Business Organizations
Professor David Lourie
Spring 2025
WELCOME!
• Expectations – you are all adults, and I treat this class as if it were a
professional job (great for the diligent; bad for the others).
• Course and Syllabus Review
Agency
• An agency relationship involves the delegation of responsibility or
authority by one person, the “principal,” to another person, the
“agent.”
• Agent acts in a representative capacity, on behalf of the principal.
• Business associations can only act through agents.
• Ex. – partnership, corporation, or LLC – a partner or representative must sign
K on behalf of the entity.
-Agency law applies to individuals as well as business associations.
-ex. – sports agent, real estate agent
Requirements for Establishing Agency
Relationship
1.) Consent
-both the principal and the agent must consent to the agent’s
acting on the principal’s behalf.
-The consent of the principal alone or the agent alone is not
sufficient.
-Consent may be oral, written or implied from a party’s conduct.
2.) Control
-an agency relationship requires the agent to be subject to the
principal’s control.
-Many courts have construed this requirement to mean that the
principal must have the right to control the way the agent performs
the task, not that the principal must actually exercise control over the
agent’s performance.
NOT Required for an Agency Relationship
1.) Consideration
-agency law does not require that an agent receive consideration
(payment) for their services.
2.) Signed Writing
-agreement between principal and agent does not need to be in
writing, unless it falls within the statute of frauds.
Agency – Tort and Contract
• Agency Issues may arise in tort or contract.
Tort
• A typical case involves a tort committed by an employee. Thus, the
question is usually whether the employer will also be liable to the
injured third party for the employee’s tort.
Contract
• When an agent enters a contract with a third party, the primary issue
is whether the principal is liable to the third party on that contract.
Partnership Law
• Uniform Partnership Act (“UPA”) has been adopted by most states to
uniformize state partnership law.
• Forming a general partnership entails far fewer formalities than
forming other types of business associations.
• The UPA § 6 defines a partnership as “an association of two or more
persons to carry on as co-owners a business for profit.”
Partnership Definition Elements
• Association
• even if those persons did not intend to form a partnership, a court may find
that a partnership exists regardless of their intent.
Persons
• “person,” as defined in the UPA § 2, includes entities as well.
“To carry on”
• a partnership may have a limited duration or be formed to accomplish a
specific purpose.
Partnership, cont.
• “Business for profit”
• A partnership must involve a business as opposed to a hobby and must be
established as a profit-making enterprise.
• Thus, you cannot have a non-profit partnership, even though you can have a
non-profit corporation under state corporate law.
“Co-owners”
• Under the UPA § 7(4), a person who has a right to share in profits is presumed
to be a partner.
• Can be rebutted with contrary evidence.
Limited Liability Entities
• One of the most important ways in which transactional lawyers can create
value their clients is by helping them choose appropriate organizational
structures for their businesses.
• Until recently, the only important standard form contracts provided were
the corporation and the general partnership.
• In the last decade or so, a third standard form contract has been added to
this short list of options: the LLC. LLCs have been around for a couple of
decades.
• Prior to 1988, however, only a few states had adopted LLC statutes and
very few had been formed. In 1988, the situation changed dramatically.
• The Internal Revenue Service concluded that LLCs could be classified as a
partnership for federal tax purposes.
• With that development, the concept took off. Many states adopted LLC
statutes and numerous LLCs have been formed.
LLCs
• popularity of LLCs.
• They provide a standard form contract that incorporates many of the
most attractive features of partnerships and corporations.
• The LLC is a unincorporated business organization that can provide its
members with pass through tax treatment, limited liability, and the
ability to actively participate in firm management.
LLCs
• The LLC differs from a partnership—and resembles a corporation—in
that an LLC can only be created by filing articles of organization with
the Secretary of State.
• The articles of organization are comparable to corporate articles of
incorporation and are treated as such by the statute with respect to
such questions as amendment and filing.
• In addition, the LLC may adopt an operating agreement, which fulfills
many of the same functions as a partnership agreement or corporate
bylaws.
LLCs
• Typical LLC statutes provide flexibility.
• The default rule is comparable to the general partnership form, vesting
management in the LLC’s members.
• In some states, the number of votes cast by each member is voting is
determined by their proportional share in the book value of the membership
interests; in others, the partnership rule of one person one vote is used.
• In general, both of these rules are subject to any contrary provisions of the
articles of organization and operating agreement.
• The LLC thus provides substantial flexibility in structuring the firm’s decisionmaking processes.
CORPORATIONS
• distinction between publicly traded corporations and those that are
closely held.
• of the 5 million or so corporations in the United States, only about
50,000 are publicly traded and of those, only about 10,000 are on a
major exchange.
• most lawyers who represent corporations will represent closely held
companies, not publicly traded ones.
“Closely Held” Corporation
A "closely held corporation" is a company where a small number of individuals own
the majority of the shares, meaning the ownership is concentrated among a limited
group, often family members, and the stock is typically not traded publicly on a
stock exchange; essentially, it's a private company with a restricted shareholder
base.
Key points about closely held corporations:
Limited shareholders: Only a few individuals hold a significant portion of the
company's stock.
Private ownership: Shares are not publicly traded on a stock market.
Family businesses: Often, closely held corporations are family-owned businesses.
Less formal operations: Due to the small number of owners, they may have less
stringent management structures compared to publicly traded companies.
CORPORATIONS, CONT.
o Of approximately 5,000,000 corporations in the US. Less than 50,000 are publicly
traded, even in the most rudimentary way.
o In 1955, institutions held approximately 23% of outstanding shares in publicly
traded corporations. By 1990 they held more than 50% of such shares and continue
to do so.
o institutional holdings break down approximately as follows:
# of shares held (in mils) % of publicly held shares
Private pensions 679,000. 19.9
Public pensions 283,000 8.3
Mutual funds 246,000 7.2
Insurance Cos. 235,000 6.9
Banks and trusts 314,000 9.2
Foundations/endowments 62,000 1.8
Publicly Traded Corporations
• shareholders in publicly traded corporations typically have only an
diminished relationship to their corporations.
• This is partly due to the fact that public capital markets provide an easy exit
opportunity and millions of shares and thousands of shareholders in each
publicly traded corporation change each day.
• In addition, most of the shareholders in publicly traded corporations own
only an infinitesimal percentage of the corporate stock.
• They therefore have little incentive to be actively engaged in monitoring
the corporation, much less in participating in its affairs.
• In fact, shareholders in the secondary market, particularly retail
shareholders, typically buy shares not because they have some connection
or affinity to the company but for their view of its profit potential, often,
short-term potential.
CHAPTER 1 – AGENCY
• WHO is an Agent?
GORTON V. DOTY
• FACTS
• HOLDING
GORTON, CONT.
The basic standard for the existence of an agency relationship is:
(1) a manifestation of consent by one person (the principal) that
another person (the agent) act
(a) on the principal’s behalf, and
(b) subject to the principal’s control; and
(2) the agent’s consent to so act
GORTON, CONT.
ANALYSIS
• Dissent – what’s the argument?
1.) “mere fact” Ms. Doty mandated that the coach be the driver was not
sufficient to mean that Ms. Doty had manifested an intent that the coach was
to be subject to her control in driving the car.
2.) car was given to the coach not for Doty’s benefit, but for the school’s (i.e.,
coach was not acting on Doty’s behalf but rather on the school’s behalf).
• Issue is not how the parties describe their relationship, but rather
whether the three-part test is satisfied under all of the circumstances.
MJ & Partners Restaurant Limited Partnership
v. Zadikoff
• FACTS
• HOLDING
MJ & PARTNERS, cont.
Argument - Zadikoff was an agent of MJ&Partners and violated his
fiduciary obligations.
Held: agency can be established by “actual practices.”
-the “degree of control plaintiffs exerted over [Zadikoff’s] actions,
and the extent to which these actions could be imputed to
plaintiffs for the purposes of determining liability.”
Why does it matter if he is an agent? If he’s not, cannot rely on the
concept of fiduciary obligation.
Rose v. Giamatti
FACTS
• Rose sought a temporary restraining order and preliminary injunction in
state court against baseball commissioner A. Bartlett Giamatti, Major
League Baseball, and the Cincinnati Reds.
• Giamatti moved to remove the case to United States district court, with the
consent of the other defendants.
• Rose objected to the removal, asserting a lack of complete diversity of
citizenship between himself and the defendants.
• In order to resolve that procedural dispute, the court had to decide
whether the Commissioner of Baseball is an agent of Major League
Baseball.
Rose, cont.
HOLDING
Court rejects Rose’s argument that Major League Baseball was a proper
party because it could be held liable for the Commissioner’s actions on a
principal-agent theory:
• a party cannot be held liable for conduct of a person over whom it has no
control.
• constituent clubs agreed to allow a completely independent commissioner to govern
disciplinary matters.
• Since the Major League Agreement and the terms of Rose’s own employment
contract vest absolute power to police activities “not in the best interests” of
baseball in the Commissioner, the court concluded that Giamatti was not acting as an
agent for Major League Baseball with regard to such disciplinary functions.
A. Gay Jenson Farms Co. v. Cargill
FACTS
• Plaintiffs were farmers who sold grain to Warren Grain & Seed Co., a
local grain elevator operator, and were not paid.
• The defendant is Cargill, Inc., a giant international dealer in grain,
seed, etc.
• Cargill extended credit to Warren.
• Over time the debt grew, from an initial line of credit of $175,000 to
$3.6 million when Warren ceased operations.
CARGILL, CONT.
• Cargill is liable because of the control it exercised over Warren.
• The basis for this conclusion is the nine factors listed, plus Cargill’s
aggressive financing.
CONTROL
• By having Warren implement its recommendations, Cargill manifested
its consent that Warren would be its agent.
• Warren acted on Cargill's behalf in getting grain while being entirely
funded by Cargill.
• An agency relationship was established by Cargill's interference with
the internal affairs of Warren, demonstrating its de facto control.
LIABILITY OF PRINCIPAL TO THIRD PARTIES IN
CONTRACT
• the primary issue is whether a principal is liable to a third party on a
contract executed by an agent on the principal’s behalf.
RULE:
A principal will be liable to a third party on a contract entered into by
an agent if
1.) the agent had actual or apparent authority to bind the
principal when the agent executed the contract; OR
2.) if the principal ratified or adopted the contract later on.
ACTUAL v. APPARENT AUTHORITY
• Actual Authority
• If a principal has authorized an agent to act on the principal’s behalf, the
agent has authority to act for the principal.
Apparent Authority
• where a principal creates the appearance that an agent has authority to bind
him when in fact the agent has no authority to bind the principal at all.
ACTUAL AUTHORITY
• Actual authority involves three requirements:
(1) The authority must be conferred by the principal on the agent
(either expressly or impliedly)
(2) to conduct the specified action on behalf of the principal,
(3) which the principal would otherwise have had the capacity to do on
his own.
Actual authority may be express or implied.
EXPRESS V. IMPLIED ACTUAL AUTHORITY
• Express actual authority
• created by the principal’s words to the agent
• principal tells the agent to act on his behalf.
Implied actual authority
• agent draws a reasonable inference from principal’s conduct that the agent has
authority to act on the principal’s behalf, even though the principal has never told
the agent to act for him in that way.
• reasonable person standard—if the principal’s conduct would lead a reasonable
person in the agent’s position to believe the agent had authority to act on the
principal’s behalf, then the agent had implied actual authority to do so.
Mill Street Church of Christ v. Hogan
• Church hired Bill Hogan to paint the church building.
• Bill Hogan needed a helper and hired his brother Sam Hogan.
• After a half hour on the job, Sam was injured when a ladder broke.
• Sam sought worker’s compensation, which turned on whether he was
an employee, which turned on whether Bill had authority, implied or
apparent, to hire him.
Mill Street, cont.
• Sam wins because
(a) Bill had implied actual authority to hire him, based on need and
past experience in hiring helpers for work for the Church;
(a) Actual authority looks to the relationship between principal and agent. If
the agent reasonably believed he had authority, implied actual authority
exists.
and
(b) Bill had apparent authority based on Sam’s past experience in
having been hired to work with Bill.
Karl Rove & Co. v. Thornburgh
• When Richard Thornburgh ran for the U.S. Senate, and lost, Thornburgh
left behind an unpaid bill of almost $170,000 owed to Karl Rove & Co. for
services in conducting a direct mail campaign.
• It is clear that the authorized campaign committee—the “Thornburgh for
Senate Committee”—had hired Rove & Co. and that it was liable.
• Unfortunately, the committee was broke.
• So Rove sued Thornburgh personally, seeking to hold Thornburg personally
liable on the debt.
• the case turned on whether Thornburgh’s longtime aide Murray Dickman,
in entering into a the contractual relationship with Rove & Co., acted as
Thornburgh’s agent and within the scope of his authority. If so, Dickman’s
assent to the contract would be binding on Thornburgh.
Rove, cont.
HOLDING
• Thornburgh is liable. Because Dickman is Thornburgh’s agent, Dickman’s assent to
the contract constitutes assent by Thornbugh.
• Court Quote:
A candidate for federal office already has at least two methods by which he could
protect himself from personal liability for the contracts entered into by his principal
campaign committee. First, he could incorporate his campaign committee. If the
committee were incorporated, then the candidate–whether or not he is a
shareholder— is shielded from personal liability by the corporate entity, assuming,
of course, that he takes no personal action that creates liability apart from the
corporation’s. Second, a candidate could include in all contracts entered into by his
principal campaign committee a provision expressly stipulating that the contracting
party may look only to the committee and its assets for compensation, thereby
eschewing the candidate’s personal liability, either directly or indirectly.
