduce agency costs by monitoring and restricting transaction entered into by the fiduciary. 3. The fiduciary’s conduct may be better constrained through contractual provisions. (b) A partnership’s lack of financial ability to pursue an opportunity negates the partnership’s claim to the opportunity. (c) The partnership refused the deal. - 22 - Business Organizations The Partnership James Sinton 7/11/2023 Response: The partner still has an obligation to find financing for the partnership. The partner still has an obligation to solve the problem. Enea v. Superior Court 233 The partnership held real estate with an office building. One of the partners rented office space from the partnership and breach his fiduciary duty of loyalty by paying under fair rental value for the space. 2. Fiduciary duty and contractual waiver UPA §§ 21-22 Duty of loyalty §404(b) sets the boundaries of the partner’s duty of loyalty. The duty is limited to: 1. Business opportunities. It disallows a partner from swiping a business opportunity away from the partnership. 2. Profits. It requires the partner to account for any profit or benefit derived from conducting partnership business or from using partnership property. 3. COI. It requires a partner to refrain from engaging in COI transactions. 4. Competing. It requires a partner to refrain from competing with the partnership. RUPA §§ 103, 404 RUPA codified the fiduciary duty, because it sought to make a partner’s duties more predictable. §404(a) sets the only fiduciary duties (the duty of loyalty and the duty of care) a partner owes to the partnership and other partners. It has cabined the fiduciary duties of partner. Eliminating or modifying the duties Singer v. Singer 227 The court held that the partnership agreement could eliminate the fiduciary duty owed to partners. Good faith and fair dealing §404(d) imposes on partners an obligation of good faith and fair dealing. Modifying the duties: §103(b) Under the partnership agreement, 1. It cannot eliminate the duty of loyalty, but the partnership agreement can modify it as not to be manifestly unreasonable; 2. It cannot unreasonably reduce the duty of care; 3. It cannot eliminate a partner’s right of access to the books and records, in particular it cannot unreasonably restrict the right of access; AND 4. It cannot eliminate the obligation of good faith and fair dealing. Relaxing the strictures on self-dealing §404(e) relaxes the duty of loyalty when the partner furthers his own interest. §404(f) permits a partner to lend money to the partnership so long as the transaction satisfies the duty of good faith and fair dealing. RUPA §404(e) says that “a partner does not violate a duty or obligation under this Act or under the partnership agreement merely because the partner’s conduct furthers the partner’s own interest.” 1. Narrow interpretation. §404(e) is essentially an evidentiary rule. It establishes a presumption that the partner has not violated his duty by merely benefiting from the transaction. It holds that “a partner who directly personally benefits from the partner’s conduct in the partnership context does not, without more, establish a violation of the partner’s duties or obligations under RUPA of the partnership agreement.” 2. Broad interpretation. §404(e) means that partners are free to pursue short-term, individual self-interested transactions without notice to or the consent of the partnership, subject only to the restrictions of §404(b). The pursuit of self-interest cannot be a violation of the obligation of good faith and fair dealing. A partner is not held to the same standards as a trustee. Ratification or authority. An act that would otherwise breach the duty of loyalty may be ratified (after the fact) or authorized (before the fact) by all the partners! Delaware Delaware permits the elimination of partner’s fiduciary duties. It also allows the partnership agreement to eliminate a partner’s liabilities for breach of a fiduciary duty. The partnership agreement may not eliminate the covenant of good faith and fair dealing that a partner owes to the partnership and the other partners. 3. The Duty of Loyalty - 23 - Business Organizations The Partnership James Sinton 7/11/2023 Fairness defense Because corporate law allows a corporate manager to selfdeal so long as the transaction is entirely fair to the corporation, a partner should also be allowed to self-deal under the same total fairness standard. 1. Directors can cure the taint of self-dealing if the transaction is approved by disinterested directors or shareholders in good faith. See DGCL §144(a). 2. Directors can defend their self-dealing by proving that the transaction was entirely fair to the corporation. See Tremont. 3. RUPA §404(f) permits a partner to lend money to the partnership so long as the transaction satisfies the duty of good faith and fair dealing. This provision contemplates a fairness defense. 4. RUPA §404(e) requires more than a showing that the partner’s conduct furthers the partner’s own interest. 5. UPA §21(1) prohibits absolutely partners from transacting with the partnership as an insider without unanimous consent. UPA It has no statutory duty. Rosenthal v. Rosenthal 4. The Duty of Disclosure RUPA says yes! 1. Tort. §305(a) permits a partner to sue the partnership for wrongful acts or omissions of another partner committed in the ordinary course of the partnership’s business. 2. Breach of fiduciary duty. §405(b) permits a partner to maintain an action for breach of fiduciary duty. UPA §§ 19-20 RUPA § 404(c) The duty of care requires the partner to refrain from engaging in 1. grossly negligent or reckless conduct, 2. intentional misconduct, or 3. a knowing violation of law. RUPA adopts a similar standard contemplated by the business-judgment rule applied to corporations. It excludes ordinary negligence for business decisions. Waiver The partnership agreement cannot unreasonably reduce the duty of care. 6. A partner’s remedies against other partners Can a partner sue the partnership before dissolution? RUPA §§ 103(b), 403 Common law Meinhard suggests that the duty to disclose is an aspect of a partner’s fiduciary duty. UPA says no! 1. A partner can only seek an accounting for conduct of the business on dissolution. 2. §13, which governs liability for torts, expressly applies to persons who are not partners in the partnership. 3. §13 seems to preclude one partner from suing the partnership or another partner for negligent management or tort. An affirmative obligation to disclose (without demand) Each partner has a duty to make full disclosure of all material facts relating to the partnership business when reasonably required to allow other partners to safeguard their rights under the partnership agreement. § 403(c)(1). Obligation to disclose (with demand) §403(c)(2) requires the partnership to disclose, on the demand of a partner, other information on the partnership’s business, except where the demand is unreasonable or improper under the circumstances. Accounting action In an accounting action, the court conducts a comprehensive investigation of the transactions of the partnership and the partners, determines their relative rights, and enters a money judgment for or against each partner according the balance. Texas Texas has not adopted the affirmative obligation under §403(c)(1)! Texas still imposes the duty to disclose as a common law duty. RUPA §405 abolishes the exclusivity rule! 1. It permits a partner to maintain an action against the partnership or another partner for legal or equitable relief, with or without an accounting. 2. It reflects the policy that partners should have access to the courts not just on dissolution of the Defense to Texas common law duty to disclose Hey, but this isn’t right because §404 cabins all the duties! The pattern jury charge is wrong. We don’t have this obligation by statute. It should not be a fiduciary duty. 5. The Duty of Care - 24 - Business Organizations The Partnership partnership to resolve claims partnership and other partners. James Sinton 7/11/2023 against the 1. 2. UPA § 22, a partner may assert a breach of fiduciary duty claim against a co-partner as part of an accounting action. 1. An accounting action reviews the partnership’s affairs and the partners’ obligations to each other. 2. Exclusivity rule. The accounting action is the exclusive means by which a partner can seek recourse against her co-partners for breach of fiduciary duty. 3. 4. the partner withdraws by express will; the partner is expelled by court order for misconduct; the partner becomes a debtor in bankruptcy; OR a partner that is not a natural person is expelled or otherwise dissociated because it willfully dissolves or terminates. §602. Does the dissociation cause dissolution? 1. A partnership at will dissolves on the dissociation of a partner. 2. A partnership for term can dissolve by the express will of at least half of the partners when a. a partner dies; b. a partner dissociates under §601(6)-(10); c. a partner wrongfully dissociates. Exceptions to the exclusivity rule. 1. An accounting may not be required in a case involving disputes over a very limited time or number of transactions. 2. Some courts have abolished the rule. At least half. In a partnership for term, a partner who dissociates by express will counts towards the at least half needed to dissolve. F. Dissociation and Dissolution 1. Partner Dissociation §801 identifies the situations when a partnership dissolves: 1. A partnership at will dissolves on the dissociation of a partner by express will. 2. A partnership for term dissolves a. on the expiration of the term; b. when all the partners consent; OR c. with the consent of at least half of the partners in special circumstances of a partner’s dissociation. See above. 3. A partner can petition the court to dissolve the partnership. 4. A transferee can petition the court to dissolve the partnership. RUPA §§ 201(a), 601-602, 701, 801-803, 807 §802 permits the partners to continue the firm despite a partner’s withdrawal from the firm. It embraces the entity theory of partnership. Step 1: Has the partner dissociated? Step 2: Was the dissociation wrongful? Is it a partnership at will or for term? Step 3: Does the dissociation result in a buyout or dissolution? Events that result in dissociation §601 determines when a partner is dissociated from the partnership: 1. the partnership has notice of the partner’s express will to withdraw; 2. an event in the partnership agreement that triggers the dissociation; 3. the partner is expelled under the partnership agreement; 4. the partner is expelled by court order; See the reasons below. 5. the partner becomes a debtor in bankruptcy; 6. the partner dies. If it does not result in a dissolution, §701 requires the partnership to buyout the dissociated partner’s interest, rather than a windup. The partnership continues without a windup. Expelled by court order §601(5) identifies when a court may expel a partner for misconduct on the grounds: 1. the partner has engaged in wrongful conduct that adversely and materially affects the partnership; 2. the partner commits a willful and persistent breach of the partnership agreement or a duty owed to the partners or partnership under §404; or 3. the partner engages in conduct relating to the partnership business that makes it not reasonably practicable to carry on the business with him. Wrongful dissociation First, a partner’s dissociation is wrongful when it is in breach of an express provision of the partnership agreement. Next, a partner’s dissociation is wrongful when before the term is up: Effects of Partner’s Dissociation - 25 - Business Organizations The Partnership James Sinton 7/11/2023 On a partner’s dissociation: 1. the partner’s right to participate in the management and conduct of the partnership business terminates; 2. the partner’s duty (of loyalty) to refrain from competing with the partnership terminates; and 3. the partner’s remaining duty of loyalty and duty of care continues only for transaction before the partner’s dissociation. 4. Liability for wrongful dissociation. A partner who wrongfully dissociates from the partnership is liable to the partnership and the other partners for any damages caused by his wrongful conduct. Delayed buy-out A substantial period of time may pass between dissolution of the predecessor partnership and payment to departing partners. The departing partner may elect between 1. adding interest to his payment 2. taking his share of partnership profits 3. Partnership Dissolution Default rule: It is a partnership at will. A partnership is terminable at will by any partner. §101(8) Liability for dissociation 1. Dissociation does not discharge a partner’s liability for partnership obligations incurred before his dissociation. 2. A dissociated partner is generally not liable for partnership obligations incurred after his dissociation. 3. A dissociated partner can become liable to third parties through apparent authority. §703(b). 4. A dissociated partner may file a statement of dissociation to limit his liability. §704(a). 5. Third parties have constructive notice of the statement 90 days after it is filed. §704(c). Partnerships at will The partners have not agreed to remain partners until the expiration of a definite term or the completion of a particular undertaking. 1. The partner must give express notice to dissociate from the partnership. 2. On that partner’s withdrawal, the partnership is dissolved and must be wound up. Partnerships at term Partners agree that the partnership will continue for 1. a definite term OR 2. particular undertaking. New partner A new partner is not personally liable for partnership obligations incurred before his admission as a partner. §306(b). Partners may set a term to remain in business until a particular undertaking has been satisfied: 1. a specified sum of money is earned, 2. one or more partners recoup their investments, 3. debts are paid OR 4. property could be disposed on favorable terms. 2. Buying out dissociated partners Where a partner’s dissociation does not result in dissolution, the continuing partnership is required to buyout the dissociated partner’s interest: 1. Amount. The buyout price is the amount the dissociated partner would have received on dissolution. It assumes the assets were sold at the greater of liquidation or going concern value. §701(b). 2. Wrongful dissociation. If a partner wrongfully dissociates, the buyout price is reduced by any damages caused by his wrongful dissociation. §701(c). 3. Goodwill penalty. RUPA no long applies the good will penalty. 4. Special rule for a term. A partner who wrongfully dissociates before the expiration of a term or undertaking does not receive his buyout share until the term expires or the undertaking is completed, unless earlier payment will not cause undue hardship to the partnership. It is the dissociated partner’s burden to establish that early payment will not cause undue hardship. §701(h). On a partner’s leaving a partnership at term: A partner’s dissociation by express will does not dissolve a partnership for term, unless at least half of the partners agree to dissolution. See above. Unanimous consent The partners may unanimously agree to wind up the partnership business. Other events that can dissolve the partnership A partnership is also dissolved when See §801(3)-(6) 1. An event specified in the partnership agreement dissolves it; 2. It is unlawful to carry on the business; 3. A partner seeks judicial dissolution because - 26 - Business Organizations The Partnership James Sinton 7/11/2023 a. 4. Economic purpose. the economic purpose of the partnership is likely to be unreasonably frustrated, b. Unreasonable conduct. a partner has engaged in conduct so that it is not reasonably practicable to carry on the partnership business, OR c. Agreement is not practicable. it is not otherwise reasonably practicable to carry on the partnership business in conformity with the partnership agreement; or A transferee seeks judicial dissolution. 5. of the partnership’s dissolution 90 days after it is filed. The statements of dissolution and dissociation are convenient methods to cut-off apparent authority. Altering dissolution by agreement. 1. §103(b)(8) permits the partners to dissociate without dissolving the partnership, unless dissolution is triggered by §801(4)-(6). 2. The partners may also agree to abandon winding up the partnership and continue the business. 3. It must be unanimous including the dissociated partners. Unlawful to continue the partnership business Drashner v. Sorenson 279 Drashner, who spent most of his time at the Brass Rail Bar in Rapid City, sued the partnership, claiming that it should be dissolved because the other partners violated the partnership agreement by not paying him a sufficient amount to support himself and his family. A reactive dissolution occurs when it is unlawful for all or substantially all of the partnership business to be continued. §801(4). If the partnership cures the illegality within 90 days after notice to the partnership, it is effective to stop dissolution. Effectively, Drashner said the partnership should be dissolved because it was not otherwise reasonably practicable to carry on the partnership business according to the partnership agreement. §801(5)(iii). Partner seeks judicial dissolution A partner seeks judicial dissolution because 1. Economic purpose. the economic purpose of the partnership is likely to be unreasonably frustrated, 2. Unreasonable conduct. a partner has engaged in conduct so that it is not reasonably practicable to carry on the partnership business, Sorenson and Deis (the good partners) OR 3. Agreement is not practicable. it is not otherwise reasonably practicable to carry on the partnership business in conformity with the partnership agreement. Drashner (the drunk partner) Sorenson and Deis counterclaimed that the partnership should be dissolved because Drashner has engaged in conduct related to the partnership business which makes it not reasonably practicable to carry on the business in the partnership with that partner. §801(5)(ii). Drashner was spending too much time at the bar during business hours. 4. Consequences of dissolution The assets of the partnership are distributed in the order: 1. Non-partner creditors are paid; 2. Partner creditors are paid; 3. Partners receive a return of their capital contributions; and 4. Partners receive any remaining profits according to their profit shares. Transferee seeks judicial dissolution A transferee of a partner’s interest seeks judicial dissolution. Liability after dissolution. §804 A partnership is bound by a partner’s act after dissolution if 1. the act is appropriate for winding up the business; or 2. the act would have bound the partnership before dissolution and the 3d party does not have notice of the dissolution. 3. A partner who incurs partnership liability beyond windup is liable to his co-partners for acts taken after he acquired knowledge of the partnership’s dissolution. 4. A partner may file a statement of dissolution, which provides constructive notice to third parties Partnership unable to satisfy its debts If the partnership assets are deficient to satisfy it’s liabilities, the partners must contribute according to their share of the losses. What is winding-up? 1. Winding up the partnership business entails selling its assets, paying its debts, and distributing the net balance, if any, to the partners in cash according to their interests. 2. It requires the partnership assets to be sold and distributed according to the in-cash rule. - 27 - Business Organizations The Partnership James Sinton 7/11/2023 In-cash rule: A partner has no right to, and may not be required to accept, a distribution in kin, unless otherwise agreed. Exception to in-cash rule The Rinke court ordered an in-kind distribution of the partnership assets where 1. the partnership owed no creditors; 2. only the partners were interested in the assets; and 3. an in-kind distribution was fair to the partners. - 28 - Business Organizations The Corporation James Sinton 7/11/2023 Shareholders may sell their shares in the corporation at any time. The Corporation Claims against the corporation or its owners: 1. The duty of care process claim The decision-making process was grossly negligent. See Van Gorkom. 2. Duty of care substance claim The corporate owner’s decision was irrational. 3. Waste claim The decision was irrational. 4. The duty of loyalty The D/O had a CIO. 5. Dissolution for misappropriation of corporate assets The corporate assets reflect a de facto dividend that has been misappropriated by the D/O or controlling shareholder. 6. Dissolution for oppressive conduct The shareholder had a reasonable expectation to receive a similar de facto dividend. 7. Fraudulent transfers The corporate owners received fraudulent transfers from the corporation without adequate consideration. 8. Piercing the corporate veil The corporate owners have not respected the separate legal entity by using corporate assets for their personal benefit. 9. Seize the controlling shareholder’s stock A creditor of a shareholder sues to seize his stock. 10. Reverse piercing the corporate veil A creditor of a shareholder seeks to hold the corporation liable for the shareholder’s debts. Centralized management Every partner has a right to participate in the management. §401. A majority of partners decided ordinary matters. Limited liability All partners are personally liable for a general partnership’s obligations. The partners are jointly and severally liable. Shareholders enjoy limited liability – a shareholder’s losses are limited to the value of his investment. Creditors usually have no recourse against the shareholders personally. Free transferability of ownership interests New partners may be Shares are freely admitted only by transferable. unanimous consent. Tax status Partnerships enjoy passthrough tax status. A. Introduction 1. Comparing it with the partnership Publicly held corporations must be taxed as a separate legal entity. On distributions, the shareholders pay taxes on the dividends received. For almost every characteristic of the general partnership, the partnership has the exact opposite. Continuity of existence Partnerships are relatively easy to dissolve. It has centralized management – the board of directors are elected. Shareholders may only vote on fundamental transactions. The Internal Affairs Doctrine (Choice of law rule) For resolving internal affairs of the corporation, the law of the state of incorporation governs. Entity status UPA partnership is not an entity distinct from its owners. RUPA partnership is an entity The board of directors controls the business of the corporation. Closely held corporations may elect to be taxed in a pass-through like manner. A corporation is an entity distinct from its owners. 2. Choosing a state of incorporation Characteristics of Delaware. 1. It has a liberal corporation statute that seeks to enable rather than regulate corporate transactions. 2. It has an extensive body of cases, which increases predictability. 3. It has an experienced bench and bar that specialize in corporate transactions. A corporation has perpetual existence, unless the board of directors and shareholders approve dissolution. - 29 - Business Organizations The Corporation 4. James Sinton 7/11/2023 Many states are adopting Delaware’s code to attract corporations. 3. Franchise tax. 1. A corporation chartered in Delaware must pay the state’s franchise tax. 2. If the corporation does business in another state, it must qualify as a foreign corporation and pay a tax to that state. 3. This might impose a significant tax burden on closely held corporations. 4. 5. 6. agent at the office (typically the agent is the lawyer). Nature of the business. It is sufficient to say “the example in the statute.” The total number of shares of stock, the par value is the minimum amount. The name and mailing address of the incorporator The name and address of the initial directors. Articles of incorporation 1. To form a corporation, one must first file a “certificate of incorporation” 2. It embodies important items about the corporation (name, address, nature of business and total number shares of stock that the corporation is authorized to issue). 3. The corporation prohibited from issuing shares in excess of the number in the certificate. A corporation may not ratify the authorization! Most closely held corporations incorporate in the state of their business. 1. Franchise tax is the tax for incorporating in that state. 2. If you do business in another state, you have to pay a franchise tax in the state of incorporation plus another tax in the state where you are doing business. 3. For most small businesses, this is wasting money. So they incorporate locally. 4. Most publicly held companies have incorporated in Delaware. 5. The reality is that Delaware was one of the first movers by being business responsive and flexible. 6. They have business savvy judges that are not elected. For public corporations, the Delaware statutes are more efficient, the courts are responsive, and have expedited litigation procedures for corporations. Organizational meeting You call the organizational meeting. §108. What do you at the meeting? You elect the board of directors. You approve the basics – minutes, stock certificate, certificate of incorporation. After the certificate of incorporation is filed, the initial directors call an organizational meeting. The Internal Affairs Doctrine (Choice of law rule) For resolving internal affairs of the corporation, the law of the state of incorporation governs. The initial directors approve: 1. the certificate of incorporation 2. the corporation’s minute book 3. the form of stock certificate that will represent ownership of the corporation’s shares; and 4. the corporate seal. B. Formation 1. Incorporation and its aftermath Bylaws DGCL §§ 102-103, 107-109, 141, 151, 165, 211 MBCA §§ 2.01-2.07, 6.01-6.02, 6.20, 7.03, 8.06 At the organizational meeting, the board of directors adopt the bylaws. How do you form a corporation? 1. You must first file a public document, called the articles of incorproation, with the state. 2. You file it with the Secretary of the State. It can be amended by the shareholders. §109. The bylaws are the complete code for the conduct of corporate affairs. 1. the rules for calling and conducting shareholders’ meetings 2. the number of directors; 3. the methods of electing and removing directors; 4. the manner in which board vacancies are filled; 5. committees of the board; 6. the rules for calling and conducting directors’ meetings; What goes in the public document? DGCL §102(a) the certificate of incorporation 1. The name of the corporation plus 1 of the words 2. The address of the corporation’s registered office (where the corporation wants state correspondence to go) and the corporation’s - 30 - Business Organizations The Corporation 7. 8. 9. 10. 11. 12. 13. 14. James Sinton 7/11/2023 the identification of officers and the duties of each officer; the methods of electing and removing officers; the indemnification of directors and officers to the extent permitted by statute; the advancement of expenses to directors and officers who are sued as a consequence of their positions; the purchase of directors’ and officers’ insurance; share certificates; the corporation’s fiscal year; and the manner in which the bylaws may be amended. Preferred shares often have priority on liquidation. Mandatory If the dividend is mandatory, the board of directors must declare a dividend on the preferred shares if it is financially and legally able to do so. Discretionary If the dividend is discretionary, the board may choose whether to declare a dividend on the preferred shares. If the board does not pay the preferred dividend, it may not declare a dividend on the common shares. Annual meeting of shareholders 1. At this meeting, the shareholders elect directors. 2. The directors elected at this meeting hold office for one year. Cumulative If the dividend is cumulative, the board may not declare a dividend on the common shares unless it has satisfied its obligation, which accounts for unpaid dividends, to distribute dividends to the preferred shares. 2. Financing the corporation How does a corporation raise money? 1. Debt. The corporation borrows money from a lending institution. What characterizes debt? Fixed payment schedule or a lump sum. The creditor has some rights to enforce the obligation. 2. Equity. This is fancy speak for investments; the investor expects the corporation to distribute money; the corporation is not generally required to distribute money. If the preferred dividend is cumulative, arrearages on unpaid dividends are added to the liquidation price. A cumulative dividend is better for preferred shares. Noncumulative If the dividend is noncumulative, the board need only declare a dividend to the preferred shares to be able to declare a common dividend. Subscription agreement 1. Promoters line up capital before the corporation’s formation through subscription agreements. 2. Subscriptions are really offers to purchase the corporation’s shares when issued by the board of directors. A noncumulative dividend is better for common shares. Participating If the dividend is participating, after the preferred shares receive the dividend, the preferred shares are allowed to join in further dividends with the common shares on a specified basis. Common shares 1. Common stock is the residual interest in the corporation. They represent the actual ownership of a corporation. Common shareholders possess voting rights to and may elect the board of directors. 2. After creditors and preferred shareholders receive their interest in the corporation, the surplus belongs to the common shareholders. A participating dividend is better for preferred shares. Nonparticipating If the dividend is nonparticipating, all dividends accrue to the common shares once the preferred dividend is satisfied. Preferred shares Preferred shares have priority over common shares on receiving dividends. A nonparticipating dividend is better for common shares. Not all companies have preferred stock. You have some preferential rights over common shareholders. You might have a preferential dividend right. You might have a preferred liquidation right. Convertible Preferred shares are often convertible into common shares. - 31 - Business Organizations The Corporation James Sinton 7/11/2023 Debt 1. 2. 3. Bond. A bond is a loan secured by the corporation’s assets. Debenture. A debenture is an unsecured loan. Bonds and debentures are often convertible into common shares. Indenture. An indenture is a contract between the corporation and an indenture trustee that represents the bondholders and debentureholders. It describes the terms of the bonds or debentures and provides for enforcement by the trustee in cases of default. Three questions on promoter’s contracts: 1. Did the promoter make a contract or merely solicit an offer? 2. If a contract exists, is the corporation liable? a. Adoption. If the corporation adopts the contract, it is bound. b. Novation. It is an agreement between the parties (promoter, corporation, and 3d party) that at least the corporation will be responsible for promoter’s obligation. It merely is a contract of substitution. 3. If the corporation adopts the contract, does the promoter remain liable? a. The promoter remains liable for the contract even if the corporation adopts the contract. The promoter can shift liability to the corporation if all the parties execute a novation. b. Otherwise, if the corporation has not formed, the promoter is liable. Priority of corporate finance 1. Debtholders have an absolute contract right to receive principal and interest payments. 2. Debtholders may place the corporation in bankruptcy. 3. Debtholders have preference over all shareholders. 4. Preferred shareholders have preference over common shareholders. 5. Common shareholders are the residual. 5. Defective incorporation DGCL §§ 105-106, 329 MBCA §§ 2.03-2.04 3. Preemptive rights DGCL § 102(b)(3) MBCA § 6.30 When a third party seeks to sue a shareholder for the obligations of the corporation that failed to form: Preemptive rights are merely a contractive right to purchase shares of the corporation to maintain your ownership interest. a. De jure corporation A de jure corporation is a corporation that satisfies the statutory requirements to form a corporation. Opt-in preemptive rights Texas is an opt-in jurisdiction. Unless you include a preemptive rights in the articles of incorporation, the shareholders don’t get preemptive rights. b. De facto corporation It only applies when the third party is unaware that the corporation has not been formed AND incorporation fails. Opt-out preemptive rights It recognizes that the purported corporate owners substantially complied with the statutory formalities to form a corporation, which should allow them to enjoy the limited liability they expected. Unless you limit preemptive rights in the articles, the shareholders automatically have preemptive rights. 4. Promoters’ contracts Cantor v. Sunshine Greenery, Inc. 306 The court concluded that Brunetti was not personally liable because Sunshine Greenery was a de facto corporation at the time Brunetti contracted with Cantor on behalf of Sunshine. R 2d of Agency §§ 84, 86, 326 R 3d of Agency §§ 4.04, 6.04 A promoter is someone who helps to form and organize a corporation. He is the entrepreneur and in charge of getting it organized. De facto corporation status allows the shareholders to retain their limited liability in suits against third parties. Promoter liability applies when all the parties know the corporation has not been formed. - 32 - Business Organizations The Corporation James Sinton 7/11/2023 The creditor of de facto corporation cannot sue the shareholders for the corporation’s obligations. The corporation says you are estopped from raising that defense, because you dealt with the individual as if he was the corporation’s agent. De facto corporation test. To satisfy as a de facto corporation, there must be: 1. a statute that permits incorporation; (Today, this is met in every jurisdiction; it is a useless factor). 2. a bona fide attempt to incorporate; and (This is the tough one! It requires a showing of a good faith attempt to incorporate. Courts have no sympathy when the purported corporate owners do not even complete the formalities necessary to incorporate.) 3. some actual use or exercise of corporate privileges. 3. 3d party v. Shareholders. The corporation by estoppel doctrine allows shareholder of a defective corporation to retain their limited liability when a third party understands his contract to be with the purported corporation. The third party voluntarily contracted with the corporation and knew of its limited liability. The third party did not bargain for the shareholders to be parties of the contract. Argument against finding a de fact corporation. e. Comparing the protections of each It deters or discourages incorporators from forming the corporation correctly, and undermines the purpose of the formalities. It allows the courts to bail you out even though you have unclean hands. Tort liability Corporation by estoppel It is narrower on this concept. d. Corporations by estoppel (Purported corporation) It does not protect the shareholders from tort liability, because the tort victim did not make a deliberate decision to contract with the corporation. It only applies to liability for contract. It does provide protection if the corporation has not filed its articles. 1. 3d party v. Corporation. A corporation may not avoid a contract based on defective incorporation. §329(a). Threshold Corporation by estoppel It takes less to satisfy the 3d branch of corporation by estoppel. The corporation claims because it did not exist, it is not bound by the contract. The third party says the corporation is estopped from raising that defense, because you held out to the world you were a corporation. It preserves the corporation’s limited liability even against tort victims. De facto corporation It requires a colorable attempt to incorporate and some actual exercise of corporate privileges. It merely requires a third party to consciously decide to deal with a purported corporation. Traditional Estoppel 1. Acting on behalf of the corporation represents to the third party that the corporation has been lawfully formed. 2. The third party has changed his position based on that representation. 3. The corporation is not able to deny its corporate status at a later time. 2. De facto corporation It is broader on tort and contract liability. f. Statutory protections Model Act Under the Model Act, corporation by estoppel and de facto corporation no longer apply. It has given statutory protection by establishing conclusive proof when the documents are filed with the Secretary of State. §2.03(b). Corporation v. 3d party. A third party may not avoid a contract with a corporation based on defective incorporation. §329(a) If you act on behalf of a corporation, knowing there was no incorporation, you are jointly and severally liable for all liabilities. §2.04. The third party claims you did not exist, so I am not bound by the contract. Delaware - 33 - Business Organizations The Corporation James Sinton 7/11/2023 A copy of the articles merely creates a presumption of incorporation that can be rebutted. §105. Extraordinary matters include 1. amending the certificate of incorporation, 2. mergers, 3. sales of substantially all of the corporation’s assets, and 4. dissolutions. The rebuttable presumption implies that the doctrines are viable defense to attacks on incorporation. §329(a) codifies the first and second branches of estoppel by corporation. Directors Delaware has not codified the third branch. One argument is that the third branch does not apply because §329 is silent. Charlestown Boot & Shoe Co. v. Dunsmore 327 The directors are not subject to the control of the shareholders. 6. Ultra Vires Doctrine Default rule: The board is the locus of power of the corporation. §141(a); 8.01(b) allows the corporation to be managed by the shareholders DGCL §§ 102, 122, 124 MBCA §§ 2.02, 3.02, 3.04 Directors are true fiduciaries of the corporation; they have the duty to act solely in the best interests of the corporation. DGCL §102(a)(3) permits a corporation to describe its purpose generally such as to perform any lawful act. MBCA §§ 2.02(b)(2)(i), 3.01(a) makes the declaration of a corporation’s purposes optional. Directors are not agents of the shareholders! Nor are they agents of the corporation. 1. The directors are not subject to the control of the corporation. They are the principals; they control the corporation. 2. They hold their office charged with the duty to act for the corporation. 3. Shareholders cannot act in relation to the ordinary business of the corporation, nor can they control the directors. General rule is that §124 wipes out ultra vires. It establishes three exceptions to the application of ultra vires: 1. It allows stockholders to sue the corporation to enjoin the corporation. 2. The corporation directly (directors decide to sue) or derivatively can sue former or incumbent officers for damages. 3. The Attorney General can sue the corporation. A director’s informational rights Ultra vires tends to apply when corporate conduct does not benefit the corporation at all. Directors have a right to inspect the corporation’s books and records as long as they do so absent a detrimental purpose. C. Management and Operation Special meeting 1. Allocation of Power A special meeting can be held for the shareholders. §211(d); §7.02(a)(1). DGCL §§ 109, 141-142, 211, 220, 223, 225, 228, 242 MBCA §§ 7.02-7.04, 8.01, 8.08-8.10, 8.40, 10.03, 10.20, 16.05 Default rule: The board gets to call a special meeting. §211(d). You want to include in the bylaws that the shareholders can also call a special meeting. Traditional model of corporate governance 1. Board of directors appoints the officers and supervises the management of the corporation’s business. 2. Officers run the corporation’s day-to-day operations. 3. Shareholders elect the board and vote on extraordinary matters. Otherwise have little role in running the corporation’s business. Shareholder action without a meeting §228(a) permits the shareholders to act outside of the meeting if the shareholders send in written consent of what they want done. The written consent must comprise of the shareholders holding a majority of the voting shares in the corporation. Model Act requires unanimity! - 34 - Business Organizations The Corporation James Sinton 7/11/2023 §7.04(a) permits the shareholders to take action without a meeting if it is unanimous among voting shareholders. Judicial removal of a director 1. Some view that courts lack the power to remove directors; 2. Others view that courts have the power to remove directors for misconduct. Shareholder quorum To constitute a quorum, a majority of shares entitled to vote on a matter must be represented in person or by proxy at the meeting. Can the board itself remove a director? No, the board lacks the power to remove a director. §216 requires more than 1/3 of the shares entitled to vote to amount to quorum. Vacancies on the board §7.27(a) allows only a percentage greater than majority to constitute quorum. Default Rule: §223(a) the board has the power to fill the vacancies. It must be included in the articles or articles to allow the shareholders to fill the vacancies. Removal of Directors The Model Act Either the shareholders or the board of directors my fill the vacancy. §8.10(a) A director may be removed without cause, unless the articles or the bylaws say something different. §8.08(a) Three restrictions on the shareholders’ authority to remove directors without cause 1. If the board is classified or staggered, directors may be removed only for cause. DGCL §141(k)(1). 2. Where the corporation permits cumulative voting, a single director may not be removed if the votes cast against his removal would be sufficient to elect him. §141(k)(2); §8.08(c) 3. When a particular class of stock has the right to elect a director, only the shareholders eligible to vote for that director may vote for the removal. §141(k); 8.08(b). 2. Interference with the Shareholder Franchise DGCL §§ 102, 109, 141, 212, 228, 242 MBCA §§ 2.02, 7.21, 8.02, 10.03, 10.20 A board is prohibited from interfering with the shareholder franchise. Blasius Industries, Inc. v. Atlas Corp. (1) A 9.1% shareholder sought the corporation’s board to engage in a leveraged restructuring. (2) The board refused to follow the shareholders plan. (3) That shareholder began a consent solicitation – where you get the consent from a majority of the shareholders – to amend the bylaws to increase the size of the board. (4) The board amended the bylaws and filled the newly created vacancies. Classified board is divided into three groups with one group of directors standing for election each year. It discourages a hostile takeover in a single term. Cumulative voting provides proportional representation for minority shareholders. board The court held that only compelling circumstances will justify a board’s interference with the shareholder franchise. What constitutes cause? 1. Acceptance of employment with a direct competitor of the corporation; 2. Engaging in a competing business; 3. A director’s temporary financial difficulties and absence from the state did constitute as cause. 4. The removal must be based on substantial grounds showing a breach of trust rather than on whim, caprice, mistake, or misunderstanding. The board’s superior business judgment does not satisfy as compelling circumstances. 