Apparent Authority
REMINDER:
Apparent Authority
• where a principal creates the appearance that an agent has authority to bind
him when in fact the agent has no authority to bind the principal at all.
Lind v. Schenley Industries, Inc.
• Lind had been working for Park and Tilford (PT) and was promoted to the
position of district manager.
• PT’s vice-president, Herrfeldt, told him that he would answer to Kaufman
and that he should find out from Kaufman what his salary would be.
• Lind claims Kaufman promised him a 1 percent commission on the sales of
the people under him. He never received this commission and eventually
sued.
• Does Kaufman have apparent authority?
• The jury found for Lind, and the trial judge JNOV’d him on the grounds that
he “could not reasonably have believed that Kaufman was authorized to
offer him a commission that would . . . ‘have almost quadrupled Lind’s then
salary.’”
Lind, cont.
• Reversed.
• Kaufman had apparent authority.
• Park and Tilford (through its board or CEO) installed Herrfeldt as sales
manager, which clothed him with apparent, and possibly actual,
authority to set salaries. And he had authority to tell others what his
position was. Thus, he was authorized to create his own apparent
authority.
Lind – Problems with Result
1.) what were Kaufman’s real duties? Kaufman had apparent authority to offer Lind the
commission only if offering it was reasonably close to the basic duties that PT had publicly
authorized him (Kaufman) to perform. Apparently Kaufman had authority to set Lind’s salary.
Is a commission close enough to a salary that a company that holds someone out as
authorized to set a salary apparently authorizes him or her to set a commission?
2.) how reasonable was a 1 percent commission? The dissent argues that it would have
quadrupled Lind’s pay. If so, then the apparent authority argument becomes more dubious.
Apparent authority will apply only if a third party (here Lind) can reasonably believe that the
principal (PT), in holding someone (Kaufman) out as its authorized agent, is authorizing the
agent to offer a commission. If the 1 percent commission that Kaufman offered is out of line
with offers that others in the industry would make, then Lind has a tough time claiming that in
publicly appointing Kaufman its agent PT apparently authorized him to make the 1 percent
commission offer.
3.) should one believe L? Given that he didn’t complain about his failure to receive the
commission for several years, he may be lying about the whole matter.
Ackerman v. Sobol Family Partnership, LLP
• Coe conducts settlement talks on behalf of his client Ackerman (and
several others) with several defendants. After considerable back-andforth, they reach a deal.
• Ackerman then tries to back out.
Ackerman, cont.
• Coe's client is bound by apparent authority.
• The course of conduct by her (her participation without complaint in
the long settlement negotiations that Coe handled) is such as to
create that apparent authority, and she gives no evidence of having
revoked Coe's authority.
• The course of conduct (Coe repeatedly assuring the defendants that
he had authority, and Ackerman never complaining) also indicates
that the defendants believed in good faith that Coe had authority.
Ackerman, cont.
(a) that
for apparent authority to exist, (i) the principal (the client) must create the agent's
(the attorney's) apparent authority through his or her conduct, and (ii) the third
party must rely on the principal's representations in good faith; (b) that any
revocation of that authority must be clear; (c) that attorneys do not necessarily
have apparent authority to settle a case; and (d) that appointing an agent to a
position creates apparent authority for the agent "to do acts consistent" with that
position.
Inherent Authority
• We are skipping inherent authority cases – Watteau, Kidd, and
Nogales
Ratification
• “ratify” means to confirm or approve
• A party who ratifies a contract treats an agent’s unauthorized act as if
the agent had been authorized to act for him at the time of the
contract. The act is given effect as if it had been authorized at the
outset.
• ratification is permitted only if the purported agent indicated at the
time of the contract that he was acting for someone else.
• If the agent made such a representation to a third party, the “someone else”
may ratify the unauthorized contract and make it his own.
Ratification is retroactive to the time of the original contract; effect is the
ratifying party had been a party to the contract from the outset.
Ratification Requirements
1.) the ratifying party must have knowledge of all the material facts.
2.) the ratifying party must ratify the entire contract. The ratifying party
cannot ratify part of a contract and disaffirm the rest.
3.) because ratification is retroactive to the time of the original
contract, the ratifying party must have contractual capacity not only at
the time of ratification but also at the time the contract was formed.
Ratification
• Can be expressed or implied.
• An example of an express ratification is where a corporation’s board
of directors passes a resolution to ratify a lease that a corporate
officer executed without authority to bind the corporation.
• An implied ratification would arise if the corporation knowingly
moved into the leased space without a formal board resolution
ratifying the lease.
• Regardless of whether ratification is express or implied, the effect is
the same: the ratifying party is liable on the contract just as if it had
been a party to the contract from the very beginning.
Botticello v. Stefanovicz
• Walter and Mary Stefanowicz, husband and wife, owned a farm as tenants
in common.
• Walter leased it to Botticello, with an option to purchase, without
consulting Mary.
• Botticello (having foolishly failed to obtain a title search) occupied the
farm, paid rent, and made improvements over a period of several years,
but when he sought to exercise his option, the Stefanowiczes refused to
allow him to do so.
• Botticello sued for specific performance.
• The trial court found in his favor on the alternative theories that (a) Walter
acted as Mary’s agent and (b) Mary ratified the contract by receiving and
accepting rent payments and by acquiescing in the improvements.
Botticello, cont.
• Botticello loses as to Mary, and specific performance is not
appropriate, but the case is remanded for determination of some
remedy against Walter.
• There is no evidence to support the position that Walter was Mary’s
agent. The marital relationship is not enough.
• In previous transactions, Mary had signed the deed. Mary did not
ratify because she did not accept the payments or benefits “with an
intent to ratify, and with full knowledge of all the material
circumstances.”
Ercanbrack v. Crandall-Walker Motor Company,
Inc.
• Plaintiff Ercanbrack went to defendant’s showroom and, on October 25,
1973, left thinking he had bought a new black Ford truck for future
delivery.
• He had signed a document with a statement in bold letters, just below his
own signature, that the document was not valid unless signed by the sales
manager or an officer of the defendant. The document was signed only by
the salesman.
• In March of 1974, plaintiff had an informal conversation with an officer of
the defendant, asking about the truck, and the response was, “we haven’t
heard on it yet.”
• Finally, in May 1974, plaintiff asked again and was told that the price had
increased. Plaintiff refused to take the new truck and sued.
Crandall, cont.
• The trial court’s grant of the defendant’s motion to dismiss is
affirmed.
• According to the majority, the defendant had no knowledge of the
order and therefore there was no ratification or estoppel.
Adoption
• Even if an agent had no authority whatsoever to bind the principal at
the time of the contract, and there was no effective ratification after
the fact, a principal may still adopt a contract as his own.
• Like ratification, adoption may be express or implied.
• The primary difference between ratification and adoption is that,
unlike ratification, adoption is not retroactive to the time of the
original contract.
• The adopting party is liable on the contract only from the moment of
adoption forward.
Adoption, cont.
• Adoption is a fallback position.
• If everything else fails (no actual authority, no apparent authority, no
effective ratification), look to see if there was an adoption.
Estoppel
• In applying estoppel, the court recognizes that the purported agent
did not have any actual or apparent authority to engage in the
transaction at hand.
• Due to some fault of the principal, however, the court will hold that
the principal is bound.
• most common estoppel situation is where a principal permits an
imposter to be in a position where the imposter appears to have
authority to act on the principal’s behalf.
Hoddeson v. Koos Bros.
• Joan Hoddeson went to the Koos Bros. furniture store to buy
bedroom furniture. She was helped by “a tall man with dark hair
frosted at the temples and clad in a gray suit.” He accepted her order
and her $168.50 in cash, but he turned out to be an imposter. When
Hoddeson realized that she was not going to get her furniture, she
brought this lawsuit.
• Remand – she should be allowed to prove her case based on
estoppel.
Trustees of the American Federation of Musicians
and Employers’ Pension Fund v. Steven Scott
Enterprises, Inc.,
• Steven Scott employed musicians for various events and was obligated to make
contributions to the union pension fund.
• Apparently, a dispute arose about whether it had made adequate contributions,
and it entered into a series of settlement agreements over a period of three
years.
• The agreements were signed by Moriarity, the union president, who was also a
trustee of the pension fund.
• Each agreement contained the following sentence: “Negotiation of check for
pension benefit contributions shall be deemed ratification of this Agreement.”
• Steven Scott sent a series of 15 separate checks to the pension fund, each one
accompanied by a copy of the settlement agreement. The checks were routinely
processed and negotiated.
• Moriarity did not have authority to bind the pension fund, which brought this suit
seeking an audit. Steven Scott resisted on the basis of the settlement agreement
Steven Scott, cont.
• Steven Scott wins.
• The pension fund, as to the first 13 checks, was estopped to deny
Moriarity’s representation that he was authorized to sign.
• Steven Scott reasonably relied on that promise and the pension funds
accepted the checks.
• It would be unjust to allow the pension fund to avoid the settlement
agreements now.
• Moreover, Moriarity had apparent authority.
Steven Scott, cont.
• Before sending the last two checks, however, Steven Scott had received a
copy of the pension fund’s Trust Agreement, which reveals Moriarity’s lack
of authority.
• Thus, Steven Scott cannot rely on estoppel or apparent authority. Not to
worry.
• Ratification saves the day. The pension fund received the checks, along
with the settlement agreements, and cashed the checks.
• “Once the Pension Fund had knowledge of the settlement agreements, its
failure to repudiate Moriarity’s actions constituted ratification of the
agreements.”
• “The ratification clause was explicit. The Pension Fund cannot now complain that it
failed to read or inquire into the meaning of this clause simply because its clerical
workers did not notice the settlement agreements or chose not to read the
agreements.”
Atlantic Salmon A/S v. Curran
• The defendant, Curran, was a seafood wholesaler who bought salmon from
the plaintiffs and failed to pay a total of about $256,000.
• Curran signed all the purchase documents as representative of Boston
Seafood Exchange, Inc. or Boston International Seafood Exchange, Inc.
There were no corporations with such names.
• Curran had formed a corporation called Marketing Designs, Inc., created
for the purpose of selling motor vehicles, but before Curran started doing
business with the plaintiffs, that corporation had been dissolved “for failure
to make requisite corporate filings.”
• After Curran started doing business with the plaintiffs “a certificate was
filed with the city clerk of Boston declaring that Marketing Designs, Inc.
(then dissolved), was conducting business under the name of Boston
Seafood Exchange (not with the designation “Inc.” and not also under the
name Boston International Seafood Exchange, Inc.).”
• The trial judge found in favor of Curran.
Atlantic Salmon, cont.
• Judgment entered for the plaintiffs.
• Curran claimed to represent a partially disclosed (unidentified)
principal, Marketing Designs, Inc. The blackletter law is that the
agent remains liable on the contract in such cases.
• If the agent wants to avoid liability, he must reveal not only that he is
acting on behalf of a principal, but the identity of the principal. The
third party has no obligation to ask.
• The theory seems to be that in such cases it is generally understood by the
agent and the third party that the agent remains liable. That theory, however,
does not seem to fit the facts of this case
Analysis
• As a general matter, agency-based liability in disclosed principal cases
rests on one of two grounds.
• 1.) if the intent of the parties is that the agent, as well as the
principal, is to be a party to the contract, then the agent is bound
under ordinary contract principles. Restatement (Second) of Agency §
323.
• The tough issue in these cases is usually figuring out precisely what the
parties intended. In general it will be presumed that the intent was only to
bind the agent is obviously safer if the contract says so explicitly
Atlantic Salmon, cont.
2.) Second, there are situations in which the agent had no authority to
bind the principal and the principal refuses to ratify the contract. Can
the third party get compensation for all or part of his or her loss from
the agent?
-In the vast majority of jurisdictions the answer is yes, although
the theories used often differ.
-Most jurisdictions hold that there is an implied warranty of
authority; the agent implicitly warrants to the third party that he
or she has the authority to enter into the contract. Restatement
§ 329 adopts this approach.
1/15
Liability of Principal to 3rd Parties in Tort (85)
a. Servant or Independent Contractor? (85)
i. Humble Oil & Refining Co. v. Martin (Tex. 1949)(86)
ii. Hoover v. Sun Oil Co. (Del. 1965)(89)
iii. Murphy v. Holiday Inns, Inc. (Va. 1975)(93)
iv. Parker v. Domino’s Pizza (Fla. Dist. Ct. App. 1993)(96)
b. Tort Liability and Apparent Agency (101)
i. Miller v. McDonald’s Corp (Oregon 1997)(101)
Tort Liability
general rule is that a master is liable to an injured third party
on a tort committed by a “servant” if the servant was acting
within the scope of employment when the tort occurred.
1. Was the tort committed by a servant or an independent
contractor?
2. If the tort was committed by a servant, was the servant acting
within the scope of its employment when the tort occurred?
Servant or Independent Contractor?
• no bright-line test for when a tortfeasor will be considered a servant and
when he will be considered an independent contractor.
Independent Contractor
• An independent contractor generally has a task to complete, but it is
up to the contractor to determine how to accomplish that task.
• although the employer may dictate the end result, the employer does
not dictate the means to achieve that end goal.
Servant
• A servant, by contrast, is subject to the principal’s control. The principal can
dictate both the end goal and the means to get there. In that sense, a
servant is not independent of the master.