3. Formalities required for board action DGCL §§ 141, 229 MBCA §§ 8.20-8.25, 14.30 General Rule: A board of directors may exercise its power only as a body at a meeting duly assembled. A director threatened with removal for cause is entitled 1. To notice 2. To be heard 3. To be given a hearing Quorum Rule: If a quorum is present, it takes a majority of that quorum to approve a matter. - 35 - Business Organizations The Corporation James Sinton 7/11/2023 it would not order a new election because doing so would reward the absent director for not attending the meeting. Default Quorum: It is the majority of the total number of authorized directors, not the total of serving directors. Tomlinson The Tomlinson court held that an election absent quorum was void. Three caveats on the general rule: 1. The independent approval of an act by each of the individual directors is not effective board action; 2. Directors may not vote by proxy; and 3. Formalities as to notice, quorum, and voting must be fully adhered to. Deadlocked board The shareholders may petition the court to dissolve the corporation if the directors are deadlocked. §14.30(a)(2). Three statutory exceptions: 1. Directors may act by unanimous consent instead of having a meeting. §141(f); §8.21 2. Directors may participate in a meeting remotely, such as a conference call. §141(i); §8.21 3. The board may delegate most matters to committees, which may comprised of one or more directors. §141(c); §8.25 4. Authority of officers DGCL § 142 MBCA §§ 8.40-8.44 Officers are agents of the corporation. They can bind the corporation by their apparent authority. President Notice for board meetings 1. Delaware is silent on when notice must be given. 2. The Model Act does not require notice for regular meetings. 3. It does require notice for special meetings at least two days in advance with the date, time and place. 4. Waiver. A director may waive notice by writing or attending the meeting without objection. Lee v. Jenkins Brothers 345 The court held that the president has at least apparent authority to bind the corporation to ordinary transactions, but not for extraordinary transactions. Some jurisdictions take a restrictive view of the authority that a president has through his position. Quorum 1. A quorum of directors is a majority of the total number of authorized directors in the articles. 2. The certificate or bylaws may specify a percentage other than a majority not less than one-third of the total number of authorized directors. 3. If a quorum is present, it takes a majority of that quorum to approve a matter. A president may have implied authority based upon the board’s acquiescence to a course of conduct. Ratification. The board can ratify the president’s unauthorized conduct if the corporation accepts the benefits of a transaction with the board’s knowledge. Vice president Closely held corporations 1. Unanimous assent or acquiescence by directors is normally viewed as the equivalent of formal board action. 2. Informal assent or acquiescence by less than all of the directors should be insufficient to constitute valid board action. 3. When all of the shareholders approve a transaction, courts often ignore that the board, rather than the shareholders, was the body to make the decision. No apparent authority. Some courts view that the vice president has no apparent authority derived from his office alone, unless the authority has been conferred by the bylaws. Some authority. Other courts view that the vice president has some authority where he was allowed to exercise general executive responsibilities. Secretary He is the custodian of the corporation’s records, and has the authority to certify corporate records including board resolutions. Board vote without quorum Gearing v. Kelly 342 When a director deliberately skipped a board meeting to defeat quorum and the board voted anyway, the court held - 36 - Business Organizations The Corporation James Sinton 7/11/2023 Straight voting Straight voting election of directors, each shareholder casts his voting power equally. Shareholders may not give more than one vote per share to any single nominee. No business authority. The secretary usually has no authority to engage in business transactions. Treasurer The treasurer receives, safeguards, and disburses the corporation’s funds. Every shareholder gets to vote with his entire shares for each nominee. He usually has the authority to write checks against the corporation’s account. If you are a minority shareholder straight voting eliminates your ability to elect someone to the board of directors. He usually has no authority to make contracts on behalf of the corporation. Example Able has 600 shares; Baker has 400 shares Able votes for A, B, & C. Baker votes for D, E, & F. 5. Shareholder action a. Formalities required for shareholder action A,B,C each received 600 votes D,E,F each received 400 votes. DGCL §§ 211, 213, 216, 219, 228-229 MBCA §§ 7.01-7.02, 7.04-7.07, 7.20, 7.25, 7.27-7.28 In a straight voting election anyone owning 51% of the shares elects the board. Voting Rule: Shareholders approve a matter by a majority of voting shares. The number of shareholders voting does not matter. Cumulative voting Cumulative voting election of directors, Every shareholder has a number of votes equal to the number of shares he owns multiplied by the number of board seats up for election. Absentee shareholders Delaware counts abstaining votes as “nos” It is an opt-in regime. Cumulative voting must be in the articles. Model Act does not consider the abstaining votes. §7.25(c). Shareholder action without a meeting Cumulative voting gives more voting power to a minority shareholder, so that minority shareholder can get proportional representation. §228(a) permits the shareholders to act outside of the meeting if the shareholders send in written consent of what they want done. The written consent must comprise of the shareholders holding a majority of the voting shares in the corporation. §216(3) Directors are elected by a plurality of the voting shares present. It is an alternative method of electing directors. It is not used for anything else. The Model Act requires written consent from all the voting shares to act without a meeting. §7.04(a) The shareholder may distribute the votes among the candidates in any manner. b. Straight v. Cumulative Voting DGCL § 214 MBCA §7.28 How many cumulative votes does the shareholder get? Cumulative votes for that shareholder = (Total number of shares owned by that shareholder) x (Total number of directors up for election) General rule: Most states use straight voting as the default method for the election of directors. Example Able has 1800 votes (600x3). Baker has 1200 votes (400x3). The certificate of incorporation may require cumulative voting. Suppose Able casts 900 votes for A and 900 votes for B. - 37 - Business Organizations The Corporation James Sinton 7/11/2023 Able wins those nominees, because Baker doesn’t have enough voting power to split between A and B. 2.4 = How do you diminish the effect of cumulative voting? 1. Under the general rule, a majority of shareholders can remove the shareholder at anytime without cause. 2. §141(k)(2) closes that loophole. It limits when a director can be removed without cause in the case of a corporation having cumulative voting. 3. If you are trying to remove the director under a cumulative voting scheme and the votes removing him would have been enough to elect him by the minority shareholder, that director cannot be removed without cause. Suppose Baker cases 1200 votes for D. Baker wins that nominee. Cumulative voting is advantageous to minority shareholders because it reflects proportional board representation. Baker has 40% voting power with 1/3 representation on the board. Proportional representation serves minority shareholders, because board directors have greater access to information on the business operations than shareholders. Number of shares needed Classified board. §141(d) To determine the number of shares needed to elect a specific number of directors: 𝑇𝑜𝑡𝑎𝑙 𝑠ℎ𝑎𝑟𝑒𝑠 𝑛𝑒𝑒𝑑𝑒𝑑 = You divide the board of director into staggered terms. You have a 1/3 of the directors elected each year for 3-year terms. 𝑆×𝑁 +1 𝐷+1 What is the purpose of staggered voting? If you are concerned about a hostile takeover, a staggered board makes a hostile takeover less attractive. The new majority shareholder is going to have to wait two terms to replace the directors. S = Total number of shares N = Number of directors D = Total number of directors up for election If it is a whole number, you stop. If it is not a whole number, round down. 501 = 600 × (3 + 1) 1000 Classified boards circumvent cumulative voting. Consider how many directors are up for election on a new term. 1000 × 2 +1 3+1 If cumulative voting was included in the articles, is it a breach of fiduciary duty to amend the articles to use straight voting to lockout a minority shareholder? It might lead to freeze out. Removing a director. The formula determines whether a director can be removed without cause. Shareholders may not remove a director elected by cumulative voting without cause if the votes cast against his removal would be sufficient to elect him. §141(k)(2). §214; 7.28(b) Most states define straight voting as the default method for the election of directors. The certificate of incorporation may require cumulative voting. Number of directors c. Informational rights To determine how many directors the shareholder has the power to elect: DGCL § 220 MBCA § 16.02 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑑𝑖𝑟𝑒𝑐𝑡𝑜𝑟𝑠 = 𝑋(𝐷 + 1) 𝑆 Getting access to the books and records DGCL §220 allows the shareholder to take a look at the books and records of the company. It is not an unfettered right. X = Total number of shares owned by that shareholder D = Total number of directors up for election S = Total number of shares Step 1: Shareholder demands in writing, which states a proper purpose, to inspect the corporation’s books and records. Round down to the nearest whole number. - 38 - Business Organizations The Corporation James Sinton 7/11/2023 Step 2: On a refusal, shareholder sues the corporation. D. Altering corporate norms by contract (a) If the shareholder seeks records other than the stock ledger or list of shareholders, the shareholder must include in its petition: 1. He is shareholder; 2. He has made a demand to the corporation to see its books and records; 3. He is seeking the information for a proper purpose. 1. Voting agreements DGCL §§ 141, 151, 212, 218 MBCA §§ 6.01, 7.22, 7.30-7.31, 8.08 Ringling Bros. v. Ringling 366 Shareholders may enter into voting agreements to act in concert. (b) If the shareholder seeks the stock ledger or list of shareholders, the shareholder must include in its petition: 1. He is a shareholder; and 2. He has made a demand to the corporation. For a voting agreement to be enforceable, 4. It must be in writing 5. It must be signed by the parties 6. Common-law restriction – buying votes by giving the seller a purely personal benefit is illegal per se. Step 3: On a demand for the stock ledger or list of stock holders, it is presumed that the shareholder has a proper purpose. The corporation has the burden to establish the shareholder’s inspection is for an improper purpose. A voting agreement cannot be oral or implied. Proper purpose The Model Act §7.31(a) says voting agreements are valid. The statute provides little help because it defines a proper purpose as “a purpose reasonably related to such person’s interest as a shareholder.” 2. Self-enforcing voting mechanisms §218(c) and §7.31 rely on a court to order appropriate relief if a voting agreement is breached. What is a proper purpose for inspecting the books and records of a corporation? Three alternative methods to make voting agreements selfenforcing: Skouras v. Admiralty Enterprises, Inc. 359 The court recognized that seeking records to investigate corporate mismanagement is a proper purpose under §220. a. Irrevocable proxies §212 and §7.22 A shareholder must show a clear indication of wrong-doing on the part of the corporation’s management. §212(b) allows the shareholder to convey a proxy in writing, which authorizes the proxyholder to vote on the shareholder’s behalf. Although the shareholder might have a secondary purpose, once a proper purpose is established that is enough to satisfy §220. A proxy is valid for 3 years, unless it provides for a longer period. Examples of a proper purpose: 1. To value shares; 2. To ascertain corporate financial condition; 3. Reasonably related to a shareholder’s interest. An irrevocable proxy is when the shareholder gives the right to vote his shares to another and it cannot be revoked. Examples of improper purpose: 1. Satisfying curiosity; 2. Giving information to a competitor; 3. Gathering information for a lawsuit. §212(e) permits a shareholder to create an irrevocable proxy, which must state that it is irrevocable and the proxy must be “coupled with an interest.” What does “coupled with an interest” mean? The proxyholder who purchases a proxy has an interest in recovering a personal investment, and the proxyholder’s interest is assumed to be antagonistic to the corporation. Alternative Moll suggests that the shareholder could sue the corporation on other grounds to have broader discovery rules available. - 39 - Business Organizations The Corporation James Sinton 7/11/2023 In contrast, the creditor who secures a loan against the shares has an interest to maintain or increase the value of the shares. The creditor’s interest is assumed to be consistent with the corporation’s interest. A voting trust is created only if: 1. The trust agreement is made in writing; 2. A copy of the trust agreement is deposited with the corporation at its registered office, where the agreement must be available for inspection; and 3. The shares subject to the trust is transferred to the trustee or trustees. Haft holds that an interest in the corporation satisfies §212(e). The trust agreement is not secret; other shareholders may inspect the voting trust agreement. It is a record of the corporation. To determine whether the interest is in the corporation it is important to consider the identity of the proxyholder. Because Mr. Loos was detached, he might be considered to have neither an interest in the corporation nor an interest in the shares. On the transfer, the corporation cancels the shares transferred and issues new shares in the name of the trustee. Where a shareholder in a voting agreement refuses to follow the direction of the arbitrator, it would confer an irrevocable proxy on the other shareholder. The stock is voted as the trust agreement directs. If the trustees are equally divided, the vote of the stock is divided equally among the trustees. The Model Act specifies that a proxy is coupled with an interest when given in favor of: 1. A pledgee; 2. One who purchased or agreed to purchase shares; 3. A corporate creditor who extends credit under a contract requiring the proxy; 4. A corporate employee whose employment contract requires the proxy; or 5. A party to a voting agreement. See §7.22(d) Time limit. §218 does not impose a time limit on the voting trust. Hypothetically, a voting trust might serve as a dead hand. §7.30(b) forces voting trusts to expire in ten years, unless it is extend for an additional period. Whether failure to comply with the statutory formalities renders a voting trust illegal. Mr. Loos might have had a proxy coupled with an interest, if he were made a party to the voting agreement for nominal consideration. Traditional view is that not satisfying the statutory strictures does render the trust void. b. Voting trusts §218(d) disallows a court from nullifying a trust agreement on the §218 alone. §218 and §7.30 The main purpose of a voting trust statute is to avoid secret, uncontrolled combinations of stockholders formed to acquire voting control of the corporation to the possible detriment of non-participating shareholders. Legal title is vested in one or more trustees. The shareholders transfer legal title of their stock to a trustee. The trustee owns the shares of the shareholders in the voting trust. c. Classified voting Trust agreement. The trust agreement transfers the shareholders’ right to vote to the trustee and directs the trustee on which way to vote. The trust agreement also says that other rights of the stock are transferred to the shareholders in the trust, like the right to inspect the books and records. Finally, the corporation might issue multiple classes of stock to divide the shareholders’ rights to elect directors. Class B common stock that has the right to elect one director. One class of stock might have voting rights, and the other would be identical absent voting rights. The voting trust is self-enforcing mechanism. The voting agreement can be breached by the shareholders. The voting trust can be breached by the trustee, but it would constitute a breach of fiduciary duty. Another method is to limit the number of directors a class of stock can elect. - 40 - Business Organizations The Corporation James Sinton 7/11/2023 Suppose Class A shares may elect two directors and Class B shares may elect two directors. the agreement, creditors, the public, or all of those parties. To avoid deadlock. The corporation might issue a third class of stock with the power to elect a fifth director and no economic rights. It can be issued to a disinterested party like a trustee. a. Statutory requirements Most states provide a statutory way to have a shareholder agreement that constrains the board, and if the shareholder-director violates the statute, common law might bail the shareholders out. Removal. If the voting is classified, only shareholder who may vote to elect a director may vote to remove that director. §141(k); §8.08(b) E.g., NY says the provisions of the shareholder agreement must be in the articles of incorporation! 3. Controlling the board’s discretion b. Common-law summary DGCL § 141 MBCA § 8.01 The common law has been all over the place on shareholders agreement. Who can enter into a contract to constrain the board of directors? In general, only shareholders can agree to constrain the board, even then it might be unenforceable. McQuade v. Stoneham 380 Holding: The court held a contract between directors is unenforceable because it might preclude those directors from exercising their fiduciary duty owed to the corporation. Can directors enter into an agreement to constrain their duties? No, the board owes fiduciary duties to the corporation, which requires the freedom to act in the best interest of the corporation. Some read McQuade also to say that no shareholder agreements are not appropriate. Factors to consider in determining whether the agreement interferes with the board’s discretion to constitute as unenforceable: 1. Is the agreement between the shareholders or directors? Ringling says yes to shareholders. McQuade says no to directors. 2. Does the agreement harm the corporation’s creditors? Clark 3. Does the agreement establish obligations between the parties that depend on definite external standards? Clark 4. Does the agreement seek to safeguard the interests related to a shareholder? Consider the financial and participatory interests of a shareholder. 5. To what extent does the agreement impinge or sterilize the board of directors. Long Park The court’s holding suggests that any contract that has the potential to limit or constrain a director might interfere with his fiduciary duty. Alternative If a shareholder seeks to ensure employment as an officer: 1. The shareholder can contract an employment agreement with the corporation. 2. The shareholder can alter the bylaws to say that it requires a unanimous vote to remove officers. Clark v. Dodge 384 Shareholders are free to contract to control the operations of the business. Harm to creditors: one consideration is to ask whether any creditors are being harmed by the shareholder agreement. Reasons for invalidating the shareholder agreements: 1. Shareholders are not liable for obligations of the corporation. Nor do shareholders owe a fiduciary duty to the corporation. 2. Effectively, transferring complete control of the corporation’s business operations to the shareholders through the use of shareholder agreements might encourage riskier transactions that adversely affect other shareholders outside of Definite external standard: In Clark, Dodge’s obligation to keep Clark as the general manager relied on Clark being faithful, efficient, and competent. It depended on a definite external standard. Galler Objecting minority and public interest: In the case of shareholder agreements, the court said the critical factor is - 41 - Business Organizations The Corporation James Sinton 7/11/2023 Issue: What happens when the bylaws require a supermajority to amend a particular provision, but it does not require a supermajority to amend the remaining provisions? the absence of an objecting minority interest and a detriment to the public. Long Park Impinging/Sterilizing the Board: Consider the extent to which the agreement impinges the board of directors. Frankino v. Gleason 388 The court said the board could amend the provision requiring a supermajority to amend the authorized number of board seats because the bylaws allowed the shareholders to amend any other provision of the bylaws with a simple majority. 4. Voting requirements DGCL §§ 109, 141(b), 216, 242 MBCA §§ 7.25, 8.24, 10.20 Default Rules: 1. Shareholders act by a majority of voting shares. 