Factors to Consider
• Employer’s right to control
• Skill (unskilled laborer much more likely servants)
• Regularity of Payment
• Employer’s Regular Business
• Separate Trade or Business
• Duration
• Tools and Workplace
Within the Scope of Employment?
• Once a plaintiff has established that an employer had the right
to control an employee, the plaintiff must then show that at the
time of the tortious conduct, the employee was acting within the
scope of his employment.
• master’s liability for a servant’s torts is limited to torts that are
somehow related to the task or tasks the master hired the servant to
do.
Within Scope of Employment, cont.
Authorized Conduct
For an employee’s conduct to be considered within the scope of
employment, the conduct must be of the same general nature as,or
incidental to, the conduct authorized by the employer.
Under Section 228 of the Second Restatement of Agency, conduct is
authorized so long as the conduct is:
— of the kind the servant was authorized to perform;
— occurs substantially within the authorized time and
space limits; and
— is performed, at least in part, by a purpose to serve
the master.
Similar or Incidental Conduct
Factors to be considered in determining if conduct is similar or incidental to the conduct authorized by the principal are
listed in the Second Restatement of Agency § 229(2):
— whether or not the act is one commonly done by
servants;
— the time, place and purpose of the act;
servant;
— the extent to which the business of the master is
apportioned between different servants;
— whether or not the act is outside the enterprise of
the master or, if within the enterprise, has not been
entrusted to any servant;
— the similarity in quality of the act done to the act
authorized;
— whether or not the instrumentality by which the
harm is done has been furnished by the master to the
servant;
— the extent of departure from the normal method of
accomplishing an authorized result; and
— whether or not the act is seriously criminal.
— the previous relations between the master and the
Humble Oil & Refining Co. v. Martin
• Humble owned a gas station operated by Schneider.
• Humble purported to lease the station and equipment to
Schneider and to sell gasoline and other products to him.
Schneider also repaired cars.
• Love left her car at the station for repairs, but did not set the
hand brake. The car rolled off the station and hit Martin and his
kids.
Humble, cont.
HOLDING:
• Humble is liable for acts of Schneider, its servant, and of the other
employees (including Manis, who was the only employee present
when the car was left by the plaintiff).
Humble, cont.
ANALYSIS
• legal issue turns on Humble’s legal right to control the manner
in which Schneider performs his job
• The court observes that Humble closely supervised and controlled the
way in which Schneider acted; hence Schneider was its servant, not
an independent contractor.
• The court also notes that Humble set the hours that the station was
open; Humble held title to the goods which Schneider sold on
consignment; Humble paid a big percentage of Schneider’s operating
costs. Schneider’s only real power was to hire and fire workers.
Hoover v. Sun Oil Co
Facts: Gas station attendant Smilyk apparently dropped his cigarette while
filling a car at a Sunoco gas station operated by Barone. He caused a fire, and
the
plaintiff car owner was injured in the fire.
Held: Sunoco is not liable, as Barone was an independent contractor.
Reasons: outcome turns on control.
Barone set the hours that the station was open; Barone could sell
non-Sunoco products; Barone paid rent to Sunoco under a formula
that contained a minimum rental; Barone took title to the products
he sold.
Murphy v. Holiday Inns, Inc.,
• The defendant, Holiday Inns, Inc. is a franchiser.
• It provides a name quality assurance, national advertising, and a system of
operation, in return for fees from franchisees. Its franchisees own and
operate hotels and motels.
• P Murphy, slipped and fell at motel owned by the Betsy-Len Motor Hotel
Corporation.
Murphy, cont.
• Holiday Inns is not liable. It is not a master. The control is not
sufficient.
[D]efendant was given no power to control daily maintenance of the
premises. Defendant was given no power to control Betsy-Len’s current
business expenditures, fix customer rates, or demand a share of the
profits. Defendant was given no power to hire or fire Betsy-Len’s
employees, determine employee wages of working conditions, set
standards for employee skills or productivity, supervise employee work
routine, or discipline employees for nonfeasance of misfeasance.
Parker v. Domino’s Pizza
• P sought tort damages from the franchiser resulting from the alleged
negligent operation of an automobile used in delivering pizza from
the franchisee.
• Highly detailed franchise agreement and operations manual, covering
virtually all aspects of operation, were sufficient evidence of control
to permit the case to go to the jury, even though the franchiser had
the right only to “advise” on hiring and apparently no control over
firing or hours of operation.
Parker, cont.
Tort Liability and Apparent Agency
• Plaintiff Miller bit into a foreign object (a heart shaped sapphire stone)
while eating her Big Mac at a McDonalds restaurant operated by a local
franchisee.
• She sued McDonalds, the franchisor.
• For an actual agency relationship to exist between franchisor and
franchisee, such that the former may be held vicariously liable for the
franchisee’s negligence, the franchisor must have the right to control the
methods by which franchisee performs its obligations under the franchise
agreement.
• If, in practical effect, the franchise agreement goes beyond merely setting standards,
and allocates to the franchisor the right to exercise control over daily operations of
the franchise, an agency relationship exists, and the franchisor may be held
vicariously liable for actions of the franchisee.
Scope of Employment
Brill v. Davajon
• It was a cold January night in Chicago. The streets were icy.
• David Brill, the plaintiff, was driving along Foster Avenue.
• Frank McFarland, an employee of Checker Taxi Company, was using his cab to
push a car driven by Joel Davajon. Davajon had promised McFarland $1 for the
help.
• McFarland and Davajon pulled out from the curb and struck Brill’s car. (McFarland
claimed that he and Davajon were in the middle of the street and Brill sideswiped
them, but the jury believed Brill.)
• Brill sought recovery from Checker and prevailed in the trial court.
• Checker appealed, claiming that its motion for a directed verdict should have
been granted because McFarland was acting outside the scope of his
employment.
Brill, cont.
• Checker wins. The issue was whether McFarland was the company’s agent
at the time of the accident; in other words, was his conduct within the
scope of the employment?
• The court held that because McFarland was acting in his own interest and
against instructions, his conduct was outside of the scope of the
employment. McFarland violated a clear policy of Checker.
• Moreover, he was acting in his own interests, having been promised the $1.
• This result seems consistent with Restatement (Second) of Agency § 228, in
that it was not of the same nature as the activity he was employed to carry
out nor was it actuated by any purpose to serve the cab company.
Ira S. Bushey & Sons, Inc. v. United
States
• A Coast Guard ship was in drydock in Brooklyn’s Gowanus Canal.
• The Coast Guard had contracted with the drydock owner that the ship’s crew
would have access to the ship so they could continue to live aboard.
• Seaman Lane was a member of the crew. Late one night he got drunk and, as he
was returning to the ship, opened a set of valves in the drydock. The result was
that the drydock began to fill with water and the ship fell off its blocks and
toppled over against the drydock.
• Bushey, the corporate owner of the drydock, sued the United States for damages.
• The trial court ruled that Bushey was entitled to damages in an amount to be
determined.
• The United States appealed, claiming that Lane’s act was outside the scope of his
employment.
Bushey, cont.
• Judgment Affirmed.
• policy of fairness—namely, the “deeply rooted sentiment that a
business enterprise cannot justly disclaim responsibility for accidents
which may fairly be said to be characteristic of its activities”—
• broadly conceived notion of foreseeability, and, in the end, relies on
the need to rely on judgment and intuition.
Manning v. Grimsley
• Manning, the plaintiff, was sitting in the bleachers at Fenway Park
during a game between the Red Sox and the Baltimore Orioles.
• Grimsley, a pitcher for the Orioles, was warming up in the bullpen and
Manning, among others of his ilk, was heckling him.
• The heckling apparently got to Grimsley, who fired a fastball at his
tormenters. Manning was injured.
• Manning sued Grimsley and the Orioles Club for negligence and battery.
• The trial court directed a verdict in favor of the defendants on the battery
count and the jury found in their favor on the negligence count.
Lamkin v. Brooks
• Robert Brooks was a police patrol officer in the Town of Lecompte.
• One evening, while on duty, he encountered Donnal Lamkin and his son Lonnie
along the highway and, later, in the parking lot of the Bayou Lounge. Donnal was
plainly drunk, but Brooks said he would look the other way in order to allow
Donnal to drive his car home.
• Later in the evening Brooks got a radio report that a couple of drunks were blocking the
highway at a point outside the jurisdiction of the Town.
• Brooks went there and dealt with the problem, but Donnal threatened him. Brooks went
away but later returned and wound up hitting Donnal in the face, causing serious injury.
Brooks claimed that he had returned to the scene to get Donnal’s license number for his
report of the incident.
• Donnal sued Brooks, the Town, and the insurance carrier. Donnal prevailed against
Brooks (who did not appeal) but lost to the Town and the insurance carrier. Donnal
appealed and lost again. The Supreme Court granted certiorari.
Lamkin, cont.
• The judgment in favor of the insurance carrier is upheld; the language
excluding intentional torts is unambiguous.
• The judgment in favor of the Town is reversed; Brooks’s actions were
within scope of his employment. The court states:
“In the present case, the altercation between Brooks and Donnal
clearly had its roots in Brooks’ performance of his duties as a
Lecompte police officer.” Later in the opinion the court states that
“Brooks’ tortious conduct was so closely connected in time, place and
causation to his employment duties as to be regarded as a risk of
harm fairly attributable to his employer’s business.”
Arguello v. Conoco, Inc. – Statutory Claims
• The plaintiffs complain of racial discrimination at Conoco gas stations.
Arguello and Govea were mistreated by an employee named Smith at
an outlet owned by Conoco, in a manner that violated 42 U.S.C. §§
1981 and 2000a.
• Conoco defense is that the racist employee was animated by personal
prejudice and therefore was acting outside the scope of her
employment.
• court reviews the various factors that bear on this issue and
concludes that the plaintiffs had made out a reasonable case and that
summary judgment should not have been granted in favor of Conoco.
February 13
Liability of Principal to 3rd Parties in Tort
• a. Liability for Torts of Independent Contractors (129)
• i. Majestic Realty Associates, Inc. v. Toti Contracting Co. (N.J.
1959)(129)
• ii. Anderson v. Marathon Petroleum Co. (7th P Cir. 1986)(133)
• iii. Kleeman v. Rheingold (N.Y. 1993)(139)
These are exception cases.
-there are exceptions to the rule that principals are not liable for torts of
independent contractors.
Majestic Realty Associates, Inc. v. Toti
Contracting Co.
• Parking Authority of the City of Paterson, N.J., hired Toti Contracting
to demolish a building adjacent to one owned by Majestic Realty.
• A wrecking ball operated by a Toti employee knocked a section of wall
onto the Majestic building’s roof, causing extensive damage. The Toti
employee explained: “I goofed.”
• Majestic sued the Authority.
• The trial court held that Toti was an independent contractor and,
accordingly, that the Authority could not be held liable. The
intermediate appellate court reversed.
Majestic, cont.
• appellate court is affirmed and the case is remanded for a new trial.
• The court notes well-established three exceptions independent
contractor rule.
(1) A principal who retains control over the aspect of the activity in
which the tort
occurs is liable.
• If the employer controls or has the right to control the physical performance
of the task, the employee is a servant not an independent contractor.
• What this exception thus implies is that one could be an independent
contractor for some purposes and a servant for others. What you have to look
at in such cases is where the injury occurred—did it happen in a portion of
the activity over which the employer retained close control? If so, liability. If
not, no liability.
Majestic, cont.
(2) principal can be held liable if it employed an incompetent
independent contractor.
(3) principal can be held liable where the performance involves
an inherently dangerous activity.
-This is the ground on which the court ultimately rested.
Analysis
Restatement (Second) of Agency § 213 says that the principal is liable
“if he is negligent or reckless . . . in the employment of improper
persons or instrumentalities in work involving risk of harm to others . . .
.”
Anderson v. Marathon Petroleum Co.
• Anderson was an employee of Tri-Kote, an independent contractor
hired by Marathon to sandblast the inside of oil tanks.
• Anderson died of silicosis presumably caused by the silicon to which
his work exposed him. His widow sues.
• Marathon defends on grounds that Tri-Kote was an independent
contractor.
Anderson, cont.
• As a general rule, principals are not vicariously liable for the tortious
conduct of their employees. An exception exists for conduct that is
“abnormally dangerous,” but sandblasting does not fall into that
category.
• In any event, as applied to tort suits brought against the principal by
employees of the independent contractor (as opposed to suits by
third parties), presumably even the “abnormally dangerous”
exception will not apply.
• “bedrock principle” that worker’s compensation statutes are the exclusive
means of redress for injured workers with respect to job-related injuries.
• That principle protects not only the immediate employer (Tri-Kote) but also principals
who contract with them (Marathon).
Kleeman v. Rheingold
• Plaintiff hired defendant to sue her doctor. Two days before the
statute of limitations was to run, defendant hired Fisher’s Service
Bureau to serve process.
• Fisher’s did, but by serving it on the doctor’s secretary rather than the
doctor.
• By the time the defendant discovered the error, it was too late to reserve the process, so the plaintiff sued her lawyer for malpractice
instead.
Kleeman, cont.
• Defendant cannot win on summary judgment. Lawyers have a
“nondelegable” duty to see that process is served, and cannot avoid
responsibility for negligent process serving by hiring an independent
process serving firm.
• To justify the logic, the court says that lawyers are not supposed to be
able to limit their liability exposure, that clients expect lawyers to
control the entire litigation, and that lawyers have a licensed
monopoly.
Kleeman, cont.