2. Directors act by a majority vote. 5. Share transfer restrictions DGCL §202 MBCA §6.27 Best alternative: The articles of incorporation need to include the voting requirement that increases the default rules. Statutory requirement: A share transfer restriction must be reasonable to be enforceable. It is to the public’s advantage that property maintains reasonable liquidity. §242(b)(4) says where the articles of incorporation require for action by the shareholders or board of directors a greater vote than is required by the corporate statutes, the articles cannot be altered, amended or repealed except by that greater vote. Allen v. Biltmore Tissue Corp. 392 It recognized that corporations have wide breadth in restricting the transfer of shares. A de minimis price is not enough: For the share transfer restrictions to be invalid, more than a mere disparity between option price and current value of the stock must be shown. Example: Suppose the articles required a supermajority vote to change the authorized number of directors on the board. §242 also requires a supermajority vote to amend that requirement in the articles. Supporting stock transfer restrictions: 1. Closely held corporations need a method of controlling who invests in that corporation. The owners of the corporation seek to maintain compatible decision-makers investing in the corporation. 2. The valuation of a closely held corporation is not easily determined. Corporate law presumes that the buy-out provision reflects the shareholder’s valuation of the corporation. 3. Other methods of valuation are costly, requiring an audit of the company’s assets and possibly litigation to resolve disputes over the fair value. The buy-out agreement represents the shareholders’ waiving of that costly valuation process. 4. Buy-out agreements allow the corporation to predict with some certainty the amount it needs to have on hand to satisfy the buy-out. Provisions that permit the use of supermajority votes: §141(b) is for directors §216 is for shareholders. Supporting supermajority or unanimous vote: 1. It requires controlling shareholders to seek the consent and advice of the minority shareholder. 2. It increases the power of the minority shareholders. 3. It increases the value of the minority shareholder’s participatory rights in the corporation. 4. Deadlock can be resolved through dissolution, and merely having a deadlocked board does not grind the corporation to a halt. 5. The officers manage the day-to-day business operations. Opposing supermajority or unanimous vote: 1. It is inefficient in managing the business enterprise to require a heightened voting standard. 2. Corporate decisions can be deadlocked by a single shareholder. (1) First-option agreements It is an obligation to offer the shares to the corporation of the other shareholders at a specified price before selling to a 3d party. - 42 - Business Organizations The Corporation James Sinton 7/11/2023 §342(a) provides the qualifying provisions for a statutory close corporation: 1. You cannot exceed 30 shareholders. 2. You have to at least one stock transfer restriction. 3. You cannot become a public company. (2) First-refusal agreements It is an obligation to offer the shares to the corporation or the other shareholders at the same price, and on the same terms, offered by a 3d party. §343 requires you to include a heading in the articles declaring that it is a close corporation (3) Consent agreements It is an obligation to obtain the consent of the corporation or the shareholders before selling to a 3d party. Special rules §350 If you have a shareholder agreement that restrains the discretion of the board, the agreement is valid for purposes of a statutory close corporation. (4) Buy-sell agreements It is an agreement that gives a shareholder the opportunity or obligation to sell, and the corporation or other shareholders the opportunity or obligation to purchase, shares at a specified price on the happening of specified events, such as death or termination of employment. §351 Management by stockholders You can remove centralized management and run the business straight by stockholders. (5) Prohibiting transfers to designated persons §352 The court may appoint a custodian. A provision prohibiting transfers to designated classes of persons. §353 The court may appoint a provisional director. §354 The shareholders may treat the corporation as a partnership. (6) Preserving a legal advantage Transfer restrictions are designed to preserve some legal advantage. §355 You can put in your articles a provision that permits the shareholders to dissolve the corporation for whatever grounds – an option to dissolve the corporation. Consider a corporation may forfeit its status as a closely held corporation if transfers increase the number of shareholders. E. Limited liability and piercing the corporate veil A corporation will lose its Subchapter S status if shares are transferred to specified entities or nonresident aliens. DGCL §102(b)(6) (limited liability as the default) MBCA § 6.22(b) What is limited liability? Limited liability means that shareholders are not personally liable for the obligations of the business. They are only liable to the extent of their investment in the corporation. 5. Statutory Close Corporations DGCL §§ 141(a), 342-343 It is a special set of statutes applicable to closely held corporations. Justifications for limited liability 1. The statutory close corporation is designed to allow more freedom in contracting around the corporate norms. 1. Voting agreements 2. Controlling board 3. Share transfer restrictions 2. Formation 3. 4. You have to qualify §342(a) and elect §343 to be a statutory close corporation. - 43 - It decreases the need to monitor agents (managers, directors, officers, employees) of the business. In the unlimited liability world, you are going to have to watch those managers. It reduces the costs of monitoring other shareholders – fellow owners of the company. Recall the pick your partner rule. It gives managers incentive to act efficiently. It permits the market price to impound additional information about the value of firms. Business Organizations The Corporation 5. 6. James Sinton 7/11/2023 It allows more efficient diversification. Because it reduces the need to monitor agents and shareholders, the investor can spread his wealth. It facilitates optimal investment decisions same or similar line of business on industry-wide ratios (current ratio, acid-test ratio, debt/equity ratio). When to measure? 1. At formation. Some courts consider whether the capitalization was adequate at the time of formation. These courts recognize that a corporation might have had adequate funds when formed but suffered losses during operation. A corporation does not have a continuing requirement to maintain an adequate level of capitalization. 2. Continuing obligation. Other courts view that corporations have a continuing obligation to hold adequate capital. The piercing veil factors Piercing is a last resort, because it rarely succeeds. First line of defense: Shareholder says I have limited liability. The courts consider factors to determine whether to pierce the corporate veil to hold the shareholder personally liable for the obligations of the corporation. 1. Inadequate economic capitalization 2. Siphoning off profits 3. Failure to follow corporate formalities 4. Using corporation assets for non-corporate purposes Fudge factor: some aspect of unfairness or injustice Most states do not require a minimum amount of capital to form a corporation and maintain corporate status. Supporting minimum capital requirements: Minimum capital requirements might help satisfy the claims of tort victims and creditors. Other factors to consider 1. whether the plaintiff is a tort victim or creditor arising from contract; 2. whether the corporate owners are treating the corporation like separate legal entity; 3. whether the factor has a causal connection to the corporation’s ability to satisfy its tort liability or debt; 4. whether the corporate owners are using corporate assets for non-corporate purposes. Opposing minimum capital requirements 1. The minimum requirement might not be flexible enough for the wide latitude of business enterprises from the hot dog stand to the investment bank. 2. It might be cost prohibitive to start a business and foreclose benefits to the public. (1) Inadequate economic capitalization (2) Siphoning off profits Often the corporation has been inadequately capitalized to create a judgment proof entity. The corporate owners consistently pay themselves through corporate profits, while not reinvesting into the business enterprise. Essential inquiries: 1. Does the corporation have sufficient capital to meet its reasonably foreseeable obligations? 2. Reasonably foreseeable obligations. What is the most common liability associated with the business enterprise? See the fraudulent transfer section below! (3) Corporate formalities Texas does not consider the failure of the corporation to observe corporate formalities as a basis for holding the shareholder responsible for corporate obligations. See Tex. Bus. Orgs. Code. Ann. §21.223(a)(3). How do you measure the inadequacy of economic capitalization? 1. It relies on the nature of the business including the risks of the business, the obligations ordinarily incurred in the business, and the size of the business operations – employees, assets, and dividends. 2. Laya observed that financial experts might aid in analyzaing the finances of the corporation. It suggested comparing corporation in focus with the capitalization of other corporations in the Causal connection: Consider whether adhering to corporate formalities resolves the issue of a judgment proof corporation. The corporation would have been able to satisfy the debts of the creditor but for violating the corporate formalities. YEAH RIGHT!? - 44 - Business Organizations The Corporation James Sinton 7/11/2023 Where the failure to follow formalities is so extensive that the corporation appears to be a sham, courts have been more willing to pierce the corporate veil. Vertical piercing is where the shareholder does not treat the corporation like a separate legal entity A creditor or judgment holder of the corporation sues the shareholders of that corporation. (4) Unfairness or injustice Many jurisdictions require some unfairness or injustice. S/H What does this mean? It usually reflects that the creditor cannot recover from the corporation because the corporation is insolvent. Corporation Illegitimate purpose Virginia sets a higher standard than a showing of unfairness or injustices, rather it required the creditor to prove that the corporation was used to “disguise wrongs, obscure fraud, or conceal crime.” See Perpetual Real Estate Services. Creditor The shareholders treat the corporation like their personal assets. Virginia had ratcheted up the fudge factor. Horizontal piercing theory One theory of piercing is horizontal where the brother-sister corporations are acting like a single entity. In the case of piercing the vertical veil, the creditor seeks the assets of the shareholder to satisfy the debt of the corporation. A creditor or judgment holder of the corporation sues the other corporations in the horizontal scheme. Consider the factors above that indicate vertical piercing. 1. Tort cases Brother Sister Most courts say that veil piercing is more likely for tort victims, because they did not voluntarily encounter corporate entity. Minton suggests that undercapitalization is an important factor for tort cases. Creditor 2. Contract cases Perpetual Real Estate Services applied a more stringent standard than the unfairness or injustice. Consider whether the corporations have a similar business purpose, financing, clients, and managing officers. Assumption of risk theory: Some courts impose a more stringent standard for contractual obligations, because the creditor has voluntarily bargained with the corporate entity. What factors might indicate a horizontal theory? 1. Sharing the same financial accounts, while lacking a detailed accounting. 2. One corporation puts up collateral for another. 3. One corporation is lending another money. 4. A manager is working for more than one of the corporations. 5. The corporations share the same business address. It is deemed to have contemplated the limited liability and could have implemented measures to anticipate an insolvent corporation. Tort claimants have no assumption of the risk theory, because they did not knowingly entertain the risk of the corporation’s limited liability. Vertical piercing Actual fraud requirement - 45 - Business Organizations The Corporation James Sinton 7/11/2023 In Texas, a shareholder is not liable on contractual obligation of the corporation, unless the person owed shows that the shareholder caused the corporation to be used for the purpose of perpetrating and did perpetrate an actual fraud on the person owed for the direct personal benefit of the shareholder. Tex. Bus. Orgs. Code Ann. § 21.223(b). 3. Fraudulent transfers Direct responsibility The plaintiff claims that the parentcorporation is directly responsible because it actually operated the business of its subsidiary. 5. Reverse piercing Step 1: Is it worth seizing the shareholder’s stock? Step 2: Sue the corporation with reverse piercing claim. 419 Judgment against the shareholder A shareholder’s creditor may obtain a judgment and seize the shareholder’s stock in the corporation. An alternative claim available is that the corporate owners received fraudulent transfers from the corporation. The corporation is liable for a fraudulent transfer if 1. the corporation transfers funds or assets to the corporate owner (e.g., siphoning profits); AND 2. the transfer is made without receiving a reasonably equivalent value in exchange for the transfer to that corporate owner. Seizure is only good for a majority shareholder. A minority shareholder will not be able to dissolve the assets of the corporation. If it is a fraudulent transfer, the remedy is for the transferee to return the property to the corporation. Reverse piercing defined. In a reverse veil-piercing case, a creditor of a shareholder seeks to hold the corporation liable for the shareholder’s debts. If the debtor-shareholder owns 100% of the corporation’s stock, and the creditor receives all of the stock, the creditor may dissolve the corporation. Drawbacks: 1. It is very HARD to prove. You have to prove the particular fraudulent transfer made by the corporation often with abysmal financial records. 2. The remedy for a fraudulent transfer case is limited to demanding the shareholder-transferee to return the assets of the transfer. 3. Piercing the veil allows the creditor or tort victim to satisfy the judgment against all the shareholders. Creditor S/H 4. Parent-subsidiary cases This contemplates the scenario where a corporate shareholder owns a subsidiary that is liable for a tort or contractual obligations. Corporation Vicarious liability The corporate veil can be pierced to satisfy the obligations of a shareholder or other active participant in the business on a showing that 1. The shareholder and the corporation are alter egos of each other; 2. The corporation was used to perpetrate a fraud or defeat a rightful claim; 3. An equitable result is achieved. In vertical piercing case, a creditor seeks to hold the corporate shareholder liable for the corporate-subsidiary’s obligations. The corporate-shareholder is not at fault. General rule: The courts will not pierce the corporate veil to reach the parent if the parent respects the separate identity of the subsidiary and does not exercise undue domination and control over the subsidiary’s business operations. The Phillips court instructed to consider the same factors used in determining traditional veil piercing is appropriate. - 46 - Business Organizations The Corporation James Sinton 7/11/2023 It is generally supported where a shareholder uses the corporate form to evade preexisting liabilities or otherwise hide assets from creditors. face with the rational business purpose standard. It presumes that the corporate fiduciary has made the challenged decision in good faith, with a reasonable decision-making process, and without a conflict of interest. Critical Factor It is disfavored where it might harm innocent shareholders or creditors of the corporation. Plaintiff must show that the defendant has violated one of the BJR prerequisites: 1. Good faith; 2. Reasonable decision-making process; OR 3. COI transaction F. Fiduciary duty ALI Principles §4.01 Step 2: Burden shifts to Defendant. Who owes fiduciary duties? 1. Directors 2. Officers 3. Controlling shareholders If plaintiff convincingly establishes that a corporate fiduciary has violated one of the prerequisites to the BJR, the burden shifts to the defendant to show that its decision was entirely fair to the corporation. The court applies the entire fairness standard to review the defendant’s decision. What fiduciary duties are owed? 1. Duty of Care 2. Duty of Loyalty Otherwise, the court considers whether the board’s decision is attributed to a rational business purpose. To whom is the duty owed? 1. D Corporation 2. O Corporation 3. Controlling S/H Corporation 4. Special context: S/H Other S/H D Creditors of the corporation. See Francis. a. When the corporation holds those creditor’s money or assets in trust; AND b. When the corporation is insolvent. Step 3: Burden shifts to plaintiff, but standard might differ. In the COI context, if the defendant satisfies §144(a) Courts say that §144(a) cures the COI prong. The BJR returns with the rational business purpose standard. Although, satisfying §144(a) demands that the plaintiff show the defendant used a grossly negligent decision-making process, it is probably satisfied under the good faith prong of §144(a). The Business Judgment Rule In the controlling shareholder context, if the defendant satisfies §144(a)’s curative strictures, the burden of proof shifts to the plaintiff and the entire fairness standard remains. In this procedural setting, the plaintiff must show that the transaction was unfair or lacked fairness to the corporation. MBCA § 8.31 The law presumes that, in making a business decision, directors act in good faith, on an informed basis (Duty of Care process inquiry), and in the honest belief that the action taken is in the best interest of the corporation (Duty of Loyalty). The courts do not recognize the full effect of authorization because the controlling shareholder is heavily influential to the directors and officers. Litigation roadmap Standards of review The business judgment rule is a litigation roadmap to aid in determining the likelihood of success in challenging a business judgment made by the fiduciaries of the corporation. The BJR determines the standard of review under which the court will view the corporate fiduciary’s decision. (1) Rational business purpose (2) Entire fairness standard Step 1: Corporation or creditor sues D, O, S/H. The plaintiff seeks to challenge the business decision made by the corporate fiduciary. The BJR is in his - 47 - Business Organizations The Corporation James Sinton 7/11/2023 Justifications for the BJR 1. Corporations are encouraged to take some risks with limited liability principles 2. Board decisions should be handled in the board room and not the court room 3. A hindsight bias easily taints an ex post determination weighing the substance of a decision. 4. Judges do not always have the business background to handle business decisions; P: Judges make difficult decisions everyday. 5. The market polices corporations because investors will move their money to a different investment if they are dissatisfied with corporate management; P: A closely held corporation does not enjoy the benefit of a liquid market for its stock. Smith v. Van Gorkom 475 It established the stringent standard for evaluating the reasonableness of the decision-making process. It considers the inputs available to the directors. Reasons for paying an amount greater than the market price: 1. the purchaser believes he can inject synergy into the corporation through new management; 2. the higher price reflects a controlling shareholder’s interest, while the market price reflects a minority shareholder’s interest; or 3. tax credits have value. Factors to consider in determining the reasonableness of the decision-making process: 1. Who initiated the transaction and when was it initiated? Van Gorkom, as the fiduciary, made the initial offer, which never changed, to Prtizker. It does not reflect a fair price, because the offer could have been grossly undervalued. Nor does it reflect a fair deal, because it was not thoroughly questioned. 2. Speed. The board should deliberate about the consequences of the transaction for a sufficient amount of time. D: The board has been discussing the transaction for much longer than the actual meeting; D: The board made the decision under exigent circumstances; D: We are experienced. 3. Contextually relevant information. The board should gather contextually relevant information about the transaction. D: I already knew or had the information. 4. Reviewing information. The board should review supporting documentation about the transaction. The board should fully participate in the decision-making processing. D: §144(e) allows a director to rely in good faith on the officers and experts summarizing the information. 5. Questions. The board should ask questions about the transaction. D: I asked questions outside of the meeting. 6. Experience. Some view Van Gorkom to say that experience is irrelevant. Others view Van Gorkom to say that the board’s experience is regarded if it has a sufficient nexus with the process defect. For instance, an experienced board might be able to make a faster decision. 7. Risk balancing. The amount of care required for the decision-making process is related to the risk-benefit in the transaction. (1) Good faith Most courts characterize knowingly illegal conduct as bad faith, but even illegal conduct might be in the best interest of the company. It is a subjective inquiry into whether the decision-maker really thought the decision was in the best interest of the company. Courts have defined bad faith as authorizing a transaction for some purpose other than a genuine attempt to advance corporate welfare or when it is known to constitute a violation of law. Some commentators suggest that good faith has no independent meaning to weigh the business decision of the corporate fiduciaries. 