CONCURRENCE:
• The court should have rejected the summary judgment motion on the
grounds that the defendant may have selected the process server
negligently.
• The non-delegable duty approach will instead force lawyers to hire
process servers in-house.
Thursday, February 15
Fiduciary Obligation of Agents (142)
a. Duties During Agency (142)
i. Reading v. Regem (King’s Bench 1948)(142)
ii. General Automotive Manufacturing Co. v. Singer (Wisc. 1963)(146)
b. Duties During & After Termination of Agency: “Grabbing & Leaving” (154)
i. Bancroft-Whitney Co. v. Glen (Cal. 1966)(154)
ii. Town & Country House & Home Service, Inc. v. Newbery (N.Y. 1958)(167)
iii. Corroon & Black-Rutters & Roberts, Inc. v. Hosch (Wisc. 1982)(170)
Fiduciary Duty of Agents
• All agents owe to their principals a duty of loyalty: the agent may not put his
own interests or the interests of some third party ahead of the interests of the
principal.
• While an agent is entitled to reasonable compensation from the
principal, absent agreement to the contrary, the duty of loyalty forbids the agent
from receiving any other compensation in connection with the agency relationship
unless the principal knowingly and voluntarily agrees to the contrary.
• Consequently, unless the principal validly consents the agent may not derive any
benefits, called secret profits, from the agency relationship other than the amount
promised by the principal.
Duties During Agency, cont.
Three fairly common situations constituting a breach of this duty:
1.) agent receives a payment from a third party in connection
with some transaction between the principal and the third party.
ex. – payment, bribe, kickback, tip
2.) agent obtains makes a secret profit from the agency relationship by
himself secretly transacting with the principal.
3.) agent uses her position to make a personal profit from someone
who has no relationship whatsoever with the principal.
-Reading Case
Reading v. Regem
• agent was able to use his position to make a personal profit from
a transaction otherwise having nothing to do with his regular employer.
• British solider in Egypt and smuggler.
• While in full uniform, the sergeant escorted the smuggler’s trucks (lorries)
through Cairo, which allowed them to pass the civilian police without being
inspected. For these services he was paid some £20,000.
• Special Investigation Branch found him out and “the military authorities
took possession of the money” that he had in a bank account and in cash in
his apartment.
• Sergeant sued to recover the money
Reading, cont.
• agent was required to pay over to the principal (i.e., His Majesty’s
Government) the secret profits made as a result of his misuse of the
agency position.
• The sergeant “[took] advantage of his service and violate[d] his duty of
honesty and good faith to make a profit for himself.”
• Where “the wearing of the King’s uniform and his position as a soldier is the
sole cause of his getting the money and he gets it dishonestly, that is an
advantage which he is not allowed to keep.”
Restatement Analysis
• “the agent has a duty to act solely for the benefit of the principal in all
matters connected with his agency.” Restatement (Second) of Agency §
387.
s. 404 – “purposes or those of a third person assets of the principal’s business
is subject to liability to the principal for the value of the use. If the use
predominates in producing a profit he is subject to liability, at the principal’s
election, for such profit”
ex. - A soldier uses his official uniform and position to smuggle
forbidden goods into a friendly country and thereby makes large
profits. The country by which he is employed is entitled to the profits.
General Automotive Mfg. Co. v. Singer
• Singer was a key employee of General Automotive (GA).
• His compensation was a salary plus 3 percent of gross sales. His contract of
employment called for him to devote his “entire time, skill, labor and attention” to
the job, and to work 5½ days per week.
• GA was a small firm engaged in the business of machine shop jobbing. A
customer, Husco, sent some business to Singer.
• Singer decided that GA could not handle the work and sent it out to other
shops, thereby making a profit for himself. In his defense, he took the position, in
effect, that he was in a separate brokering business with respect to orders that GA
could not handle. Singer made a profit of $64,088 on the Husco business. GA
sues to recover this profit.
GA, cont.
• GA wins, on the theory that Singer had a duty to “exercise good faith
by disclosing to Automotive all the facts regarding this matter.”
• court relies on fiduciary obligation rather than on violation of the
express terms of the contract.
Rash v. J.V. Intermediate, Ltd. [I DIDN’T ASSIGN
BUT WALKING YOU THROUGH IT]
• JVIC’s business was to “build, refurbish, expand and manage assets
for industrial process plants worldwide.”
• Rash was hired by JVIC to “start and manage a Tulsa, Oklahoma
division of its industrial plant maintenance business, inspecting,
repairing, and maintaining oil refineries and power plants.”
• Rash was apparently successful in establishing the Tulsa division. Rash
formed a company to provide scaffolding; this company entered into
contracts with JVIC. I
• In doing so, says JVIC, Rash violated his fiduciary duty. The trial court
dismissed the claim and JVIC appeals.
Rash, cont.
• The court holds that the trial court erred in dismissing the claim
based on breach of fiduciary duty.
• The court’s view seems to be that Rash violated his duty by failing to
inform JVIC of the contract with his scaffolding company.
Bancroft-Whitney Company v. Glen
• Duties During and After Termination of Agency: Herein of “Grabbing and
Leaving”
• Glen was president and director of Bancroft-Whitney (BW).
• BW was owned and dominated by the Lawyers’ Coop. Pub. Co. (LCP).
• Gosnell was the new president of LCP, and had been monitoring BW
closely.
• Glen was close to retirement, and unhappy with this new scrutiny.
• Matthew Bender wanted a west-coast office, and approached Glen about
heading it. Glen accepted, and brought many subordinates with him.
Glen, cont.
1. Gosnell asked Glen whether a raid was going on, and Glen hid the
fact.
2. Glen gave MB salary information about those employees whom MB
might hire away from BW. MB used that information to make attractive
offers to some of those employees.
3. While still employed by BW, Glen assisted in the solicitation by
Bender of some of the BW employees whom Bender wanted to hire.
HELD: GLEN VIOLATED HIS DUTY OF LOYALTY. EACH OF THESE
BREACHED IT.
Town & Country House & Home Service, Inc.
v. Newberry
• Employees of Town & Country cleaned houses in suburban New York.
• T & C had put together a list of customers by telephoning people in
several neighborhoods.
• The defendants formerly worked at the company but quit, then called
their old customers, and built their business from that base.
T&C, cont.
• Judgment for plaintiff T & C.
• Defendants are enjoined from using the customer list and must pay
damages for “customers whom they enticed away.”
Reasons: T & C spent lots of time and money building the customer list.
It was a “trade secret.”
• The court does not spell out a theory of liability, but the case
can be seen as implicitly applying a notion of duty of loyalty.
Corroon & Black-Rutters & Roberts, Inc. v.
Hosch
• Hosch worked for the insurance agency of Corroon & Black-Rutters.
• Until 1977, he worked under a non-compete agreement. As soon as the
agreement lapsed, he quit, and solicited business from his former clients.
• In order to do so, he took with him extensive information about those
clients when he left.
Held: Because the data Hosch took were not trade secrets, Hosch is not
liable to C&B.
Dissent: Hosch took much more than just names, and that information was
confidential. Courts should be more liberal in protecting information like this.
Corroon, cont.
Two Key points.
• First, as in Town & Country, whether an employee solicits clients while
still employed (or instead waits until he or she has quit) may not
matter.
• Second, simply using information acquired at an old job does not
make an employee liable under trade secret law Instead, departing
employees are liable only if they take judicially recognized “trade
secrets.”
Trade Secrets
The court cites six (broadly overlapping) factors. It then notes that all
six factors must point toward a trade secret for an employee to be
liable.
1. The information is not widely known outside the firm.
2. The information is not widely known within the firm.
3. The firm tries to guard the information.
4. The information is valuable both inside and outside the firm.
5. The firm incurred large costs in developing the information.
6. The information could not cheaply be duplicated.
Partnerships – 2/20
Chapter 2: Partnerships (209)
1. What Is a Partnership? Who Are the Partners? (209)
a. Partners Compared with Employees (209)
i. Fenwick v. Unemployment Compensation Commission (N.J. 1945)(209)
ii. Clackmas Gastroenterology Associates v.Wells (U.S. 2003)(214)
iii. Equal Employment Opportunity Commission v. Sidley Austin Brown &
Wood (7th
Cir. 2002)(220)
iv. Frank v. R.A. Pickens & Son Co. (Ark. 1978)(228)
Partnership Law
• Uniform Partnership Act (“UPA”) has been adopted by most states to
uniformize state partnership law.
• Forming a general partnership entails far fewer formalities than
forming other types of business associations.
• The UPA § 6 defines a partnership as “an association of two or more
persons to carry on as co-owners a business for profit.”
Partnership Definition Elements
• Association
• even if those persons did not intend to form a partnership, a court may find
that a partnership exists regardless of their intent.
Persons
• “person,” as defined in the UPA § 2, includes entities as well.
“To carry on”
• a partnership may have a limited duration or be formed to accomplish a
specific purpose.
Partnership, cont.
• “Business for profit”
• A partnership must involve a business as opposed to a hobby and must be
established as a profit-making enterprise.
• Thus, you cannot have a non-profit partnership, even though you can have a
non-profit corporation under state corporate law.
“Co-owners”
• Under the UPA § 7(4), a person who has a right to share in profits is presumed
to be a partner.
• Can be rebutted with contrary evidence.
Who is a Partner? – UPA Rule
Under UPA (1997) § 202(a), as interpreted and applied, three basic
elements determine who is a partner:
(a) sharing in control;
(b) sharing in profit; and
(c) sharing in losses.
Fenwick v. Unemployment
Compensation Commission
• Issue of Partners Compared With Employees
• Fenwick operated a beauty shop, at which Chesire was the receptionist.
• Chesire demanded an increase in her weekly wage of $15.
• Fenwick countered with an offer to make her a “partner.” She accepted.
• What she wound up with was a right to 20 percent of the profits, but no other
attributes of a partner.
• The Commission went after Fenwick for what it says he owed to the
unemployment compensation fund by virtue of the fact that Chesire was an
employee (the eighth employee, making Fenwick subject to the liability), not
a true partner.
Fenwick, cont.
Chesire was an employee. The decision is based on all the facts, but in
the final analysis it comes down to the two factors traditionally relied
on, profit share and control.
• Chesire lacked control; the contract expressly gave it to Fenwick.
Clackamas Gastroenterology
Associates v. Wells
• Four doctors used the corporate form for their medical practice. They
were the sole shareholders and directors and all of them participated in
control.
• The Americans with Disabilities Act applies to firms with 15 or more
employees.
If the doctors were employees, the firm was above the limit; otherwise not.
• Plaintiff claims that the Act does apply (that the doctors were employees)
and that she was fired as a result of a refusal to accommodate a disability.
• The Ninth Circuit held that since the doctors had used the corporate form,
they were employees. The Supreme Court granted cert. because of a
conflict in the circuits.
Clackamas, cont.
Reversed and remanded. The status of the doctors should be
determined by applying the common law rules of master and servant.
• The Court essentially rejects the idea that “employee” should be
defined by reference to the goals of the ADA.
Equal Employment Opportunity
Commission v. Sidley Austin Brown &
Wood
• “In 1999, Sidley & Austin (as it then was) demoted32 of its equity partners to ‘counsel’ or
‘senior counsel.’ … Sidley does not deny [this action was a] demotion and constitute[d]
adverse personnel action within the meaning of the” Age Discrimination in Employment
Act.
• The EEOC began an investigation and, having failed to obtain all the information it
wanted, seeks a subpoena duces tecum.
• The ADEA covers employees but not employers. Partners are employers, but
some people who are called partners may not be partners under the ADEA (or
under partnership law). The law firm objected to the subpoena on the ground that
the 32 demoted members of the firm were partners and therefore are not covered
by the Act.
EEOC, cont.
• EEOC is entitled to the subpoena because it needs the information
to determine whether the demoted “partners” were in fact partners
(and therefore “employers”)
Frank v. R.A. Pickens & Son Company
• R.A. Pickens & Son Company (Company), a partnership, operated a large farm on
land rented from another partnership, R.A. Pickens and Son.
• R.A. Pickens and Son was a partner in Company.
• R.A. Pickens himself was not a partner in Company but was its manager. Among
the powers given him in the partnership agreement was the power to terminate
partners.
• The plaintiff, Frank, was designated a “partner” in Company, with a 3 percent
interest. His duties consisted of general office work and bookkeeping. He was
entitled to a salary plus his share of the partnership profits.
• Pickens terminated Frank’s relationship with Company and offered to pay him his
capital account (less certain offsets), in accordance with the partnership
agreement. Frank claims to be entitled to a liquidation of the partnership and his
share of the proceeds.
Frank, cont.
Frank loses.
In partnership law, the private agreement of the parties generally
overrides the UPA’s default provisions
2/22
Partners Compared with Lenders (232)
• i. Martin v. Peyton (N.Y. 1927)(232)
• ii. Kaufman-Brown Potato Co. v. Long (9th Cir. 1950)(238)
• c. Partnership by Estoppel (242)
• i. Young v. Jones (D. S.C. 1992)(245)
• 2. Partnership Property (245)
• a. In re Fulton (Bankruptcy 1984)(245)
• b. Putnam v. Shoaf (Tenn. Ct. App. 1981)(248)
Martin v. Peyton
• Knauth Nachod & Kuhne (KNK) was in the banking and brokerage business. Hall was a
partner.
• KNK experienced losses and needed capital.
• Hall was friendly with Peyton, Perkins, and Freeman (PPF) and arranged for PPF to make a
loan of $2.5 million worth of marketable securities to KNK, for two years.