1. It is merely an aspect of the conflict of interest prong; 2. It is an aspect of rational business purpose standard; (2) Reasonable business process DGCL § 141(e) MBCA § 8.30(d), (e), (f) Standard of Care The standard of care for analyzing the decision-making process is gross negligence. Defense: 1. §144(e) provides total immunity (but it doesn’t really) 2. The shareholders approved it. 3. D has no personal liability under exculpation clause. §144(e) Statutory protection The statutes provide protection to directors who rely in good faith on information, opinions, or statements from officers, employers, and other experts. - 48 - Business Organizations The Corporation James Sinton 7/11/2023 D: §144(e) provides total immunity from liability. Marciano v. Nakash 507 It as an example of the transaction satisfying the entire fairness standard, only after failing to meet the statutory curative measures under §144(a). P: §141(e) merely removes the obligation of the director to perform his own independent research on top of his experts. It does not confer total immunity to the corporate fiduciary. The corporate opportunity doctrine It is a violation of the D/O’s duty of loyalty to misappropriate a corporate opportunity for himself. Shareholder voting protection If the disinterested shareholders are fully informed (by contextually relevant information) and approve the decision in good faith, this protects the board. Remedy: Constructive trust, the opportunity is returned to the corporation and the fiduciary is liable for any profits that he made from the opportunity. If the shareholders are not fully informed and they approve the decision, this does not protect the board. See Van Gorkom. Northeast Harbor Golf Club, Inc. v. Harris 517 The court adopted the ALI approach to determine whether the director or officer wrongfully took a corporate opportunity. Gantler held that shareholder ratification only applies to transactions that the shareholders are not otherwise legally required to approve. The varying approaches to determine whether the director or officer misappropriated a corporate opportunity: 1. Line of business test. It depends on whether the business opportunity is in the line of the corporation’s business. 2. Fairness test. It asks whether the D/O’s conduct was fair to the corporation. 3. Two-step approach. It combines the considerations of the latter two. 4. Interest or expectancy test. An opportunity is open to a fiduciary unless: (1) the corporation has an interest already existing in the opportunity; (2) the corporation has an expectancy in the opportunity growing out of an existing right; OR (3) the corporation has a substantial need for the opportunity. 5. ALI § 5.05. See below. (3) Conflict of interest transactions DGCL § 144 MBCA §§ 8.60-8.63 A pro rata distribution made by the corporation to the shareholders does not amount to a COI transaction, ordinarily there must be some benefit only offered to a D/O or controlling shareholder. Dissolution is available to shareholders when controlling shareholders, directors, or officers misappropriate corporate assets. Who is an interested party? A conflict of interest does not amount to a mere trace of bias. Nor does it reflect the impartiality required by a judge. ALI § 5.05 It adopts a bright-line rule that the D/O must disclose the business opportunity, disregarding if it is in the line of business. Nor does it consider the financial capacity of the corporation to make use of the opportunity. Who is a disinterested party? 1. The director must have no material financial interest in the transaction. Cf. §144(a). 2. The director is independent and not beholden to someone interested in the transaction. 3. In the context of a controlling shareholder, a director’s being merely elected by the controlling shareholder is not enough to constitute a tainted interest. However, the ALI’s approach is still difficult to apply because it relies on establishing a corporate opportunity. General rule: A director or senior executive may not take advantage of a corporate opportunity unless: 1. The director or senior executive first offers the corporate opportunity and makes disclosure concerning the conflict of interest and the corporate opportunity; 2. The corporate opportunity is rejected by the corporation; Cookies Food Products, Inc. 498 It is an example of entirely fair self-dealing. The court said it was entirely fair to the corporation, because the corporation benefited enormously. - 49 - Business Organizations The Corporation 3. James Sinton 7/11/2023 AND Either: a. The rejection of the opportunity is fair to the corporation; b. The opportunity is rejected in advance, following such disclosure, by disinterested directors, or in the case of a senior executive who is not a director, by a disinterested superior, in a manner that satisfies the standards of the BJR; OR c. The rejection is authorized in advance or ratified, following such disclosure, by disinterested shareholders and the rejection is not equivalent to a waste of corporate assets. 5. Dissolution for oppressive conduct The shareholder had a reasonable expectation to receive a similar de facto dividend. Wilderman v. Wilderman 541 The court applied the factors below and found that some of the defendant’s compensation was not entirely fair to the corporation. Executive compensation factors Factors to consider in determining whether the amount of executive compensation is entirely fair to the corporation: 1. What other executives similarly situated received 2. To what extent has the IRS allowed the corporation to deduct the amount as compensation. 3. Whether the salary bears a reasonable relation to the success of the corporation. 4. Whether increases in salary are geared to increases in the value of services rendered. 5. The amount of the challenged salary compared to other salaries paid by the employer. A corporate opportunity means 1. Any opportunity to engage in a business activity of which a director or senior executive becomes aware, either: a. In connection with the performance of functions as a director or senior executive, or under circumstances that should reasonably lead the director or senior executive to believe that the person offering the opportunity expects it to be offered to the corporation; OR b. Through the use of corporate information or property, if the resulting opportunity is one that the director or senior executive should reasonably be expected to believe would be of interest to the corporation; OR 2. Any opportunity to engage in a business activity of which a senior executive become aware and knows is closely related to a business in which the corporation is engaged or expects to engage. De facto dividends A dividend is a distribution of corporate profits, as decided by the board, to its shareholders. Compensation paid to an employee should reflect the reasonable value of the labor provided by the employee. When the corporation pays an employee more than the reasonable value of that employee’s labor, the compensation paid actually reflects: 1. An amount for the value of the labor, plus 2. An amount that represents a distribution of corporate profits to the employee. A de facto dividend that excludes minority shareholders is illegal: 1. fraud on the minority investors; 2. bad faith to the minority investors; 3. an illegal dividend to the majority; or 4. theft or conversion by the majority. Executive compensation Defense: §144(a) director/shareholder authorization Approaches to challenge the board’s decision in setting the compensation for an executive: 1. The duty of care process claim The decision-making process was grossly negligent. See Van Gorkom. 2. Waste claim The decision was irrational. 3. The duty of loyalty The executive had a CIO 4. Dissolution for misappropriation of corporate assets A portion of the compensation reflects a de facto dividend that has been misappropriated by the D/O or controlling shareholder. Factors considered by tax courts in determining whether a shareholder-employee’s compensation includes a de facto dividend are: 1. the type and extent of the services rendered; 2. the scarcity of qualified employees; 3. the qualifications and prior earning capacity of the employee; 4. the contributions of the employee to the business venture; 5. the net earnings of the employer; - 50 - Business Organizations The Corporation 6. 7. James Sinton 7/11/2023 the prevailing compensation paid to the employees with comparable jobs; and the peculiar characteristics of the employer’s business. Exacto Spring Corp. 1. 2. Independent investor test. The corporation pays the manager a salary in exchange for the manager’s working to increase value of corporate assets. 1. Has the manager increased the value of the corporation, which reflects a rate of return to the investors? 2. Does that rate of return reflect reasonable compensation received by the manager? Take one vote for authorization purposes of §144 with all the interested parties absent. Take a second vote to actually authorize the transaction with a quorum of the directors. (4) Rational business purpose It does not require the business decision to be reasonable, rather it asks whether a single person would consider the decision to be rational. Directors and officers do not necessarily have to prove rationality; their decision must simply be attributed to a rational business purposes. §144(a) Statutory Curative Measures The court might even attribute a rational business purpose to the decision-maker’s conduct. Most of the time the defendants plead a rational business purpose. §144(a) allows an interested director, officer, or controlling shareholder to have other directors or shareholders bless the COI transaction. (5) Entire Fairness Standard What transactions are covered by §144(a)? The §144(a) preamble contemplates a transaction between 1. a corporation and 1 or more individual, who is a director or officer of that corporation, OR 2. a corporation and another organization, which has 1 or more directors or officers that are also director or officers of that corporation or have a financial interest in that other entity. 3. The courts have extended its application to interested family members of a corporate fiduciary and controlling shareholders. It asks whether the decision or transaction was entirely fair to the corporation. It does not necessarily consider whether the transaction was fair to the shareholders. The entire fairness standard is a unitary inquiry; it is not bifurcated and all aspects of the transaction must be considered as a whole. It is a high burden to overcome, but it is not impossible. See Marciano. To establish director or shareholder approval, the defendant must show 1. Disclosure. The interested party must disclose material facts about the conflict and the transaction. D: the other directors already knew about the information; or that information was immaterial. 2. Good faith. The disinterested directors must authorize or ratify the transaction in good faith. The concept of good faith considers the reasonableness of the decision-making process employed by the disinterested directors. See Van Gorkom. 3. Disinterested directors or shareholders. The transaction must be authorized or ratified by the affirmative votes of a majority of the disinterested directors, regardless of whether it satisfies quorum. The courts have construed §144(a)(2) to require a majority of disinterested shareholders to authorize the transaction. Fair dealing It considers 1. when the transaction was timed, 2. how it was initiated, structured, negotiated, disclosed to the directors, and 3. how the approvals of the directors and the stockholders were obtained. The duty to disclose is an essential element of the fair dealing inquiry. It applies a similar inquiry as the reasonable decisionmaking process. See Tremont; Van Gorkom. Fair price It focuses on the economic and financial considerations of the proposed transaction: assets, market value, earnings, future prospects, and other elements that affect the intrinsic or inherent value of the transaction. (6) Duty to disclose Procedural advice for the §144(a)(1) board vote: - 51 - Business Organizations The Corporation James Sinton 7/11/2023 A corporate fiduciary’s obligation to disclose material facts about the transaction is an essential component of 1. COI; 2. §144(a) director and shareholder approval; AND 3. the entire fairness standard. Inside directors, as officers of the corporation, will have greater knowledge about the company’s business and affairs. The obligation to disclose is not a separate fiduciary duty, rather it is an aspect of the duties of care and loyalty. Causation The plaintiff must prove that the director’s breach of duty caused him harm. These directors might have a higher standard of oversight required than an outside director. In the context of the controlling shareholder, as a corporate fiduciary he must fully disclose material information related to the conflict of interest transaction. Was the failure to act a substantial factor in causing the harm or loss to the creditor? Narrow exception to disclosure: Tremont relaxes the obligation to disclose when the controlling shareholder withholds information that might be adverse to its position. The nature of the loss indicates whether it was a substantial factor. 1. Was it due to an economic recession? 2. Was it due to fraudulent transfers? The court found “the controlling shareholder had no duty to disclose information which might be adverse to its interests because the normal standards of arms-length bargaining do not mandate a disclosure of weakness.” Francis v. United Jersey Bank 451 As a director, Francis did nothing while her sons stole money from the corporation. She was subjected to liability for violating the duty of care in the oversight context. 1. Duty of Care Some guidance on how to adhere to the duty of care in the oversight context includes: 1. A director should have a basic understanding of the business operations. 2. A director should attend board meetings regularly. 3. A director should maintain familiarity with the financial status of the corporation by regular review of financial statements. 4. A director should seek the advice of counsel. 5. A director might have to inquire further about red flags relating to illegal conduct. 6. A director should object to illegal conduct, and if the corporation does not correct the conduct, he should resign. The duty of care arises in two contexts: 1. Oversight context. The director has a duty to oversee, monitor, and supervise the business operations. Directors are obligated to use care in monitoring the activities of the officers and the general affairs of the corporation as a whole. 2. Decision-making context. Directors have duty to use care in making decisions that affect the corporation’s welfare. a. Oversight context MBCA §§ 8.30, 8.31, 8.42 b. Decision-making context Standard of care Director have the obligation to act in good faith and with that degree of diligence, care and skill which 1. Objective standard. ordinary prudent directors would exercise 2. Subjective standard. under similar circumstances. Decision-making: 1. Reasonable decision-making process See BJR above Van Gorkom. 2. Reasonable substance of the decision Teeth of BJR. Is the decision attributed to a rational business purpose? Subjective standard 2. Duty of Loyalty A director’s level of experience can increase the level of care required by that director to use. It cannot lower the level of care required by that director. The duty of loyalty requires directors and officers to put the corporation’s interests ahead of their personal interests. Inside versus outside directors It is implicated in two principal contexts: - 52 - Business Organizations The Corporation 1. 2. James Sinton 7/11/2023 3. Conflict of interest. when directors or officers enter into contracts or other transaction with the corporation; See BJR above. OR Misappropriation. when directors or officers take potential corporate opportunities for themselves. The director steals or misappropriates business opportunities of the company. Insurance The tripod of protections seek to attract good talent to the board of directors, who might otherwise fear the full reach of personal liability contemplated by Van Gorkom. A director should always ask about each of these protections before accepting a board position. Waste Doctrine a. Exculpation statutes Rational business purpose standard: It prohibits an exchange that is so one sided that no business person of ordinary sound judgment could conclude that the corporation has received adequate consideration. DGCL § 102(b)(7) MBCA § 2.02(b)(4) The court has applied an irrational standard! It means waste occurs when you cannot find a single person who thinks it is a rational decision. §102(a) says what must go in the articles of incorporation. §102(b) says what can go in the articles of incorporation. (1) DGCL charter option statutes The charter options statutes require the protection to be included in the articles. Some courts have equated waste with irrationality. The board’s decision will be upheld unless it cannot be attributed to any rational business purpose. DGCL § 102(b)(7) applies to the liability subjected to directors and not officers. 3. Duties of controlling shareholders What claim does it protect the director from? It can eliminate or limit monetary liability to the corporation for a director’s breach of fiduciary duty. 1. It protects the directors from a Van Gorkom duty of care process claim. 2. It also protects against the directors from a Francis claim for failure to oversee the corporation. 3. It does not preclude an injunction. 4. It does not apply to suits by third parties. See piercing the corporate veil. The controlling S/H owes a fiduciary duty of loyalty to: 1. The corporation; 2. Other shareholders; and 3. It does not include the duty of care. Who is a controlling shareholder? 1. The controlling shareholder is any shareholder who has the power to direct corporate affairs. 2. Majority shareholder. It ordinarily includes in investor who owns a majority of the corporation’s voting shares. 3. Minority shareholder. It might include an investor who owns less than a majority interest in the corporation’s voting shares, but he is able to mobilize enough votes to elect a majority of the board. Exceptions Delaware has adopted exceptions to its charter option statute that include 1. Breach of the director’s duty of loyalty to the corporation or its stockholders; 2. Act or omissions not in good faith; (Some view an act of bad faith means illegal conduct) 3. Intentional misconduct; 4. Knowing violation of the law; 5. Improper distributions; and 6. Any transaction from which the director derived an improper personal benefit. §144(a) Statutory Curative Measures have been extended to the controlling shareholder context. However, the courts have been reluctant to give the full protection of §144(a) conferred to D/Os because controlling shareholders can be heavily influential towards other shareholders and D/Os. (2) Self-executing statutes 4. Protections available to D/Os It directly alters the standard of liability necessary to recover money damages from directors. The D/Os have a tripod of protections: 1. Exculpation 2. Indemnification Indiana’s approach - 53 - Business Organizations The Corporation James Sinton 7/11/2023 A director is liable only if the director has breached or failed to perform his duties in compliance with the statutory standard of care and the breach or failure to perform constitutes willful misconduct or recklessness. DGCL § 273 N.Y. BUS. CORP. LAW §§ 1104, 1111 MBCA §§ 14.30, 14.34 Three ways to have a deadlock: 1. An even split on the board; 2. An even split on shareholder deadlock; OR 3. Supermajority provisions cause deadlock. (3) Cap on money damages Some states simply create a default monetary cap on the liability of a director or officer. Although the deadlock statutes confer the power to dissolve, the courts construe this as an equitable power, which allows it to do everything short of dissolution to resolve the deadlock. b. Indemnification Indemnification permits the corporation to financially protect its directors against exposure to expenses and liabilities that may be incurred by them in connection with legal proceedings based on an alleged breach of duty. The Model Act allows dissolution on deadlock. §273 only permits a court to order a dissolution for a corporation that has two 50% shareholders. The corporation picks up the bill for legal fees and damages when a director has incurred liabilities. 2. Oppression Types 1. 2. 3. Permissive (corporation can elect to indemnify) Mandatory (corporation is required to indemnify) Prohibitive (limitations on the indemnification) Freeze out: Often, a freeze out occurs when animosity develops among the shareholders of a closely held corporation. In general, a freeze out occurs when the controlling shareholder deny the minority shareholder his financial and participatory rights in the business enterprise. c. Insurance DGCL § 145 MBCA § 8.50-8.59 In particular, a freeze out occurs when the board denies a shareholder employment and it terminates dividends, which freezes the shareholder’s return on his investment. Often a corporation gets insurance that reimburses it for the indemnification of the D/Os. DGCL § 145 permits a corporation to purchase an insurance policy on behalf of a person regardless of whether the corporation would have power to indemnify that person. Three approaches to remedy a shareholder freeze out: 1. Donahue fiduciary duty. Shareholders of a closely held corporation owe a fiduciary duty to other shareholders. 