• The terms of the loan provided that PPF would continue to collect the dividends on their
securities, would in addition be entitled to 40 percent of the KNK profits, with a minimum of
$100,000 (4 percent of the $2.5 million) and a maximum of $500,000 (20 percent of the
$2.5 million), and would have an option to buy up to a 50 percent equity interest in KNK. In
addition, PPF had inspection rights and the right to veto speculative transactions.
• The agreement also provided that Hall was to provide the “directing management” of KNK.
• PPF got signed resignations from all the KNK partners.
• KNK thereafter engaged in speculation in foreign currency (an activity that was prohibited
by the agreement with PPF), lost large amounts of money, and became insolvent.
• Creditors of KNK sue PPF on the theory that they were partners in KNK.
Martin, cont.
• The defendants are not liable. They are lenders, not partners.
• The various rights and protections are consistent with the role of
lender.
• court begins with the idea that the arrangement was one of loan and
then shows how the various terms were consistent with a loan.
Kaufman-Brown Potato Co. v. Long
• Horton and Althouse operated as Gerry Horton Farms (GHF). They
were farmers, raising crops on leased land.
• Kaufman and Brown (KB) were “distributors” of farm produce.
• GHF and KB entered into an agreement to produce and sell potatoes. GHF
was to do the farming, using its equipment. KB put up a fixed sum of
money and GHF was to invest whatever additional amounts were needed
up to the time of harvest, with the costs of harvesting split according to
profit interests. KB was entitled to be repaid its investment and to receive
40 or 50 percent of the profits.
• It also had certain rights of purchase or distribution. It took a mortgage on
the crop to secure its claim\K
• KB sues as an unsecured creditor. GHF is bankrupt.
Kaufman, cont.
• Kaufman and Brown are partners in GHF, not creditors, and are
not entitled to share in distributions to creditors.
Partnership by Estoppel
• Under UPA § 16, even if no partnership was formed in fact, people
may still be liable as if they were partners under the partnership by
estoppel doctrine.
• Partnership by estoppel is an equitable doctrine designed to protect a
third party who is misled into believing a partnership exists and relies
to his detriment on that mistaken impression.
• If you falsely represent to a third party that you are partners with
someone else, and the third party relies on your representation, you
are liable as if you really were partners with the other person.
• Your alleged partner, however, is liable as if he were partners with you only
if he consents to your representation.
Young v. Jones – Partnership by
Estoppel
• Plaintiffs deposited $500,000 in a South Carolina bank, which
forwarded it to Swiss American Fidelity Insurance Guaranty (SAFIG).
• The money is gone and SAFIG is presumably judgment proof, so the
plaintiffs sue the SAFIG auditor, Price Waterhouse, Bahamas (PWBahamas), which is presumably also judgment proof (or close to it),
so the plaintiffs want to recover from PW-US.
• The theories relied on for liability of PW-US are partnership and
partnership by estoppel.
Young, cont.
• PW-US is not liable.
• There is no evidence at all in support of actual partnership.
• As to partnership by estoppel, plaintiffs did not show that they relied
(an element of estoppel) on any holding out by PW-US.
Partnership Property
• UPA § 8(2) states: “Unless the contrary intention appears,
property acquired with partnership funds is partnership property.”
UPA § 8(1) “All property brought into the partnership stock
or subsequently acquired by purchase or otherwise, on
account of the partnership, is partnership property.”
-look to the INTENT of the parties
Factors to ascertain whether property
belongs to the partnership
or to someone else
Evidence: Is there evidence a partner contributed the property to the
partnership? Conversely, is there evidence a partner was simply
loaning the property to the partnership? (Written evidence is
particularly useful in answering these questions.)
Use: Is the partnership using the property in its business? If so,how
frequent or extensive is the partnership’s use of the property?
Upkeep: Does the partnership pay to insure and maintain the property
or are those costs borne by one someone else?
Title: Is title to the property held in the partnership’s name or in the
name of another person?
Partnership Property?
Rule #1: Property is partnership property “if acquired in the name of the
partnership.”
Rule #2: Property is partnership property “if acquired in the name of one or more
partners with an indication in the instrument passing title to the property of the
person’s capacity as a partner or of the existence of a partnership but without an
indication of the name of the partnership.”
Rule #3: Property is presumed to be partnership property “if purchased with
partnership assets.”
Rule #4: Property is presumed to be separate property of a partner “if acquired in
the name of one or more partners, without an indication in the instrument
passing title to the property of the person’s capacity as a partner or of the
existence of a partnership and without the use of partnership assets.”
In re Fulton – Partnership Property
Carroll and Fulton operated a trucking business called C & F Trucking,
with Carroll providing capital (a semi-truck) and Fulton his services as
driver. They had agreed to split the profits.
Carroll bought a used trailer for $4,000 and contributed it to the
business.
Fulton filed a voluntary bankruptcy petition and listed the trailer an
asset of his. Carroll claimed that the trailer was his.
Fulton, cont.
• C & F Trucking is a partnership and the trailer is an asset of the
partnership.
• The court notes (footnote 1) that “the only debtor in this case is the
individual Walter Charles Fulton, Sr.” However, Fulton’s filing of the
bankruptcy petition resulted in dissolution of the partnership by
operation of law, which, so the court assumes, requires a liquidation
of its assets, with Fulton’s bankruptcy estate getting half of any
amount after payment of claims of the partnership’s creditors.
Putnam v. Shoaf
-The plaintiff, Mrs. Putnam, owned a 50 percent partnership interest in
the Frog Jump Gin Company (a cotton gin).
-The partnership debts exceeded the
value of the assets.
-Mrs. Putnam found buyers, John and Maurine Shoaf, who acquired her
partnership interest, and assumed her liabilities, in return for a payment from her
to them of $21,000. (The other 50 percent partner also contributed $21,000.)
-The conveyance specifically referred to all the physical assets. About 14 months
after they acquired the partnership, the Shoafs discovered that its bookkeeper had
embezzled from the firm.
-The Shoafs sued the bookkeeper and the banks that had honored the
bookkeeper’s forged checks and ultimately recovered $68,000.
-Mrs. Putnam claimed that she was entitled to half of this recovery.
Putnam, cont.
• Mrs. Putnam loses.
• The partnership owned the inchoate claim (a type of action) and Mrs.
Putnam conveyed her interest in the partnership.
• Thus, the fact that the claim was not listed as an item of partnership
personal property is irrelevant.
Tuesday, February 27
•Tuesday, February 27
•Chapter 2: Partnerships, cont’d
•1. The Rights of Partners in Management(252)
•a. National Biscuit Co. v. Stroud (N.C. 1959)(252)
•b. Summers v. Dooley (Idaho 1971)(255)
•c. Moren ex rel. Moren v. JAX Restaurant (Minn. App. 2004)(256)
•d. RNR Investments Ltd. Partnership v. Peoples First Community
Bank (Fla. App. 2002)(259)
•e. Day v. Sidley & Austin (D. D.C. 1976)(263)
National Biscuit Company v. Stroud
• Stroud and Freeman formed a partnership to run a grocery store.
• Stroud told Nabisco that he would not be personally liable for any
more bread it sold to the store.
• Freeman ordered more bread, Nabisco delivered it, and Nabisco sued
Stroud for payment.
NBC, cont.
• Judgment for Nabisco.
• Absent an agreement to the contrary, partnership decisions are
governed by a majority vote of the partners.
• Since a majority of the partners didn’t vote to end Freeman’s authority to buy
bread on credit from Nabisco, the partnership was not bound by Stroud’s
objections.
• As each partner is an agent of the partnership, the partnership is therefore
bound by Freeman’s orders. If the partnership is liable, so is Stroud.
NBC, cont.
• In National Biscuit, Freeman could bind the partnership to third
parties because ordering bread was an act in the “usual way of
business” for his firm (see UPA (1914) § 9(1), a point that follows
straightforwardly from apparent authority. principles.
• The partnership could have restricted that apparent authority, but not
without a majority vote and Stroud did not control a majority.
Summers v. Dooley
• Summers and Dooley had equal stakes in a trash-collection
partnership.
• Dooley couldn’t work, so he hired his own replacement.
• Summers decided that they needed a third man, but Dooley
disagreed.
• Summers went ahead and hired a third man anyway, and tried to bill
the partnership for the cost.
Summers, cont.
• Summers loses.
• Partnership matters are (absent an agreement to the contrary)
decided by majority vote, this requires a majority vote, and Summers
doesn’t control a majority.
Analysis
• Although UPA § 18(b) allows partners to obtain reimbursements for
“ordinary” partnership expenses, § 18(h) requires a majority vote in
the case of disagreement among partners.
• 2 Fundamental Partnership Principles in Conflict:
1.) the rule that all partners are agents of the partnership with power
to bind the partnership
2.) the rule that all partners have equal rights to participate in the
management of the partnership.
Moren ex rel. Moren v. JAX Restaurant
• Nicole Moren and her sister, Amy Benedetti, were partners in the
ownership and operation of Jax Restaurant, which apparently specialized in pizza.
• One day, while Nicole had just finished her shift and Amy was working, one of
the cooks failed to show up, so Amy called Nicole, asking her to come in and help
out.
• Nicole agreed but, unfortunately, had just picked up her two-year-old son
Remington. Nicole’s husband, Martin Moren, promised to pick up Remington in
20 minutes, but in the meantime Nicole brought Remington into the kitchen with
her and “set him on top of the counter.” Somehow Remington’s hand got caught
in the dough press and he sustained permanent injury.
• Martin sued the partnership on behalf of Remington. The partnership in turn
filed a third-party complaint against Nicole.
• The sole issue in the present decision is whether the trial court properly dismissed the third party
complaint.
Moren, cont.
• The dismissal is affirmed.
• In order for a partner’s tortious conduct to throw vicarious liability upon
the partnership and her fellow partners, the partner must have been
acting either in the ordinary course of partnership business or with
authority from the partnership
• As with agency law, one need not prove that the partnership is in the business of
committing torts or that the partners authorized the commission of a tort. Instead, a
plaintiff need only show that the partner’s overall course of conduct was of the type
broadly authorized.
• Even though there was a personal aspect behind the decision to bring
Remington to the restaurant, Nicole acted in the ordinary course of the partnership
business and therefore was entitled to indemnity by the partnership under UPA §
401(c).
RNR Investments Ltd. Partnership v.
Peoples First Community Bank,
• Roeger served as general partner to RNR limited partnership.
• On behalf of RNR, he borrowed more from the bank ($990,000) than
he was authorized by RNR to borrow ($650,000).
• RNR defaulted on the loan, and the bank foreclosed.
• RNR defended by arguing that Roeger had not been authorized to
borrow so large amount and that the bank should have known of that
lack of authority.
• Held: Roeger had apparent authority to borrow the money and the
bank was not on notice of any lack of actual authority.
RNR, cont.
• Under the ULPA, a general partner has apparent authority to bind the
firm for “apparently carrying on in the ordinary course the limited
partnership’s activities.”
• Here, Roeger borrowed funds for constructing a house--exactly the business
of the firm.
• Roeger exceeded his actual authority only because he borrowed too large an
amount.
• The bank did not know that he lacked authority, and—said the court—was
not on notice of any restrictions on his authority.
Day v. Sidley & Austin
• Sidley had long been one of the premier establishment law firms in
Chicago.
• One of its major partners had long been Howard Trienens, a litigator with
close connections to one of Sidley’s most important clients, AT&T.
• Liebman, Williams, Bennett, Baird & Minow was a very different law firm: a
largely post-war firm that had grown rapidly but which did not have the
same old-Chicago upper-crust character that Sidley had.
• One of the major partners at Liebman was Newton Minow, a one-time FCC
commissioner who gained fame by telling the National Association of
Broadcasters that he looked into his TV set and beheld “a vast wasteland.”
Minow also played a part in starting public TV, and in initiating the $1 longdistance phone call.
Day, cont.
• Trienens and Minow had been friends since their days together as law
clerks to Justice Vinson on the Supreme Court.
• In part at their initiative, the Sidley and Liebman firms negotiated a merger
in 1972.
• Perhaps because of the differences in firm culture, however, the merger
created some dissent among the partners.
• Day’s dispute was part of that dissent.
• Day joined Sidley in the late 1930s straight out of law school. At the firm, he
fell under the sway of a young partner, Adlai Stevenson, and married the
daughter of one of the name partners (Burgess).
• In 1948, Stevenson became governor of Illinois. Day followed him to
Day, cont.
• When Day heard that Sidley was considering opening a Washington office,
he asked to head it. His father-in-law, Burgess, was still on the executive
committee, and Day got the job.
• By the time Sidley had merged with the Liebman firm, Burgess had died.
• Day was forced to share his chairmanship of the D.C. office with a Liebman
partner, and he quit. He claimed that (a) he had a contractual right to be sole
chairman of the D.C. office, and (b) the Sidley executive committee (EC) had
broken its promise that no Sidley partner would be made worse off by the
merger.
Day, cont.
• Sidley wins.
• The partnership agreement makes it clear that the EC calls the shots
at Sidley—all positions at the firm are at the sufferance of the EC. Day
thus had no contractual right to the chairmanship.
Thursday, February 29
•Thursday, February 29
•The Fiduciary Obligations of Partners(271)
a.Introduction(271) i. Meinhard v. Salmon (N.Y.