2. Statutory oppression doctrine. §14.30(a)(2)(ii) permits a shareholder to petition for dissolution if the directors or those in control of the corporation have acted, are acting, or will act in a manner that is oppressive. 3. No special C/L rules. The courts do not offer special remedies and instruct the shareholders to anticipate oppression with contractual principles. The director and officer policies typically apply three exclusions from coverage: 1. Conduct exclusions. It seeks to eliminate coverage for conduct sufficiently self-serving or egregious. 2. Other insurance exclusions. It excludes other insurance available to the corporation, such as personal injury or property damage, or libel and slander. 3. Laser exclusions. It addresses specific risks unique to the insured corporation. G. Dissension corporation in the closely held 1. Deadlock - 54 - Business Organizations The Corporation James Sinton 7/11/2023 Implied covenant of good faith and fair dealing Even if the contract has eliminated a claim for oppression, the defendant must still comply with an implied covenant of good faith and fair dealing. See Gallagher. Oppression Special C/L Rules Fiduciary Duty No Special C/L Rules Does the suit for dissolution represent a stock buy-back? The court said that shareholder’s suing for dissolution under the oppression statute did not constitute an offer to sell his stock under the shareholders’ agreement. The court recognized that the agreement did not expressly deem an oppressive conduct suit would be deemed a voluntary offer to sell. Dissolution Oppression a. Protection through Contract b. Protection in the absence of Contract Special common law rules would undermine the existing legal tools available to shareholders to anticipate oppresion, including 1. cumulative voting, 2. shareholder agreements, 3. earnings tests, 4. buy-out provisions, 5. voting trusts, 6. other voting agreements 7. statutory close corporation Essential inquiry: It asks whether and to what extent the value of shareholder’s interest in a closely held corporation has been reduced as a result of the defendant’s conduct. (1) Breach of fiduciary duty What is the Donahue duty? It is “a strict obligation on the part of majority stockholders in a close corporation to deal with the minority with the utmost good faith and loyalty.” The oppression doctrines might have to be viewed under contractual principles: Does a contract eliminate or alter the oppression doctrines? Elements to the Donahue duty 1. Closely held corporation. See three characteristics. 2. Breach. Controlling shareholder has violated his Donahue duty owed to the minority shareholder. 3. Traditional right. Show that it has not been altered by the bylaws or through implied contract. 4. Non-traditional right. Show that his status as a shareholder had a connection to that nontraditional right. See Merola. Does the contract define the key elements to an oppression claim? 1. The traditional or non-traditional rights enjoyed by each shareholder? 2. Reasonable expectations of the shareholder? 3. Legitimate business purpose? Kemp even contemplated that shareholders may limit or define their obligations owed among themselves. What is a closely held corporation? 1. A small number of shareholders; 2. Substantial majority stockholder participation in the management, direction and operations of the corporation; and 3. No ready market for the corporate stock. “Shareholders enjoy flexibility in memorializing the these expectations through agreements setting forth each party’s rights and obligations in corporate governance.” Kemp. P: 1. 2. 3. Wilkes Litigation Roadmap The fiduciary duty survived the contract; The defendant’s conduct is still governed by the implied covenant of good faith and fair dealing. Duff & Phelps recognized an implied covenant of good faith and fair dealing. The limiting term is ambiguous to admit extrinsic evidence that shows the fiduciary duty survived the contract. Step 1: Shareholder sues Shareholder. The plaintiff claims that the majority shareholder has breached the duty owed to him as a minority shareholder in the closely held corporation. - 55 - Business Organizations The Corporation James Sinton 7/11/2023 D: It owed no duty to preserve the plaintiff’s nontraditional shareholder right. As a corollary, we eliminated that duty by a matter of contract. See Gallagher. 5. D: The BJR controls the standard of review for its decision regardless of owing a fiduciary duty under Donahue. One of the justifications for the BJR is for the court not to be tempted by its inherent hindsight bias. 6. D: In the context of an employment right, the defendant has the freedom to terminate the plaintiff at anytime, for no reason under the employment-at-will doctrine. Defining Wilkes’s litigation roadmap What is a legitimate business purpose? A legitimate business purpose must be for the corporation, not for the defendant shareholder. Step 2: Defendant asserts an affirmative defense. Wilkes allows the controlling shareholders to defend their conduct by establishing a legitimate business purpose for its action. The legitimate business purpose must be for the corporation, not for the defendant shareholder. Wilkes suggests that acrimony between the shareholders is enough to represent a legitimate business purpose. Perhaps the shareholder’s conduct was due to a change in economic circumstances, such as an economic recession. D: Because of limited liability in the corporation, the majority still enjoys selfish ownership in the corporation, which should be balanced against the concept of their fiduciary obligation to the minority. The defendant should have the freedom to control the corporation similar to his own personal property. What is meant by an alternative course of action less harmful to the minority’s interest? Wilkes does not demand an alternative that is selfishly focused on the minority. The less harmful alternative must be practicable, which contemplates a concern for the other innocent shareholders and the corporation. Step 3: Burden shifts to plaintiff. Traditional/General rights of a shareholder On a showing of a legitimate business purpose, Wilkes allows the plaintiff to show that the same legitimate objective could have been achieved through an alternative course of action less harmful to the minority’s interest. General expectations, which every shareholder has, include: 1. A right to receive a proportionate share of distributed profits; 2. A right to inspect company books and records with a proper purpose; 3. A right to vote on shareholder issues; and 4. A right to be recognized as a shareholder. D: The courts must “weigh the legitimate business purpose, if any, against the practicability of a less harmful alternative.” The court must not disregard the interests of other innocent shareholders. Nor can it disregard the interest of the corporation as a whole. Non-traditional/Specific rights of a shareholder Checklist 1. 2. 3. 4. implied covenant of good faith and fair dealing. b. Has he established that his status as a shareholder is connected to that nontraditional right? Did the defendant have a legitimate business purpose for his conduct? Does a contract define that legitimate business purpose? Could the legitimate business purpose been achieved by a practicable alternative less harmful to the plaintiff’s interest? Essential Inquiry: Did all the shareholders understand that if you own stock in the corporation part of the bargain was to receive the non-traditional right claimed by the plaintiff? Is it a closely held corporation? Does the fiduciary duty run to the plaintiff? Did the defendant breach his fiduciary duty owed to the plaintiff? Identify the oppressed right pleaded by the plaintiff? a. Does a contract eliminate or limit that right? If so, go to contract interpretation, or Factors to consider in determining whether the asserted non-traditional right has a sufficient connection to an ownership interest in the corporation: - 56 - Business Organizations The Corporation 1. 2. 3. 4. 5. James Sinton 7/11/2023 3. Long-standing Corporate policy. The shareholders had a long-standing policy that each would have the nontraditional right (e.g., employment or director). Founding shareholder. Founding shareholders have expectations of significant financial and participatory rights. D: A founding shareholder is not in of itself sufficient to establish a connection between stock ownership and the non-traditional right. Course of conduct. The shareholder’s course of conduct can indicate that stock ownership relates to the nontraditional rights. Stock transfer restrictions. Whether opportunities to purchase stock were either limited or open to anyone. Dividends v. Compensation. What approach did the corporation take to distribute profits? Often closely held corporations distribute corporate earnings through compensation rather than a dividend. A plaintiff can show that defendant’s compensation is unreasonable. If this is the case, the shareholder has a claim for breach of duty of loyalty owed to the corporation. breach of implied covenant of good faith and fair dealing. How does it coincide with those non-traditional rights recognized by Wilkes? Oppression protects the fair value of a shareholder’s interest in a closely held corporation. If the shareholder’s value relies on employment, the oppression doctrines displaces the employment-at-will doctrine. Cases Donahue v. Rodd Electrotype Co. Supp 15 The court adopted a special fiduciary duty that shareholders in a closely held corporation owe between themselves. The court also adopted the equal opportunity rule, which has been effectively overruled by Wilkes. Wilkes v. Springside Nursing Home, Inc. Supp 31 The court overruled the equal opportunity rule, by adopting an affirmative defense that reviews the substance of the controlling shareholder’s decision. Examples of the non-traditional rights Merola v. Exergen Corp. Supp 40 It is an example of the plaintiff not establishing the Donahue duty owed to him, because there was no connection between stock ownership and the right to continued employment with the corporation. Specific expectations include: 1. Particularly, continued employment and benefits from managing the corporation; 2. Generally, a situation where the majority shareholder and another shareholder reached a mutual understanding about an entitlement related to stock ownership. P: Wilkes said shareholders have an automatic right to employment. D: Wilkes recognized a right to participate in the management only if stock ownership had a sufficient connection to that participatory right. Being an investor of a closely held company offers advantages: 1. Higher compensation than would could be earned at a publicly held company 2. Stable and certain employment 3. Holding a position of high-level management 4. Running your own business Rationale: The court adopted the Donahue duty because relationship between shareholders in a closely held corporation resembles the relationship between partners in a general partnership. 1. Each have a smaller group of owners than publicly held corporations; 2. Partners have statutory rights to participate in management; Most shareholders of a closely held corporation have an expectation to participate in management; 3. Neither has a ready market to buy and sell ownership interests; and 4. The transferee of a partnership interest has limited rights and admitting a new partner requires unanimous consent from the partners; Closely held corporations typically use stock transfer restrictions and special classes of stock to control who can obtain participatory rights. Employment-at-will doctrine What is the employment-at-will doctrine? The employment at-will-doctrine says that unless the employee has an employment contract for a fixed term with the corporation, the employer can terminate that employee at anytime, for no reason at all. Exceptions to the employment-at-will doctrine include: 1. breach of an express or implied promise, including representations made in employee handbooks; 2. discharge in violation of public policy (e.g., terminating employment for racial discrimination); and - 57 - Business Organizations The Corporation James Sinton 7/11/2023 Equal opportunity rule: If a shareholder of the controlling group seeks to transact with the corporation, the controlling group must provide an equal opportunity to the minority shareholders. D: Statutory protections are not appropriate where the oppressive conduct resulted from the minority shareholders’ acting in bad faith with a view toward forcing an involuntary dissolution. Some view Donahue as requiring the controlling group to offer an equal opportunity to the minority shareholders in a broader context beyond just stock redemptions. D: Employment-at-will doctrine. Others view that the application of the equal opportunity rule should depend on the shareholders being in the same situation, e.g. both directors are founders and directors. See the approaches at defining oppression and reasonable expectations. D: BJR controls the standard of review. Step 2: If the plaintiff establishes oppression: Economic theory on dividends 1. In a public corporation, economic theory suggests that when the company retains earnings rather than paying dividends it still has a positive effect on the value of the firm; dividends are effectively irrelevant to the shareholder because he can realize that increased value in the open market. 2. In a closely held corporation, no market is available to the minority shareholder realize that increased value, so dividends represent a critical financial interest for that minority shareholder 1. 2. 3. Before ordering dissolution, the court must consider whether alternative remedies short of dissolution are better for both the plaintiff’s expectations and the rights and interest of any other substantial group of shareholders. An order of dissolution must be conditioned on permitting shareholders of the to elect to purchase the complaining shareholder’s stock at fair value. Finally, the court can order dissolution. Checklist (2) Dissolution for Oppressive conduct 1. N.Y. BUS. CORP. LAW § 1104-a, 1118 MBCA §§ 14.30, 14.34 2. 3. Oppression doctrine §14.30(a)(2)(ii) permits a shareholder to petition for dissolution if the directors or those in control of the corporation have acted, are acting, or will act in a manner that is oppressive. Standing: Some dissolution statutes only allow shareholders with at least a 20% interest in a closely held corporation (e.g., corporation whose stock is not traded on a securities market to sue for dissolution). 4. Kemp Litigation Roadmap Does the plaintiff having standing to sue? Usually a minimum interest in the corporation and closely held corporation. What does oppressive conduct mean? If oppression is defined by the expectations of the shareholder: a. does a contract eliminate or reduce those expectations? If so, go to implied covenant of good faith and fair dealing. b. what expectations are actually protected? c. when is it measured? d. does it contemplate expectations of a shareholder who involuntarily received his shares? Are there alternative remedies to dissolution? Defining Kemp’s dissolution for oppression Step 1: Shareholder sues corporation. What does it mean to act in a manner that is oppressive? The plaintiff claims the corporation should be dissolved because either the directors or those in control of the corporation have acted, are acting, or will act in a manner that is oppressive. Moll provided three separate definitions of oppression: 1. Oppression is conduct that frustrates the reasonable expectations of the investors. See Kemp; and below. 2. Oppression refers to burdensome, harsh, and wrongful conduct. It is a breach of the general fiduciary duty of good faith and fair dealing that majority shareholders in a corporation owe to the minority shareholders. See Van Gorkom; Tremont. D: The defendant was not aware of the plaintiff’s expectations. Nor should have the defendant been aware of the plaintiff’s expectations because they were unreasonable. - 58 - Business Organizations The Corporation 3. James Sinton 7/11/2023 Oppression is conduct that constitutes a violation of the strict fiduciary duty of utmost good faith and loyalty owed by partners between partners. See Donahue. 50% ownership The court said that in determining whether the plaintiff was a minority shareholder, entitled to sue for dissolution, the focus must be on that shareholder’s power. Reasonable expectations Kemp adopted a reasonable expectations test to define oppressive conduct for purposes of deciding when to dissolve the corporation. In re Kemp & Beatley, Inc. Supp 44 Facts: After the complaining shareholders retired, the corporation changed its long-standing policy of distributing dividend only to shareholders by distributing de facto dividends to only employees. What is a protected reasonable expectation? It is more than a shareholder’s subjective wish and desire. The courts refuse to consider the subjective desire of the complaining shareholder! Kemp said oppression should be deemed to arise only when: 1. The majority’s conduct substantially defeats the expectations of the complaining shareholders; AND 2. Those expectations were both reasonable under the circumstances and central to the shareholder’s decision to join the venture. The reasonable expectations resemble an implied contract between the shareholders. The majority shareholder must have some level of awareness of the minority’s expectations. See Kemp. When should a shareholder’s reasonable expectation be measured? D: Kemp said that the expectations are to be determined at time the shareholder committed his capital to the venture. De facto dividends A dividend is a distribution of corporate profits, as decided by the board, to its shareholders. P: It really should not be limited to this narrow of a time frame. Expectations change between the shareholders as the company grows, matures, or suffers losses. Compensation paid to an employee should reflect the reasonable value of the labor provided by the employee. One court has said the reasonable expectations are to be ascertained by examining the entire history of the relationship between the majority and minority shareholder. 1. Expectations at the inception of their relationship; 2. Those expectation altered over time; and 3. The expectations which develop over their course of dealing. Meiselman. When the corporation pays an employee more than the reasonable value of that employee’s labor, the compensation paid actually reflects: 3. An amount for the value of the labor, plus 4. An amount that represents a distribution of corporate profits to the employee. A de facto dividend that excludes minority shareholders is illegal: 5. fraud on the minority investors; 6. bad faith to the minority investors; 7. an illegal dividend to the majority; or 8. theft or conversion by the majority. Can investors who receive their shares via gift or inheritance have reasonable expectations? D: Kemp’s formulation precludes a finding of oppression, because an investor, who involuntarily obtains shares, lacks the requisite expectations related to being an investor. Factors considered by tax courts in determining whether a shareholder-employee’s compensation includes a de facto dividend are: 8. the type and extent of the services rendered; 9. the scarcity of qualified employees; 10. the qualifications and prior earning capacity of the employee; 11. the contributions of the employee to the business venture; 12. the net earnings of the employer; P: The shareholder at least has the general expectations related to stock ownership. It cannot mean that this shareholder lacks any expectations. Also, the shareholder should be able to enjoy those reasonable expectations that are enjoyed by other shareholders. The court should apply a normative theory to find reasonable expectations under the circumstances. - 59 - Business Organizations The Corporation James Sinton 7/11/2023 13. the prevailing compensation paid to the employees with comparable jobs; and 14. the peculiar characteristics of the employer’s business. Exacto Spring Corp. 3. Dissolution in general DGCL §§ 273, 275, 355 N.Y. BUS. CORP. LAW § 1002 MBCA §§ 14.02, 14.20, 14.30 MODEL STAT. CLOSE CORP. SUPP. § 33 Independent investor test. The corporation pays the manager a salary in exchange for the manager’s working to increase value of corporate assets. 3. Has the manager increased the value of the corporation, which reflects a rate of return to the investors? 4. Does that rate of return reflect reasonable compensation received by the manager? Dissolution involves 1. the termination of the corporation’s existence; 2. the sale of the business; 3. the repayment of debt to creditors; and 4. the pro rata distribution of any remaining assets to shareholders. Three types of dissolution are usually possible: 1. voluntary dissolution; 2. involuntary dissolution; 3. administrative dissolution. (3) No special rules DGCL §§ 341-56 If a duty is owed to the plaintiff, the court applies the BJR. Voluntary dissolution Rationales for not adopting special rules 1. Special common law rules would undermine the existing legal tools available to shareholders, including cumulative voting, shareholder agreements, earnings tests, buy-out provisions, voting trusts, or other voting agreements. 2. Delaware corporate law provides special statutory protections for closely held corporations. It refers to a dissolution following a vote by the board or shareholders with board approval. Involuntary dissolution MBCA §14.30 (any shareholder can petition) DGCL §273 (limited to 2 equal shareholder corp) It refers to a dissolution that is ordered or compelled by a court, because someone has done something bad. Rationales for adopting special rules Investors in closely held corporations typically fail to engage in bargaining that anticipates dissension or oppression. 