1928)(271)
b.ii. Sandvick v. LaCrosse(North Dakota 2008)(277)
c.iii. Singer v. Singer (Okla. Ct. App. 1981)(283)
d.iv. Nemec v. Shrader(Oklahoma App. 1981)(287)
Meinhard v. Salmon
• Louisa Gerry leased a hotel to Salmon for 20 years.
• Salmon renovated it for $200,000. Half the money came from Salmon, and half
from Meinhard.
• Salmon and Meinhard agreed that Salmon would manage the building and split
the profits 60-40 with Meinhard for 5 years, then 50-50 for the rest of the lease.
• As the end of the lease approached, Eldridge Gerry had become owner of the
property and wanted to replace the building, as part of a much larger project
involving land adjacent to the hotel leased to Salmon and Meinhard.
• Gerry asked Salmon to lease the larger tract and invest in the substantial amount
of additional construction contemplated by Gerry. Salmon took the new lease.
• Meinhard sued for being cut out of the deal.
Meinhard, cont.
Judgment for Meinhard. Salmon breached his duty of loyalty to
Meinhard.
Traditionally, partners were viewed as fiduciaries who owed a
duty of loyalty to the partnership
Judge Benjamin Cardozo, set an extraordinarily high standard for
partners to maintain.
Roadmap for Partnership Opportunity Cases
roadmap for analyzing a partnership opportunity case.
There are six significant considerations to address:
(1) the nexus between the partnership and the opportunity;
(2) disclosure of the opportunity to the other partner(s);
(3) the partnership’s ability to take advantage of the opportunity had
the opportunity been disclosed;
(4) the defendant’s timing in exploiting the opportunity;
(5) the plaintiff’s timing in bringing the lawsuit; and
(6) an appropriate remedy.
1. Nexus
Nexus: Was there a partnership opportunity to usurp?
For a partnership opportunity to exist, there must be a nexus (the Latin
word for “connection”) between the existing partnership and the
opportunity. Without this nexus, there is no partnership opportunity
to usurp.
2. Disclosure
Disclosure: Did the defendant partner disclose the existence
of the opportunity to the other partner(s)?
-usurping partners almost never disclose that an opportunity exists;
they sneak around behind the other partners’ backs to secure an
unjust reward.
3. Partnership Resources
Could the partnership or the other partners have exploited the
opportunity if the existence of the opportunity had been disclosed by
the defendant?
4. Defendant’s Timing
When did the defendant take advantage of the opportunity?
A partner who learns of the opportunity during the life of the
partnership cannot wait until the partnership is over to appropriate a
partnership opportunity and thereby avoid liability for breach of
fiduciary duty.
you cannot escape your fiduciary duty merely by stalling.
5. Plaintiff’s Timing
When did the plaintiff assert an interest in the opportunity?
Partners often wait to see whether an opportunity pans out before
asserting a partnership opportunity claim; yet courts rarely deny them
relief on that basis.
Here, the plaintiff gets the benefit of hindsight. As between the
defendant’s breach of fiduciary duty and the plaintiff’s delay in bringing
a claim, courts view the delay as the lesser of two evils.
The fact that a partner waited to assert his claim is unlikely to be fatal
to that claim.
6. Remedy
An appropriate remedy should ensure that profits from the new
venture are divided up in the same way they would have been if the
opportunity had been exploited by the partnership rather than the
defendant partner.
Cardozo basically awarded Meinhard a fifty percent interest in the
corporation Salmon had formed to capitalize on the opportunity, so
that Meinhard would receive half the profits from the new venture, just
as he would have had the Meinhard- Salmon partnership been able to
avail itself of the new deal.
Sandvick v. LaCrosse
• Sandvick and Bragg sue LaCrosse and Haughton, claiming a violation
of fiduciary obligation.
• The four had invested jointly in five-year oil and gasleases (the Horn leases),
which they hoped to be able to sell at a profit.
• Title to the leases was held by Empire Oil Company, which was owned by
LaCrosse.
• The investors’ joint checking account was entitled Empire Oil Company JV. All four
had previously invested among themselves and with others in various other oil
and gas deals, but the investment at issue in the case was not part of a series of
investments.
• The district court found that “[n]o agreement was entered into, express or
implied, limiting the parties’ abilities to continue activity which did not include
the other parties to these proceedings.”
Sandvick, cont.
• Near the end of the five-year term, Haughton and LaCrosse
purchased the Horn Top Leases, which were in effect extensions of
the Horn leases held by the four investors.
• Sandvick and Bragg claim that they were entitled to share in these
leases. The district court rejected this claim, relying on the conclusion
that there had been neither a partnership nor a joint venture among
the four men.
• Sandvick and Bragg appeal.
Sandvick, cont.
• Reversed and remanded.
• The investment did not amount to a partnership but it was a “business”
conducted as a joint venture.
• The court states, “A joint venture is similar to a partnership but is more
limited in scope and duration, and principles of partnership law apply to
the joint venture relationship.”
• The court then must “look to the scope of the venture and decide whether
any fiduciary duties were breached by LaCrosse and Haughton.”
• The court concludes that LaCrosse and Haughton did in fact breach their
duty of loyalty, citing Meinhard v. Salmon
• It was in LaCrosse’s and Haughton’s best interest not to sell the original leases during
the remaining six months of the original term. Having excluded Sandvick and Bragg,
LaCrosse and Haughton potentially stood to benefit more by waiting to sell the
leases until after the original term expired
Partnership v. Joint Venture
“There is no essential difference between a partnership and a joint
venture; they are factual relationships between two or more persons
who conduct a business enterprise together.”
“A joint venture is governed by the same law as a partnership. The
main distinction between the two is that a joint venture is a temporary
association for the purpose of a single undertaking, while a partnership
envisions a continuing relationship among the parties.”
Singer v. Singer
• The Singers were an Oklahoma oil family who invested jointly in several projects.
They did so through explicit partnerships, the most important of which was
named Josaline.
• They typically invited the Trachtnbergs to invest as co-owners (though not as
partners).
• The Josaline partnership agreement (in Section 8) explicitly allowed the partners
to compete with the partnership.
• Stanley and Andrea Singer (through their partnership Gemini) bought land (from
IDS) in which Joe L. Singer wanted a stake.
• Because the Josaline partnership agreement allowed them to buy the land
outside of the partnership, he argued that there was a broader oral partnership
including all of the Singers and the Trachtnbergs.
• By not offering the land to this broader partnership, says Joe L., Stanley and
Andrea violated their fiduciary duty to it.
Singer, cont.
• There was no broader oral partnership.
• The only relevant partnership was Josaline, and the Josaline
agreement explicitly allowed partners to compete with the
partnership.
Nemec v. Shrader
• Nemec and Wittkemper retired from Booz Allen on March 31, 2006.
• Both had been directors and senior executives of the firm (which had
incorporated after operating for many years as a partnership).
• Upon retirement, Nemec held 76,000 shares of Booz Allen and Wittkemper
held 28,000 shares.
• The shares were subject to an agreement that gave Nemec and
Wittkemper a put for two years at book value and gave Booz Allen a call at
book value after two years.
• In late 2007 Booz Allen entered into negotiations to sell its government
division, one of two major divisions, to The Carlyle Group for $2.54
billion—which translated into about $700 per Booz Allen share. This would
have amounted to $53,200,000 for Nemec.
Nemec, cont.
• By March of 2008, as the two years was about to transpire, Nemec and
Wittkemper became aware of the Carlyle deal.
• When Nemec asked Shrader, the Booz Allen chair and CEO, if he would
keep his shares until the closing of the Carlyle deal, Shrader said that it was
an “easy moral decision.” (See footnote 6.)
• “Nevertheless, in April 2008, before the transaction was formally approved,
Booz Allen redeemed plaintiffs’ respective shares at the pre-transaction
book value— $162.46 per share.” This amounted to $12,346,900 for
Nemec.
• Thus, even if the book value of the business retained by Booz Allen, plus its
other assets, was zero, Nemec lost out on more than $40,000,000.
• He sued.
Nemec, cont.
• Nemec and Wittkemper lose. The contract was unambiguous and it
controls.
• There was no breach of fiduciary obligation by the directors because, given
the contract, there was no fiduciary obligation, and, even if there was, the
directors’ judgment was protected by the business judgment rule.
• There is a suggestion that if the directors had decided not to redeem the
Nemec and Wittkemper shares, the continuing shareholders might have
had an actionable complaint.
• The same reasoning disposes of the claims of violation of the duty of good
faith and fair dealing and of unjust enrichment.
• The court notes that a successful bad faith claim should be a rarity.
Tuesday, March 5
• Tuesday, March 5
• Chapter 2: Partnerships, cont’d
• 1. The Fiduciary Obligations of Partners, cont’d
• a. After Dissolution (296) i. Bane v. Ferguson (7th Cir. 1989)(296)
• b. Grabbing and Leaving (296)
• i. Meehan v. Shaughnessy (Mass. 1989)(298)
• ii. Gibbs v. Breed, Abbott & Morgan (N.Y. Sup. Ct. 2000)(305)
• c. Expulsion (311)
• i. Lawlis v. Kightlinger & Gray (Ind. App. 1990)(311)
• ii. Bohatch v. Butler & Binion (Tex. 1998)(317)
Bane v. Ferguson
• When Bane retired from Isham, Lincoln & Beale he became entitled
to a pension that would end if the firm dissolved. Later the firm
merged with another firm.
• The merger turned out to be a disaster and the merged firm
dissolved.
• Bane sued on two theories, the only plausible one being that the
partners had violated their fiduciary obligations by mismanagement
in arranging for the merger.
Bane, cont.
• No cause of action.
• Bane was not a partner at the time of the alleged mismanagement so
the partners owed him no fiduciary duty.
• Even if the defendants were fiduciaries, they were protected by the
business judgment rule.
Meehan v. Shaughnessy – Grabbing
and Leaving
• Meehan and Boyle were partners in the litigation-oriented law firm of
Parker Coulter (PC). While working as partners, they decided to leave.
• Without notifying their colleagues, they took several steps:
(a) They approached Cohen, another partner, and asked her to join them in
forming the new firm of Meehan Boyle & Cohen (MBC). She agreed.
(b) They approached three associates and asked them to follow them to
MBC. They too agreed.
(c) Two of the departing lawyers met with one of the clients to convince it to
route its business to MBC. It agreed.
(d) After notifying the firm on November 30, 1984, that they would form
MBC January 1, 1985, they wrote letters to their clients inviting them to
move their business to MBC.
Meehan, cont.
PC made several other allegations.
• Boyle told one of the other lawyers who was leaving (Schafer) to
manage his cases in a way that would defer payment to 1985.
• When a PC partner left (in an unrelated affair), Boyle reassigned most
of his cases to Schafer and himself.
• The PC partnership agreement required that departing partners give
the firm 3-months’ notice. For reasons not explained, PC waived this
requirement.
• The agreement also provided that partners could take with them
pending cases, so long as they paid the firm an appropriate fee.
Meehan, cont.
• Meehan and Boyle sued for amounts they claimed PC owed them, and for
declaratory judgment on the amounts they owed PC. PC counterclaimed on
the ground that Meehan and Boyle violated their fiduciary duty and
breached the partnership agreement.
Held: MBC breached their duties to the partnership, but only in two ways.
(i) They contacted their clients in December in a way that did not fairly give
the clients a choice to stay with PC.
(ii) Until December, they lied to their partners about their plans to leave.
Although MBC talked about doing other impermissible things (e.g., deferring
payment until 1985), they appear not to have done so.
Gibbs v. Breed, Abbott & Morgan
• Gibbs and Sheehan had been the only partners in the Breed, Abbott
& Morgan (BAM) trusts and estates department.
• In June 27, 1991, they left to join Chadbourne & Parke and took with
them several of the associates and other employees in the BAM T/E
department.
• Gibbs and Sheehan did not solicit clients before leaving BAM, but did
so after their departure and 92 of 201 BAM T/E clients quickly
followed them.
• On April 26, 1991, Sheehan had prepared a memo with details as to
the salaries, bonuses, billable hours, etc. of the BAM T/E associates
and other employees.
Gibbs, cont.
• On June 19, 1991, Gibbs and Sheehan informed BAM’s presiding
partner that they had accepted Chadbourne’s offer.
• On June 24, 1991, they sent to Chadbourne a memo with detailed
information about the BAM associates and other employees and
Chadbourne began interviewing some of them.
• This case began as a suit by Gibbs and Sheehan for money due them.
• BAM counterclaimed, asserting breach of fiduciary duty.
Gibbs, cont.
Held:
• It was o.k. for Gibbs and Sheehan to talk to each other about leaving before
telling anyone at BAM.
• It was also o.k. for them to take their desk files with them.
• On this appeal there was no remaining claim of improper solicitation of
clients.
• Gibbs and Sheehan stepped over the line, however, in supplying
Chadbourne with the detailed information on associates and other
employees and in recruiting them (presumably by helping Chadbourne to
do so).
• The case is remanded for a determination of damages, if any.
Lawlis v. Kightlinger & Gray Expulsion
• Lawlis was a partner in the Indianapolis law firm of Kightlinger & Gray.
• In 1982, he became an alcoholic, but he hid his problem from the
partnership until mid-1983.
• When he told his partners about it, they outlined a series of steps for him
to take to deal with his alcoholism. They and he then signed an agreement
about the problem, and the agreement explicitly provided that he would
have “no second chance.”
• Lawlis took several months off work, but by 1984 was back on the bottle.
• The firm now gave Lawlis a second chance. The partners specified another
set of steps for him to take, and someone (the court does not say) told
Lawlis that the firm would return him to full partnership if he complied
with the program.
• This time, Lawlis apparently complied and broke his habit.
Lawlis, cont.
• In 1986, Lawlis demanded that the partnership boost his partnership
participation by half.
• Within a month of his demand, a partner in the firm (Wampler) told
him that the firm would expel him, and two days later the firm
reclaimed its files from his office.
• In February 1987, the firm expelled Lawlis by a 7-1 vote (Lawlis
dissenting).
• Lawlis sued, claiming that the expulsion was unlawful.
Lawlis, cont.
Held: Judgment for defendants.
• First, Lawlis claimed that the firm had wrongfully expelled him. By the
firm’s partnership agreement expulsion required a 2/3 vote of the partners,
argued Lawlis, but he had been expelled by Wampler’s unilateral
announcement.
• No way, says the court. Wampler simply announced what the other partners
intended to do. The firm expelled Lawlis in February, and followed the proper
procedures to do so.
• Second, Lawlis claimed that his partners had violated their fiduciary duties
toward him, because they had expelled him to increase their own draw.
Lawlis had no serious evidence of this, and the court effectively holds that
it does not care anyway.
• Whatever may have been the partners’ intent (we never learn), their partnership
agreement let them dissolve the partnership for any reason by a 2/3 vote. Such a
“guillotine” provision is fine, says the court. The partners violate no fiduciary duty
unless they wrongfully withhold money due an expelled partner.
Bohatch v. Butler & Binion
• Colette Bohatch was one of three partners in Butler & Binion’s Washington
office.
• She suspected that John McDonald, one of the other partners in that
office, was padding his time sheets and over-billing their client Pennzoil.
• She reported her concerns to the firm’s managing partner. McDonald was
cleared after an investigation.
• Meanwhile, McDonald told Bohatch that Pennzoil was dissatisfied with her
work.
• The firm subsequently expelled Bohatch. She sued for breach of the
partnership agreement and breach of fiduciary duty.
• As edited, the case omits the breach of contract claims, upon which Bohatch
prevailed.
Bohtach, cont,
• The court declined to create a “whistleblower” exception to the general
rule that a partnership may expel a partner for business reasons, including
the preservation of good working relationships between the partners and
with clients.
• The thrust of the opinion is that a partnership relationship is based on
interpersonal trust and that a partner who violates that trust can be
expelled without liability for breach of fiduciary duty.
• DISSENT - The partners violated their fiduciary duty to Bohatch by expelling
her as retaliation for making a good faith effort to alert the firm’s
leadership to possible over-billing of a client.
Bohatach, cont.
CONCURRENCE:
• The concurrence takes the majority to task for missing the main issue in the case.
• The majority devotes a great deal of analytical effort to establishing the
proposition that Bohatch had no right to remain a partner if a majority of her
fellow partners wanted her out. But that is not the issue; the issue is whether
Bohatch is entitled to damages for breach of fiduciary duty.
• The concurrence also recognizes that the majority’s blanket rule may deter some
lawyers from reporting suspected misconduct.
• The concurrence argues that a law firm may, without incurring liability, expel a
lawyer (such as Bohatch) who mistakenly reports what she believes to be
unethical conduct, but suggests that a law firm that expels a lawyer who correctly
reports unethical conduct generally will be liable.
Owen v. Cohen – Right to Dissolve
• Owen and Cohen became partners in a bowling alley. Owen put up
$6,986, which was to be repaid out of the profits of the business.
• Cohen apparently thought he was entitled to run the show. He
belittled and mistreated Owen. After three months, as far as Owen
was concerned, it was “I’ve had all I can take and I’m not going to take
any more.”
• He filed an action in equity seeking dissolution and a sale of the
partnership assets.
• The trial court appointed a receiver to run the business and, after
trial, ordered dissolution, with the proceeds to go first to repay
Owen’s $6,986, then to be divided between Owen and Cohen.
Owen, cont.
• Affirmed.
• Dissolution is an appropriate remedy because of Cohen’s misconduct.
• See UPA (1914) § 32, quoted by the court.
• Since Cohen was at fault, he is not entitled to the benefit of the
agreement that the $6,986 was to be repaid out of profits.
Collins v. Lewis
• Collins and Lewis were partners for the building and operation of a
cafeteria.
• Lewis was to be the contractor/manager/operator and Collins was to put
up the money.
• The original estimate was that the cost of building and equipping the
cafeteria would be about $300,000.
• In the original proposal, Lewis was to receive a salary, but it is not clear
whether this was part of the final agreement.
• Collins was to be repaid at the rate of $30,000 in the first year of operation
and $60,000 a year thereafter, secured by Lewis’s interest in the
partnership.
Collins, cont.
• A number of delays and other problems were encountered.
• When the outlay exceeded $600,000, Collins had had enough. There
were mutual recriminations. Collins refused to put up more money.
Collins sued for dissolution, receivership, and foreclosure on the debt.
• After a five-week jury trial, Lewis prevailed. It was found that Lewis
was not at fault. Collins had an obligation to continue to make money
available.
Collins, cont.
Held: Collins was not entitled to relief.
• He is still bound to make money available.
• He is legally entitled to dissolve, subject to liability for breach of the
agreement.
• But he is not entitled to a judicial decree of dissolution, since there is no
reason why the partnership cannot work out satisfactorily if Collins lives up
to his end of the bargain.
• Mere bad blood between the partners is not enough to justify judicial
dissolution.
• Lewis did not pay Collins the $30,000 that Collins was due under the
agreement, but he invested at least as much in the cafeteria out of its
earnings to make up for Collins’s failure to provide funds, so Collins has no
right to foreclose on the debt.
Page v. Page
• The Page boys, H.B. (plaintiff) and George (defendant) were brothers,
and partners in a linen supply business. Each had invested $43,000 in
the business at the outset and it had suffered losses of $62,000 over
its eight-year existence.
• H.B.’s wholly owned corporation held a $47,000 demand note from
the partnership. The partnership had recently started to show a
profit.
• H.B. sues to dissolve.
Page, cont.
Held: Judgment for H.B.
• A partner can generally dissolve the partnership whenever he or she
wishes to do so.
• That rule applies here, since there is no evidence that the partnership
was a partnership for a term.
• This rule is subject, however, to the fiduciary duties that partners owe
to each other.
• Hence, a partner cannot dissolve a partnership in order to capture the
partnership business individually. Here, no evidence of such bad faith
exists.
Partners at Loggerheads: Dissolution Solution Under the UPA (1914)
(325)
a. Right to Dissolve (325)
i. Owen v. Cohen (Cal. 1941)(325)
ii. Collins v. Lewis (Tex. Ct. Civ. App. 1955)(329)
iii. Page v. Page (Cal. 1961)(334)
Partnership Dissolution Under the
UPA
• partnership is dissolved when a partner ceases to be associated in
carrying on the partnership’s business.
• when a partner leaves, for any reason, the partnership dissolves (it’s
easy to dissolve!)
• A partnership does not terminate on dissolution! The UPA § 29
envisions that once a partnership dissolves, partnership affairs will be
wound up, and only then will the partnership terminate.
Dissolution, cont.
Formation  Dissolution  Winding Up  Termination
causes of dissolution embodied in UPA § 31 and § 32:
— the end of a partnership’s term or the accomplishment of a specific
undertaking;
— a partner’s express will;
— an event that makes it illegal to carry on the partnership’s business;
— the expulsion of a partner in accordance with the partnership agreement;
— a partner’s death;
— the bankruptcy of a partner or the partnership; and
— the issuance of a court decree.
Distinguishing Rightful from Wrongful
Dissolution
“term partnership” is formed to last for a specified period
of time (e.g., a partnership with a two-year term) or until a specific
task has been accomplished (e.g., a partnership to make a movie).
a partner has the power to dissolve a term partnership by his
express will before the term is up. However, if he does, he will be
liable to the other partners for breach of contract = wrongful
dissolution
Dissolution, cont.
“partnership at will” does not have a built-in ending. An at-will
partnership is open-ended;
-most partnerships are at will—i.e., they exist at the will of the
partners.
A partner in an at-will partnership may dissolve the partnership by
his express will at any time without liability to the other partners
for breach. His dissolution is rightful.
Dissolution, cont.
Alternatively, a party who has no right to dissolve may ask the
court to dissolve the partnership.
UPA § 32 provides that a court may decree dissolution (1) where a partner
has been guilty of conduct prejudicial to partnership’s business or
persistently breached the partnership agreement; (2) when the partnership’s
business can only be carried on at a loss; (3) if other circumstances render a
dissolution equitable; or (4) in certain other limited situations.
a court is never obligated to dissolve a partnership.
Dissolution, cont.
If rightfully dissolve partnership, can:
either (a) require that partnership affairs be wound up and force
liquidation pursuant to UPA § 38(1), or (b) have the partnership buy
him out and let the partnership’s business continue without him
under UPA § 42.
a partner who wrongfully dissolves a partnership cannot force liquidation.
His only option is a buyout, less whatever damages he owes for breach of
contract.
Chapter 2: Partnerships, cont’d
1. Partners at Loggerheads: Dissolution Solution Under the UPA (1914),
cont’d
a. The Consequences of Dissolution (337)
i. Prentiss v. Sheffel (Ariz. App. 1973)(337)
ii. Disotell v. Stiltner (Alaska S. Ct. 2004)(341)
iii. Monin v. Monin (Ky. App. 1989)(349)
iv. Pav-Saver Corp. v. Vasso Corp. (Ill. App. 1986)(352)
b. The Sharing of Losses (358)
i. Kovacik v. Reed (Cal. S. Ct. 1957)(358)
Prentiss v. Sheffel
• The plaintiffs, Sheffel and Iger, each owned 42.5 percent partnership
interests in a shopping center. The defendant, Prentiss, owned 15 percent.
• Sheffel and Iger could not get along with Prentiss and ultimately excluded
him entirely from partnership decision-making.
• Prentiss failed to contribute $6,000 that was his share of an operating
deficit.
• Sheffel and Iger sued for dissolution.
• The trial court found that they had frozen out Prentiss and held that this
resulted in dissolution.
• The court ordered a sale of the property. Sheffel and Iger were the high
bidders, at $2,250,000.
• Prentiss appeals, claiming that it was improper for the court to have
allowed Sheffel and Iger to bid, since they had the advantage of using
“paper” dollars (that is, their own interest in the equity.)
Prentiss, cont.
HELD:
• It was o.k. to allow Sheffel and Iger to bid.
• In fact, Prentiss would have been worse off if they had not bid, since
their bid was higher than that of any outsider.
• There is no evidence of Sheffel and Iger trying to take unfair
advantage of Prentiss. If Prentiss didn’t like the deal (dissolution at
will) he should have bargained for a different deal.
Disotell v. Stiltner
• In 1994 Stiltner, the owner of a real estate and property management business,
paid $275,000 for two lots with a commercial building, called by the court “the
hotel property.”
• In 1997 Stiltner met Disotell, a general contractor, who agreed with Stiltner that
they would build and operate a hotel on the Stiltner property, as partners.
• They had no written agreement. The deal was that Stiltner would contribute the
property; that Disotell would contribute his services as general contractor in
building the hotel; and that Disotell would pay Stiltner $137,500, half of the cost
of the property—but, as the court puts it, “only from the profits of the business.”
• Stiltner in 1998 quitclaimed a half interest in the property to Disotell.
• After Disotell had done some significant amount of work, but before construction
began, the partners had a falling out, construction never began, and Stiltner
occupied the property to the exclusion of Disotell.
• Disotell sued.
Disotell, cont.
• The trial court found that Stiltner had dissolved the partnership and was
not at fault in doing so. It ordered that Stiltner would have the option to
buy out Disotell’s interest for $73,213.50, and that, if Stiltner did not do so
the property would be sold by a receiver appointed by the court and the
proceeds distributed as directed by the court.
• Disotell objected to the option awarded to Stiltner, claiming that he was
entitled to liquidation as a matter of law. Disotell also objected to the trial
court’s determination of the amount to be paid for the option and to its
ruling that the $137,500 was a partnership debt, to be paid out of the
proceeds of any liquidation, rather than an amount that in effect should be
ignored because it was to be paid to Stiltner only out of profits from the
business, of which there were none.
Disotell, cont.
Despite the language of UPA (1914) § 38, it was not error for the trial court to give Stiltner the option,
to prevent the economic waste of a liquidation sale, but it was error to set the amount without
sufficient evidence of value.
The court further concluded that the $137,500 was not a debt of the partnership, but this leaves a gap,
since Disotell had not contributed the services he had promised and it would not make sense to let him
take half of the proceeds of the sale of the property, for which he paid nothing.
So the case is remanded to the trial court to find the inferred “intent” of the partners—that is, what
would have been a reasonable outcome in the circumstances, taking account of the amount of time
that Disotell had in fact spent on the project.
NOTE: Under partnership law dissolution is a matter of right for each partner; no judicial decree is
required, though it may be wise to go to court to seek a determination of issues such as whether the
dissolution was wrongful, and to seek the appointment of a receiver.
Monin v. Monin
• Charles and Sonny Monin, through a partnership, hauled milk for a
dairymen’s association (DI).
• Eventually, their partnership collapsed and Sonny notified Charles that he
would dissolve it. He also told Charles that he wanted to apply for the DI
contract once the partnership’s contract expired.
• Charles and Sonny held a private auction for the partnership’s assets
(including the DI contract). Charles bid the highest amount, $86,000.
• Note two points: Charles’s bid was contingent on winning the DI bid, and
Sonny signed a covenant not to compete.