1. Corporate owners are family members personal friends. 2. They have mutual trust. 3. They are often unsophisticated in business and legal matters 4. It is expensive to contract for shareholder protections when the parties are trying to get the business off the ground. 5. They are engaged in developing a long-term association and usually seek to avoid harming their relationship by omitting contractual protections. 6. Shareholders, who have received there stock as a result of gift or inheritance, have no viable opportunity to bargain for contractual protections. Under the Model Act, a shareholder may petition for court-ordered dissolution on 1. director or shareholder deadlock; 2. misapplication or waste of corporate assets; and 3. fraudulent, illegal, or oppressive actions by directors or those in control. See MBCA §14.30. It allows any shareholder to petition with no minimum interest in the corporation. Delaware authorizes shareholders of corporations having only two shareholders each of which owns 50% of the stock to petition for involuntary dissolution. See DGCL §273. Administrative dissolution Nixon v. Blackwell Supp 56 The court refused to adopt special common law rules to remedy the freeze out problem of shareholders in closely held corporations. MBCA §14.20 It refers to a dissolution for noncompliance with the requirements of the state, such as failure to pay taxes or franchise fees. Nixon is an example of a COI transaction being entirely fair to the corporation. Common-law powers to dissolve - 60 - Business Organizations The Corporation James Sinton 7/11/2023 power to dissolve a corporation. The court may appoint a receiver to liquidate the corporation, if the plaintiff shows 1. gross mismanagement, 2. positive misconduct by the corporate officers, 3. breach of trust, OR 4. extreme circumstances showing imminent danger of great loss to the corporation. - 61 - Business Organizations The Limited Partnership James Sinton 7/11/2023 The Limited Partnership It is not publicly filed. Linkage. B. Management and Operation 1. 2. 3. 4. 5. RULPA are not stand-alone Acts. It links to the general partnership law. The problem is that linkage is a total disaster, because the courts do not know when not to apply linkage. It uses the general partnership statutes as the base. RULPA provisions are only written to cover a limited partnership issue that is handled differently from the general partnership Act. §101(7) defines a limited partnership as a partnership having a general partner and a limited partner. §403(a) links a general partner’s powers and liabilities to the same powers and liabilities of a general partner in a partnership without limited partners. §1105 says “any case not provided for in RULPA the provisions of UPA/RUPA govern.” RULPA §§ 302, 305, 402-403 ULPA §§ 302, 304, 402, 406-407 General partners RULPA §403(a) indicates a general partner in a limited partnership has the same rights and powers as a general partner in a general partnership. The general partners have the right to manage the business of the limited partnership. Those rights and powers would include, among others, 1. the ability to participate in management; 2. the ability to bind the partnership through apparent authority to transactions in the ordinary course of business; and 3. the ability to vote. A. Formation RULPA §§ 101(2), 102, 104, 201, 204, 501 ULPA §§ 102(2), 108, 201, 204, 501 ULPA §402 address a general partner’s agency authority. How do you form a limited partnership? §406 addresses a general partner’s right to participate in management and right to vote. First, you need two more co-owners that carry on a business for profit. §407 addresses a general partner’s inspection and information rights. Certificate of limited partnership Next, Limited partnerships can only be formed by filing a certificate of limited partnership with the secretary of state. Limited partners The certificate includes: 1. the name of the limited partnership; 2. the identity of the general partners; 3. the location of the firm’s office; 4. whether the limited partnership is a limited liability partnership. See RULPA §201(a). Management rights 1. Several cases hold limited partners cannot take part in the management of the business. 2. Often partnership agreements deny management rights to limited partners. 3. ULPA §302 indicates a limited a partner lacks management rights and agency authority. When do you begin a limited partnership? 1. A limited partnership is formed at the time of filing the certificate of limited partnership with the Secretary of State if there has been substantial compliance with the requirements of this section. §201(b). 2. It does not require an instrument for the partnership agreement. 3. Substantial compliance. Limited liability can begin upon substantial compliance with filing and drafting the certificate. Agency authority 1. RULPA is silent to the issue whether a limited partner is an agent of the limited partnership, who can bind the venture, via apparent authority. 2. Some cases hold a limited partner has no agency authority. 3. The partnership agreement should explicitly say the limited partners lack agency authority. 4. ULPA §302 indicates a limited a partner lacks management rights and agency authority. Limited partnership agreement It defines the rights and obligations of the partners. - 62 - Business Organizations The Limited Partnership James Sinton 7/11/2023 Creditors Voting rights 1. RULPA does not confer voting rights to limited partners. Partnership agreements tend to grant voting rights on some issues to limited partners. 2. ULPA default rule: Limited partners have default voting rights on a number of extraordinary matters, including the right to vote on the expulsion of a general partner, and the right to vote on amending the partnership agreement. ULPA §§ 302, 406(b)(1), 603(4). RULPA §502 entitles a creditor to enforce a limited partner’s promise to contribute to the venture. §607 prohibits a distribution to a partner if it would leave the firm insolvent. §608 makes partners liable to the limited partnership for wrongful distributions and, in some instances, for rightful distributions. Removing a partner The partnership agreement controls whether limited partners have a removal right. ULPA Equitable power to remove a general partner In Curley, the court used its equitable powers to remove a general partner, who had exhibited gross misconduct in managing the firm. §502 retains a creditor’s right to enforce a contribution obligation of a partner. §508 retains the prohibition on distributions that would render the firm insolvent. It appointed an interim receiver until the limited partners could vote to continue the partnership and appoint one or more new general partners. §509 makes partners liable for wrongful distributions, but it does not impose liability for distributions that were rightfully made. Inspection and information rights RULPA §305 provides limited partners the right to inspect business records and the right to obtain information about the limited partnership. Winding up RULPA ULPA §304 provides a limited partner with inspection and information rights. §601 entitles a partner to interim distributions to the extent a partnership agreement specifies. Ordinarily, a partner has no default right to demand interim distributions since the partnership agreement governs. C. Financial Rights and Obligations RULPA §§ 101(2), 501-504, 601, 604, 607-608 ULPA §§ 102(2), 406, 501-505, 508-509 §604 provides general and limited partners with a default distribution right upon withdrawal. Distributions, profits, and losses ULPA RULPA §503 says that a partner does not have a right to any distribution before the dissolution and winding up of the limited partnership unless the limited partnership decides to make an interim distribution. §§503 and 504 allocates profits, losses, and distributions pro rata. Default rule: The profits, losses, and distributions of a limited partnership are allocated on the basis of the value of the contributions made by each partner to the extent they have been received by the partnership and have not been returned. D. Entity Status ULPA § 104 RULPA ULPA When linking to RUPA, the limited partnership is an entity. §503 is silent on the allocation of profits and losses, requiring the partnership agreement to it. - 63 - Business Organizations The Limited Partnership James Sinton 7/11/2023 The characteristics of a limited partnership suggest separateness between the partners and the business. 1. Limited partners have limited liability for the obligations of the business; §303(a) 2. Limited partners can bring derivative lawsuits on behalf of the limited partnership; §1001 3. The dissociation of a partner does not necessarily result in the dissolution of the limited partnership §801 4. 5. 6. Did the limited partner make important business decisions? Did the limited partner handle the financials? Did the limited partner exercise authority associated with a general partner in a general partnership? ULPA (1916) §7 A limited partner shall not become liable as a general partner, unless, in addition to the exercise of his rights and powers as a limited partner, he takes part in the control of the business. ULPA ULPA expressly defines a limited partnership as entity distinct from its partners. E. Limited Liability The limited partner is subject to personal liability if The limited partner participates in the control of the business. General rule: A limited partner is not liable for the obligations of a limited partnership. It provided limited liability, unless the limited partner violated the control rule. The general partner is personally liable for the obligations of the limited partnership. RULPA (1976) §303(a) General rule: A limited partner is not liable for the obligations of a limited partnership. 1. In general, it limits the liability of the limited partner by applying a standing rule for some creditors. 2. In particular, it eliminates a claim for tort victims against the limited partner when the limited partner is exercising control powers that are not substantially the same as a general partner. Name in the partnership! §303(d) A limited partner who knowingly permits his name to be used in the name of the LP is liable to creditors who extend credit to the LP without actual knowledge that the limited partner is not a general partner. 1. The control rule RULPA § 303 ULPA § 303 The limited partner is subject to personal liability if 1. The limited partner is also a general partner; 2. The limited partner participates in the control of the business; OR 3. The limited partner’s participation in the control of the business is a. not substantially the same as the exercise of the powers of a general partner, b. he is liable only to persons who transact business with the limited partnership with actual knowledge of his participation in control. A limited partner can lose his limited liability protection, if he participates in the control of the business. The original ULPA subjected the limited partner to personal liability based on the amount of control. Limited partners can lose their limited liability if they participate in the control of the business. RULPA started to weaken the control rule by tying personal liability to aspects of apparent authority. Finally, ULPA §303 completely eliminated the control rule. RULPA (1985) §303(a) General rule: A limited partner is not liable for the obligations of a limited partnership. 1. In general, it limits the liability of the limited partner by apply a standing rule for all creditors. What amounts to taking part in the control of the business? 1. Is the limited partner a passive investor? 2. To what extent did the limited partner participate in the business? 3. Is his only contribution to the partnership his services? - 64 - Business Organizations The Limited Partnership 2. 3. James Sinton 7/11/2023 In particular, it effectively excludes tort victims and bankruptcy trustees from being able to sue the limited partners. Fraudulent conduct can involve a transaction with the limited partnership, subjecting the limited partner to liability. The limited partner is subjected to personal liability if 1. The limited partner is also a general partner; OR 2. The limited partner participates in the control of the business, but he is only liable to persons who transact with the limited partnership reasonably believing, based upon the limited partner’s conduct that the limited partner is a general partner. Statutory safe-harbors RULPA §303(b) expressly excludes limited partner conduct from being considered participation in the control of the business solely by doing one or more of an enumerated list of actions. Important amendments RULPA (1985) §303(b) provides that a limited partner does not participate in the control of the business solely by being an officer, director, or shareholder of a general partner that is a corporation. Also, a limited partner does not participate in the control of the business by voting on matters, which the limited partnership agreement states in writing may be subject to approval or disapproval of limited partners. Holzman v. De Escamilla 799 It is an example of the limited partners violating the control rule to be subjected to personal liability. - 65 - Business Organizations The Limited Partnership James Sinton 7/11/2023 RULPA (1976) §303(b) (b) A limited partner does not participate in the control of the business within the meaning of subsection (a) solely by doing one or more of the following: (1) being a contractor for or an agent or employee of the limited partnership; (2) consulting with and advising a general partner with respect to the business of the limited partnership; (3) acting as surety for the limited partnership; (4) approving or disapproving an amendment to the partnership agreement; or (5) voting on one or more of the following matters: (i) the dissolution and winding up of the limited partnership; (ii) the sale, exchange, lease, mortgage, pledge, or other transfer of all or substantially all of the assets of the limited partnership other than in the ordinary course of its business; (iii) the incurrence of indebtedness by the limited partnership other than in the ordinary course of its business; (iv) a change in the nature of the business; or (v) the removal of a general partner. RULPA (1985) §303(b) (b) A limited partner does not participate in the control of the business within the meaning of subsection (a) solely by doing one or more of the following: (1) being a contractor for or an agent or employee of the limited partnership or of a general partner or being an officer, director, or shareholder of a general partner that is a corporation; (2) consulting with and advising a general partner with respect to the business of the limited partnership; (3) acting as surety for the limited partnership or guaranteeing or assuming one or more specific obligations of the limited partnership; (4) approving or disapproving an amendment to the partnership agreement taking any action required or permitted by law to bring or pursue a derivative action in the right of the limited partnership; or (5) requesting or attending a meeting of partners; (6) proposing, approving, or disapproving, by voting or otherwise, one or more of the following matters: (i) the dissolution and winding up of the limited partnership; (ii) the sale, exchange, lease, mortgage, pledge, or other transfer of all or substantially all of the assets of the limited partnership; (iii) the incurrence of indebtedness by the limited partnership other than in the ordinary course of its business; (iv) a change in the nature of the business; or (v) the admission or removal of a general partner; (vi) the admission or removal of a limited partner; (vii) a transaction involving an actual or potential conflict of interest between a general partner and the limited partnership or the limited partners; (viii) an amendment to the partnership agreement or certificate of limited partnership; or (ix) matters related to the business of the limited partnership not otherwise enumerated in this subsection (b), which the partnership agreement states in writing may be subject to the approval or disapproval of limited partners; (7) winding up the limited partnership pursuant to Section 803; or (8) exercising any right or power permitted to limited partners under this Act and not specifically enumerated in this subsection (b). - 66 - Business Organizations The Limited Partnership James Sinton 7/11/2023 2. 2. Control of the entity general partner RULPA §§ 101(5), (7), (11), 303, 403 ULPA § 102(8), (11), (14) Ordinarily, the general partner is an entity with limited liability of its own, e.g., a corporation. 3. LP General Partner Limited Partner 4. Limited Partner & S/H 5. Corporation Control Rule. RULPA (1976) §303(d) does not offer statutory protections for limited partners, who also serve as agents of a general partner-entity. Those limited partners can become subject to personal liability by violating the control rule. RULPA §303(b) Safe-harbor. Fiduciary Relationships. a. D/O Corporation b. Controlling S/H Corporation c. Controlling S/H Minority S/H d. General partner Partnership & Limited Partner Piercing the corporate veil. A creditor of the corporation seeks to hold the shareholder liable for the corporation’s obligation. Reverse piercing the corporate veil. A creditor of a shareholder seeks to hold the corporation liable for the shareholder’s debts Defense as a limited partner in RULPA RULPA (1985) §303(b) provides that a limited partner does not participate in the control of the business solely by being an officer, director, or shareholder of a general partner that is a corporation. 1. Corporate owner capacity. It relies on the limited partner to be acting in his capacity as an officer, director, or shareholder. 2. Limited partner capacity. It does not offer protection if the limited partner is solely acting in his capacity as a limited partner. S/H Corporate general partners of limited partnerships If the general partner as a corporation is only marginally capitalized, the limited partnership resembles a corporation. Ways that a corporate general partner differs from an individual general partner include: 1. A corporate general partner is subject to the control of someone else. 2. A corporate general partner might be purchased, sold, or reorganized, disrupting the limited partnership’s control over the transfer of managerial authority. 3. A corporate general partner might have de minimis assets relative to the business it is managing. 4. The owners of the corporation might deplete the corporation’s assets without the consent of the limited partnership. Courts refuse to impose liability Some cases have refused to impose personal liability on limited partners who participate in the control of an entity general partner. Initial concerns In Delaney, a limited partnership was formed with 1. Interlease Corporation as the general partner 2. Crombie, Kahn, and Sanders, who were the sole officers, directors and shareholders of Interlease, served as limited partners Liability of limited partners The limited partnership entered into a lease, and breached. Legal theories that subject a limited partner to personal liability for its relationship with either the entity or the general partner include: 1. Apparent authority/Estoppel. Limited partners who participate in the control of an entity general partner should seek to ensure that third parties are aware of the capacity in which limited partners are acting. Otherwise, that limited partner could be subjected to liability for the obligations of the partnership. D: RULPA §303(b) Safe-harbor. The court expressed concern that a corporation serving as general partner might undermine its personal liability in a limited partnership. It held that the personal liability subjected to a limited partner by the control rule cannot be evaded merely by acting through a corporation. - 67 - Business Organizations The Limited Partnership James Sinton 7/11/2023 KE Property Management held to the extent that a partnership agreement empowers a limited partner discretion to take actions affecting the governance of the limited partnership, the limited partner may be subject to the obligations of a fiduciary among partners. F. Fiduciary Duties Suing the partnership Derivative lawsuits in limited partnerships are often easier to justify. Limited partnership GPs often have permanent tenure No provision for removal of a general partner Often only one GP No public market for interest A limited partner’s obligations to the partnership and other partners depend on the degree of control provided to that limited partner under the partnership agreement. Corporation Directors are periodically elected Directors are removable for cause by S/H The RULPA has not expressly prohibited a limited partnership agreement from imposing fiduciary duties on limited partners, so some courts have allowed the partnership agreement to define the fiduciary relationship between its partners. Officers are removable by directors Several directors and officers to collectively manage corporation Many corporations have market for shares Confidential relationship creates a fiduciary duty SIn re Villa West Associates says look to the relationship between the limited partner and the limited partnership. 1. General partners RULPA §§ 107, 305, 403, 1105 ULPA §§ 112, 408 The court did not rely on the partnership agreement establishing the fiduciary relationship among partners of a limited partnership. UPA § 21 RUPA § 404 A fiduciary duty arises where a special confidence has developed between the parties. General rule: The general partner owes a fiduciary duty to the limited partnership and his other partners. It does not depend on the legal relation, such as between limited partners. RULPA links to UPA and RUPA §404. Mere concert of action, without more, does not establish a fiduciary relationship. ULPA §408 addresses a general partner’s fiduciary duties in a manner that is nearly identical to RUPA §404. The fiduciary relationship requires a confidence of one another and a dependence arising from weakness of age, mental strength, business intelligence, knowledge of facts, involved or other conditions which give one an advantage over the other. 2. Limited Partners RULPA §§ 101(8), 1105 ULPA §305 RULPA ULPA RULPA does not expressly address the fiduciary duties of limited partners. It relies on linkage to define the fiduciary relationship between a limited partner and the limited partnership. Thus, because limited partners are defined as partners, they owe a fiduciary duty to the partnership and other partners. General Rule: A limited partner is presumed not to have a fiduciary duty, but the partnership agreement can impose one. §305(a) says that “a limited partner does not have any fiduciary duty to the limited partnership or to any other partner solely by reason of being a limited partner.” Partnership agreement creates a fiduciary duty §305(b) requires the limited partner to act consistently with the obligation of good faith and fair dealing. Bond Purchase says look to the partnership agreement. - 68 - Business Organizations The Limited Partnership James Sinton 7/11/2023 The former general partner is not entitled to receive a distribution on dissociation. The limited partnership owes no fiduciary duty, unless the partnership agreement expressly imposes a fiduciary duty or creates a role for a limited partner, which gives rise to a fiduciary duty. §§606 and 607 defines the effect of dissociation on a general partner’s agency power. G. Exit rights: Dissociation and dissolution Limited partner Default Rule: A limited partner has no right to dissociate before the termination of the limited partnership. It constitutes a wrongful dissociation to do so. 1. Dissociation RULPA §§ 402, 602-604 ULPA §§ 601-607 It may be exercised only through the partnership agreement. RULPA §601(a) eliminates a limited partner’s right from dissociating before the firm’s termination. General partners §602 allows a general partner to withdraw at any time by giving written notice to the other partners. §601(b)(1) allows a limited partner to dissociate by express will. The withdrawing partner may be liable for damages to the partnership if withdrawal violates the partnership agreement. §602(a)(3) defines the effect of dissociation, which is that the former limited partner becomes a transferee of his own transferable interest. Limited partners LP Default rule: A limited partner may withdraw upon not less than six months’ prior written notice to each general partner. The former limited partner is not entitled to receive a distribution on dissociation. Judicial Expulsion §§601(b)(5) and 603(5) allow for judicial expulsion of limited and general partners for misconduct. §603 allows a limited partner to withdraw under circumstances specified in the partnership agreement. Withdrawing partner is entitled to receive §604 entitles a withdrawing partner to receive a distribution provided for in the partnership agreement. 2. Dissolution Amount to receive on withdrawal A withdrawing partner is entitled to receive within a reasonable time after withdrawal the fair value of his interest in the limited partnership as of the date of withdrawal based upon his right to share in distributions from the limited partnership. Dissolution is NOT caused by the dissociation of a limited partner. RULPA §§ 801-804 ULPA §§ 801-808, 812 A limited partnership is dissolved 1. at the time specified in the certificate of limited partnership; 2. upon the occurrence of events specified in a written partnership agreement; 3. upon the written consent of all partners; 4. upon an event of withdrawal of a GP under §402; and 5. by the entry of a judicial dissolution under §802. ULPA General partner Under §§603 and 604, a general partner has dissociation rights and powers similar to those in RUPA. The court may decree dissolution whenever it is not reasonably practicable to carry on the business in conformity with the partnership agreement. §605(a)(5) defines the effect of dissociation, which is that the former general partner becomes a transferee of his own transferable interest. - 69 - Business Organizations Limited Liability Partnership James Sinton 7/11/2023 The Limited Liability Partnership When does limited liability begin? Limited liability begins as soon as the registration statement is filed with the Secretary of State. The LLP was first created in Texas! An LLP can either be 1. a general partnership (LLP) OR 2. a limited partnership (LLLP) What is the effect of LLP registration on existing contracts? 1. It is unclear what the effect of converting to an LLP has on existing contracts. 2. The focus should be based on the creditors’ expectations as to who would be liable. 3. Consider how the courts have resolved issues whether a new partner is personally liable, or the former partners are not liable. The LLP is not a separate business organization, like the general partnership or corporation. General partnership law applies to the LLP. It is considered a general partnership and all of the partners have the rights to participate in managing the business. Registration fees Most states require LLPs to pay registration fees, e.g., $200/year per partner. A. Formation RUPA §§ 101(5), 201, 1001-1003 What happens when you forget to register the LLP? A Texas court has held that failing to pay the registration fee results in the LLP losing its limited liability during the period that it’s not registered. It takes the same elements as a general partnership plus statutory formalities. A limited liability partnership is an association of two or more persons to carry on as co-owners a business for profit. It reached this decision by observing limited liability depends on registering, and the LLP formation provision does not account for substantial compliance analogous to the LP. You form the general partnership and file an application to elect to flip the liability rule applied to general partnerships. The business vehicle has already been formed as a general partnership. B. Limited Liability Approaches to limited liability It is required to file a document with the secretary of state. The document includes 1. the firm’s name which includes LLP; 2. the firm’s address; and 3. a statement of its business purpose. Some statutes create a full shield of protection for partner, but chisel it away to account for the partner’s own conduct. 1. Conduct. The partner is liable for his own negligence, wrongful acts or misconduct. 2. Supervisory. The partner is liable for any person under his direct supervision and control. Capital contribution or Liability insurance Some jurisdictions require an LLP to have either liability insurance, or a pool of funds designated and segregated for the satisfaction of judgments against the partnership. Supervisory liability Many LLP provisions subject the partner to liability for any person under the partner’s direct supervision and control. NM requires $1,000,000 to be stashed away in a separate fund to cover creditor’s debts. Is the partner liable for negligent supervision? 1. Requiring negligent supervision undermines the independent meaning of the second clause. Absent negligent conduct, the second clause imposes a form of vicarious liability on the partner. 2. Assuming the first clause requires negligent supervision, the supervisor owes no duty to its Converting General Partnership to LLP Third parties contracting with a GP should explicitly anticipate a GP converting to a LLP in the contract. What is required to approve LLP registration? RUPA defines the vote necessary to amend the partnership agreement, which is unanimous. - 70 - Business Organizations Limited Liability Partnership James Sinton 7/11/2023 subordinates. It cannot be intended to impose a statutory duty. Corporation The corporation has a full shield of liability for the shareholders. The corporation has two levels of taxation Is the partner strictly liable for his supervision and control? 1. The second clause imposes liability for any person under the partner’s direct supervision and control. 2. Is this respondeat superior or vicarious liability? 3. That person must be acting within the scope of partnership’s business. Where limited liability partnerships enjoy full protections, courts may turn to fraudulent transfer or veil-piercing doctrines to hold the partners liable for the obligations of the partnership. Partnership default rules and Limited liability Management rights Default rule: Each partner has a right to participate in the management of the business. RUPA §306(c) GP Management rights are required to oversee the business because the partners are personally liable for the obligations of the business. RUPA §306(c) provides that the partner is not liable for the partnership debts solely for being a partner or acting as a partner. 1. It creates a full shield of protection for tort and contract claims against the partnership or partners. See RUPA §306(c)(“whether arising in contract, tort, or otherwise”). 2. Personal misconduct. Partners remain personally liable for their personal misconduct. LLP The risk of personal liability from poor management is lessened. That risk has diminished the need for each partner to participate in the business. Poor management decisions can harm all the partners personally. Utah’s approach First, it makes all partners liable. Next, it turns off liability arising from negligence, wrongful acts or misconduct. 1. It is silent on contractual liability. 2. Partners remain liable for contractual obligations of the partnership and partners. Why are tort victims precluded from suing a partner in a limited liability partnership? Often, tort victims do not voluntarily encounter the limited partnership. Profit sharing Default rule: Partners share profits equally. Comparing the LLP to other organizations General partners are personally liable Limited partners have liability if they violate the control rule Partnerships have passthrough taxation Piercing theories Who are the people under the partner’s direct supervision and control? 1. One view is that direct supervision requires a close connection with the managing partner and his subordinate. 2. Another view is that direct supervision considers any subordinate of the managing partner. 3. Finally, the level of control shared among or partitioned between the partners defines a partner’s direct control. Limited Partnership Limited Liability Partnership General partners are not personally liable Limited Liability Partnership General partners are not personally liable Connecticut has the supervisory liability hole. - 71 - GP The equal sharing is needed because each partner has put his credit in the game. LLP Suppose the risk allocation among shareholders is not symmetrical. It should not be based on capital contributions, because each partner is taking an equal amount of risk with personal liability. A partner engaged in a high risk area might seek an increased share of profits to compensate for that risk, if the other partners do not share in the risk due to limited liability. Business Organizations Limited Liability Partnership James Sinton 7/11/2023 Admitting new partners Default rule: A unanimous vote of the partners is required to admit a new partner. GP Misconduct of a new partner subjects the partnership to liability, and personal liability for the partners. LLP Limited liability diminishes the precautions needed for choosing a new partner. Kus v. Irving Supp 80 Irving, Dubicki, and Camassar are partners in a limited liability partnership. Kus sued Irving, Dubicki, and Camassar for Irving’s misconduct. Holding: The court held that Dubicki and Camassar could not be held liable because of the partnership’s limited liability. - 72 - Business Organizations The Limited Liability Limited Partnership The Limited Liability James Sinton 7/11/2023 Limited Partnership The LLLP is not a separate business entity. It is merely an LP that filed with the Secretary of State to elect limited liability. RULPA allows the LP to elect the RUPA limited liability provision. LLLP LP LL general partner LL limited partner General partner The general partner in a LLLP is liable for obligations of the business only when a general partner in an LLP would be liable. Effectively, the general partner has limited liability with a full shield of liability protection. A firm that is not a limited partnership, when it fails to register, cannot be an LLLP. Limited partner In many states, the limited partner in an LLLP is liable for obligations of the business only when a general partner in an LLP would be liable. Control Rule Other states speak only of general partners receiving limited liability. The limited partner still can fall subject to the control rule! Under RULPA (1985), a limited partner who participates in the control of the business can become personally liable for at least some of the venture’s obligations. A general partner may be afforded more protections than a limited partner. - 73 - Business Organizations The Limited Liability Company James Sinton 7/11/2023 Some LLC statutes explicitly promote freedom of contract and encourage the enforcement of the parties’ private arrangements. DLLCA §18-1101(c)(“It is the policy of this chapter to give the maximum effect to the principle of freedom of contract and to the enforceability of limited liability company agreements”); See also 17-1101(c)(using the same language to recognize the importance of contractual freedoms in the partnership context) The Limited Liability Company The LLC is a non-corporate business structure that provides its owners, members, with: 1. limited liability (full shield) for the obligations of the venture, even if a member participates in the control of the business; 2. pass-through tax treatment; and 3. tremendous freedom to contractually arrange the internal operations of the venture. Partnerships have the same characteristic; they provide significant freedom of contract too! It borrows every provision from corporate law and partnership law. Management and operation LLC statutes are not that uniform. 1. RULLCA will become more uniform, but has not been widely adopted. 2. Texas has its own version. 3. Each state has its own flavor. DLLCA §§ 18-101(10), 18-201, 18-302, 18-401 to -402, 18503 RULLCA §§ 102(10), (12); 407 The operating agreement is like the bylaws, it is a private document. Judicial interpretation You do not need an operating agreement for an LLC. Delaware assumes you are going to have an operating agreement, because DLLCA does not have many default rules. Anderson observed that a typical LLC Act is a hybrid of provisions culled from the individual state’s partnership statutes and business corporation law. General governance The court focuses on the particular aspect of the LLC that gives rise to the problem, with emphasis on the foundational business form from which that characteristic originated. RULLCA It defaults to a member-managed template. RULLCA §407(b) says that ordinary business matters are decided by a majority of the members per capita, in a member-managed LLC. Formation The LLC is formed by filing a document known as articles of organization with the secretary of state. Delaware DLLCA §18-402 says that the management of the LLC is vested in the members by their proportionate interest in the profits of the LLC. Operating agreement RULLCA requires unanimous consent by the members to amend the operating agreement. §407. §18-503 defines how profits are shared between the members. DLLCA requires unanimous consent by the members to amend the operating agreement. §18-302(f). Therefore, if the LLC agreement modifies the profit distribution, it will affect the method of governance. The LLC is governed by the operating agreement or limited liability company agreement, which defines the rights, duties, obligations of the members and its business enterprise. LLC statutes allow for two different management templates: 1. Member-managed – it assigns all management function to the members and resembles a partnership. 2. Manager-managed – it assigns all management to a group of managers who may or may not be members and resembles a corporation. Freedom of contract is central to the LLC’s structure. Role of Contract This is the most important advantage! - 74 - Business Organizations The Limited Liability Company James Sinton 7/11/2023 LLC might divide management function between the members and managers. 1. Members may decide extraordinary business decisions; and 2. Managers may manage the day-to-day operations. Information and Inspection rights LLC statutes often provide members with defined rights to inspect the records of the venture. Financial Rights and Obligations Removing a manager RULLCA §407(c) allows a majority of the members to remove a manager without notice or cause. DLLCA §§ 18-502 to -504, 18-601, 18-607 RULLCA §§ 403-407 DLLCA §18-402 leaves the method of removing a manager to the operating agreement of the LLC. It will leave a court to search for the method of removal in other provisions of the operating agreement. Allocation of the financial rights depends on the default management template. Agency authority Ordinarily, agency authority is defined by the management scheme elected by the LLC. 1. If you are a member-managed, all the members are agents and can bind the LLC. 2. If you are manager-managed, it is like a corporation. Only the managers are agents of the LLC. Member-managed Equal sharing of profits. Manager-managed Profits are shared on a pro rata basis of the contributions. See general partnership rules. See corporate rules. DLLCA §18-503 says that members split profits bases on their contributions to the LLC. It allows the operating agreement to define the allocation of profits. Some states provide a statutory agency authority provision, which allows the LLC agreement to cut off the statutory authority of the members, when the LLC is managermanaged. See Kentucky. Classes of ownership Some statutes allow for the creation of multiple classes of LLC ownership interest with different rights and privileges. RULLCA no longer adopts a default rule for statutory agency authority. In the absent of a default rule, RULLCA shifts the answer to the rules of agency law! Some think this is a great move. Entity Status DLLCA §§ 18-201, 18-701 RULLCA §§ 104, 105 Delaware: Do members have agency authority in the LLC? The last sentence of §18-402 says unless otherwise provided in an LLC agreement, each member and manager has the authority to bind the LLC. An LLC is explicitly characterized as a separate legal entity whose identity is distinct from that of its owners. Limited Liability Does each member in a manager-managed LLC have agency authority? This is like saying shareholders are agents of the corporation. Ordinarily, agency authority is related to management authority. What does authority mean? Does it include apparent authority? What does “except as otherwise provided” mean? DLLCA § 18-303 RULLCA § 304 The LLC provides its owners with limited liability for the venture’s obligations. Limited liability provides the members a full shield of protection against vicarious liability. If the member is responsible for the negligence or illegal conduct, that member can be responsible personally for the resulting harm. Apparent Authority Most statutes require a deviation from the default management scheme to be specified in the articles of organization (public). Delaware allows the specification to be made in the operating agreement (private). - 75 - Business Organizations The Limited Liability Company James Sinton 7/11/2023 Under §18-1101, Delaware allows the operating agreement to eliminate: 1. The fiduciary duty of the members or managers; OR 2. The liabilities for breach of fiduciary duties of a member or manager. Piercing the veil Piercing the veil is a viable claim in the LLC context. Some LLC statutes expressly apply corporate piercing the veil standards to LLCs. Texas has expressly allowed for the standards for piercing corporations to be applied to LLCs. Retaining the fiduciary duties of a manager, but limiting the liabilities for breach of those duties allows the members to seek an injunction against the managers. Formalities are disregarded Most importantly, some of the piercing statutes disregard whether the owners of the LLC adhere to statutory formalities. The LLC is too flexible, varying of a business organization to rely on adherence to statutory formalities. Recall Texas has eliminated formalities as a factor in considering whether to pierce the corporate veil. Reverse piercing Courts have allowed the creditor of a member to reverse pierce the LLCs assets to satisfy the personal debts of the member. Fiduciary duties DLLCA § 18-1101 RULLCA §§ 110, 409 In a manager-managed LLC, the managers have central management and owe a fiduciary duty. In a member-managed LLC, the members have management authority and owe a fiduciary duty. To whom do they owe the fiduciary duty? Some statutes say the fiduciary duty runs to the LLC and each managing member. See Florida. You might analogize the LLC to the corporation, which would not impose a duty owed to the member, which reflects a shareholder. RULLCA cabins the fiduciary duties of a member similar to RUPA. Delaware Delaware is silent as to whether either the members or managers owe a fiduciary duty, and if any, to whom they owe that duty. VGS held that the managers, in a manager-managed LLC, owed a fiduciary duty to the LLC, the members, and their fellow managers. - 76 -