• DI refused to do business with Charles, and sent its business to Sonny instead.
Charles sued claiming breach of fiduciary duties.
Monin, cont.
Judgment for Charles.
Note: The court leaves it unclear whether this is a fiduciary duty case or a
contract case. The ambiguity derives from the way it does not tell us the content
of Sonny’s non-compete agreement:
(A) Sonny might have agreed not to compete for the DI contract.
(B) Sonny might have agreed not to compete with Charles in his new role
as sole proprietor of the former partnership business, provided Charles
won the DI contract.
If (A), then Sonny has breached the contract, and the court’s talk of fiduciary duty
is irrelevant. If (B), then Sonny did not breach the non-compete agreement. If
Charles is to collect, he must collect on some other, presumably fiduciary-duty,
claim
Pav-Saver Corporation v. Vasso
Corporation
• Dale was the idea man and patent holder. Meersman was a lawyer and the
money man.
• Dale had a patent on a machine for laying down concrete. He operated
through Pav-Saver Corporation (PSC), of which he was the majority
shareholder. Meersman operated through Vasso Corporation, in which he
held all the shares.
• PSC and Vasso formed a partnership called Pav-Saver Manufacturing
Company (PSC Mfg.) to exploit the Pav-Saver patents.
• Their agreement, drafted by Meersman, required PSC to grant to PSC Mfg.
an exclusive license of its patents and trademark. Paragraph 11 of the
agreement provided that the partnership was “permanent” and provided a
formula for liquidated damages in the event of dissolution (which is called
“termination”).
Pav-Saver, cont.
• After several years of operation, Dale (through PSC) “terminated” (the
correct word is “dissolved”).
• Meersman then took over, claiming that he was entitled under § 38 of
UPA (1914) to continue to operate the business and to collect
damages under the formula in the partnership agreement.
• Dale then filed suit seeking a return of the patents and trademark.
Pav-Saver, cont.
• Meersman (Vasso) wins. He is entitled to continue to operate the
business, subject to § 38. He is entitled to damages, as specified in
the agreement, of $384,612 payable over 10 years.
• Dale is entitled to his share of the value of the partnership, $165,000.
(Under UPA (1914) § 38 Dale is not entitled to be paid his share of
goodwill; under UPA (1997) § 701 he would be so entitled.)
• Meersman is entitled to continue to use the patents and trademark;
they are part of the goodwill of the business. The liquidated damages
provision is not a penalty.
Kovacik v. Reed
• Kovacik and Reed entered into a general partnership to operate a kitchen
remodeling business. Kovacik made an initial capital contribution of
$10,000. Reed made no capital contribution, but did contribute a
promise of future services by agreeing to superintend the partnership’s
work and to estimate the jobs on which the partnership bid. Kovacik
contributed no services.
• Kovacik and Reed agreed to share profits equally (50/50), but made no
provision for allocating losses. Reed apparently took no salary.
• Unfortunately, things did not go as planned and Kovacik dissolved the
partnership after only ten months on grounds that it was unprofitable.
• Kovacik claimed that the partnership had lost $8,680 and instituted a
proceeding for an accounting in which he sought to recover one half of
the partnership’s capital loss from Reed.
Kovacik, cont.
HELD:
• In a so-called service partnership, in which one partner contributes all
the capital and the other contributes solely labor, and the partner
who contributes solely labor is not compensated for his services,
neither party is liable to the other for contribution for any loss
sustained.
•Thursday, March 21
• c. Law Partnership Dissolution (361)
• i. Meehan v. Shaughnessy (Mass. S. Ct. 1989)(361)
• 2. Partners at Loggerheads: Dissolution Solution Under the UPA
(1997)(366)
• a. Giles v Giles Land Company (Kansas App 2012)(367)
• b. Creel v Lily (Maryland 1999)(374)
• 3. Buyout Agreements
• a. G&S Investments v. Belman (Ariz. Ct. App. 1984)(382)
Meehan v. Shaughnessy
• issue turns on the interpretation of a provision of the partnership
agreement covering a partner’s financial claim on dissolution.
• The agreement provided that the firm (PC) was entitled to a “fair
charge” for cases removed by a departing partner and that any future
fees would then belong to the departing partner.
• The firm takes all other unfinished business, but it is not required to
pay a “fair charge”
• In addition to “unfinished business” that a departing partner takes,
such a partner is entitled to his or her capital account plus his or her
share of current partnership income.
Meehan, cont.
• This agreement is enforceable.
• Despite language in the agreement suggesting that the rule for
unfinished business applies only to business taken away by Meehan
and Boyle that was originated by them, the court concludes that the
same rule applies to all unfinished business
Giles v. Giles Land Company
• Kelly Giles was a partner in Giles Land Company, which owned “thousands”
of acres of farmland and ranchland and was one of several partnerships
owned by the Giles family.
• GLC was a limited partnership. The bulk of the limited partnership interests
had been transferred to Kelly and his six siblings by their parents, Norman
Lee Giles and Dolores N. Giles.
• Norman and Dolores held over 90 % of the general partnership interests.
Kelly and two of his siblings held the remaining general partnership
interests.
• Kelly was on the outs with the rest. Apparently he thought he could do a
better job of running the business and at one point berated his father so
severely as to reduce his father to tears.
Giles, cont.
• All but Kelly concluded that they should transform the partnership into an
LLC.
• Kelly responded by seeking access to the books and records, and filed a suit
to compel the others to provide access; the trial court ultimately rejected
that claim.
• In the meantime, the others had filed a counterclaim seeking to dissociate
Kelly from the partnership, under the Kansas version of UPA (1997) § 601.
• The trial court granted this counterclaim.
Giles, cont.
• Affirmed. Kelly’s conduct satisfied both the first and third subsections
of UPA (1997) § 601(5) (which is designated § 601(e) in the Kansas
statute).
• Goodbye Kelly
Creel v. Lilly
• Joseph Creel, Arnold Lilly, and Roy Altizer formed a partnership to
sell NASCAR memorabilia.
• Their partnership agreement provided: that upon termination of the partnership
the assets and liabilities “shall be ascertained” and the net amounts distributed
to the partners (§ 7(a)); and that upon the death of a partner, his partnership
interest would go to his estate, but subject to a right of first refusal to the other
partners if his estate tried to sell the interest.
• Upon the death of Joseph Creel, Lilly and Altizer hired an accountant to assess the
value of the business, and paid Creel’s widow his share of that amount.
• She contested the amount, and sued to liquidate the partnership. The accountant
had considered the inventory and cash on hand, but apparently had decided that
the young firm had no going-concern value.
Creel, cont.
HELD:
• Allowing partners (or their heirs) to force a liquidation would be “harsh
and destructive.” Therefore, unless the parties expressly give themselves that
right, the court will not interpret either the UPA (1914) or the UPA (1997) as
mandating it.
• In paying Creel’s widow the assessed value of his interest, Lilly and Altizer
did exactly what their partnership agreement stipulated. She has no right
to force a liquidation.
G & S Investments v. Belman
• Century Park (a limited partnership) ran an apartment house in
Tucson. The general partners were G&S (Gibson and Smith) and
Nordale.
• Nordale went nuts, and took to snorting cocaine, propositioning at
least one underage female tenant, and generally making bad business
decisions.
• G&S sued to dissolve the partnership under § 38 of the UPA (1914).
Section 38 would involve a judicial determination of the reasons for
dissolution.
Belman, cont.
• If the court were to dissolve it for “wrongful” conduct on Nordale’s
part (under UPA § 32), Nordale would not be entitled to share in the
partnership’s goodwill (§ 38(c)).
• While that litigation was in progress, Nordale died. Now, G&S claimed
that it could continue the partnership under Article 19 of the
partnership agreement by buying out Nordale’s interest. The price
under Article 19 would have been Nordale’s capital account, plus the
average annual profit over the last three years.
• Nordale’s estate first claimed that the filing of the dissolution suit
itself constituted dissolution. If so, then it would be entitled to its
share of the value (i.e., real market value) of the partnership. Second,
the estate claimed that the term “capital account” in Article 19 was
ambiguous—apparently hoping to incorporate market value into it.
Belman, cont.
HELD:
Holding: The filing of the suit was not itself dissolution. Dissolution
instead occurred when Nordale died.
As a result, the rights of the partners are governed by Article 19, and
the “capital account” language of the article does not incorporate
market value.
Tuesday, March 26
•Chapter 2: Partnerships, cont’d 1
•. Limited Partnerships (386)
•a. Frigidaire Sales Corp. v. Union Properties, Inc. (Wash.
1977)(387)
•b. Jerman v. O’Leary (Ariz. App. 1985)(389)
Limited Partnerships
• A limited partnership is a partnership with two types of
partners:
-general partners, who are personally liable for the firm’s
obligations, and limited partners who have limited liability.
Limited Partnerships
• In general, partners are personally liable for the debts of the
partnership,
but limited partners are not.
• In general, shareholders are not liable for the debts of a corporation.
• In general, officers are not liable for the debts they cause a
corporation to incur.
-see how corporate lawyers can combine these different rules to form
limited partnerships in which no human being has personal liability.
Frigidaire Sales Corp. v. Union
Properties, Inc.,
• Mannon and Baxter are limited partners in Commercial Investors.
• CI’s general partner is Union Properties, a corporation of which
Mannon and Baxter are shareholders, officers, and directors.
• CI breached a contract with Frigidaire, and Frigidaire sued Mannon
and Baxter personally, as well as Union Properties.
Frigidaire, cont.
• Judgment for Mannon and Baxter.
• This is a straightforward case of form over substance. Mannon and
Baxter managed CI’s affairs, but only in their capacity as officers and
directors of UP.
• Because the court recognized that role differentiation, the fact that
they participated in management as officers or directors of the
corporate general partner did not jeopardize their status as limited
partners.
Frigidaire, cont.
• Generally, partners have personal liability for the debts of the
partnership.
• In limited partnerships, however, limited partners enjoy limited
liability. They become liable for partnership liabilities only if they help
manage the partnership—when they effectively become general
partners.
• Every limited partnership must have at least one general partner, but
Washington (the state at issue) allows limited partnerships to have
corporations as their general partner.
Jerman v. O’Leary
• The O’Learys were general partners in a limited partnership formed to
develop a mobile home park.
• After the park was developed and sold, the limited partnership retained
ownership of 36 acres, 11 of which were later transferred to the county
government in connection with a re-zoning of the property.
• The O’Learys offered to purchase the remaining 25 acres from the partnership
for $110,250.
• After Jerman objected on grounds that the land was worth considerably more,
the O’Learys asked the other limited partners to approve the sale.
• When they did so, the O’Learys went forward with the transaction. Jerman
sued.
Jerman, cont.
Issue:
• The limited partnership statute then in effect held that a general partner
could not, without consent of the limited partners, possess partnership
property for non-partnership purposes.
• The limited partnership agreement signed by all members allowed the
general partner, without consent of the limited partners, to acquire “less
than substantially all” of the partnership property “upon terms which the
General Partner shall determine in its sole discretion.”
• Did that provision trump the statute?
Jerman, cont.
• The consent required by the statute could be inferred from the
agreement.
• In dicta, the court went even further, quoting an earlier decision holding “in the
absence of an express prohibition, the Act leaves the members of a limited
partnership free to determine their rights with respect to each other by any
contractual agreement which does not contravene public policy or run afoul of the
common law.”
• In a decision reminiscent of Meinhard v. Salmon, however, the court went on to hold
that the general partners had a fiduciary duty to disclose all material information
relating to the value of the property.
• Accordingly, the court remanded for a new trial at which the finder of fact is to
determine whether the O’Learys violated their fiduciary duty by paying a below fair
market price.
• c. Sonet v. Plum Creek Timber Co., L.P. (Del. Ch. 1998)(394)
• d. Cincinnati SMSA L.P. v. Cincinnati Bell Cellular Systems Co.
(Del. 1998)(401)
• e. In re: El Paso Pipline Partners, L.P. Derivative
Litigation(Delaware 2014)(405)
Sonet v. Plum Creek Timber Co., L.P.
• A real estate limited partnership plans to convert to a REIT visa a merger of
the limited partnership into a newly created business trust.
• A holder of limited partnership interests brought suit against the limited
partnership’s general partner and its general partner, alleging breach of
fiduciary duty in connection with the merger.
• The Court of Chancery, New Castle County, Chandler, Chancellor, held that,
with regard to the merger, general partner was not subject to common law
fiduciary duty doctrines.
Issue: As the court itself put the question: “what controls the governance
process in the context of limited partnerships—the partnership agreement or
common law fiduciary duty doctrines?”
Sonet, cont
• A general partner has the fiduciary duty to manage the partnership in its interest
and in the interests of the limited partners, in the absence of contrary
agreement.
• Where the limited partnership agreement makes plain the parties’ intent to
preempt fiduciary principles, the contractual provisions prevail over any contrary
rules of fiduciary duty.
• Accordingly, when a limited partner alleges a breach of fiduciary duty, the first
question must be whether the partnership agreement proscribes the conduct in
question.
• Only where the contract is silent or ambiguous, or where principles of equity are
implicated, will a court begin to look for guidance from the statutory default
rules, traditional notions of fiduciary duties, or other extrinsic evidence.
• As applied to this case, in which the limited partnership agreement specifically
provided that a general partner had sole discretion to set the terms of a merger,
subject to a vote of the limited partners to approve the merger, the contract
controls.
Cincinnati SMSA L.P. v. Cincinnati Bell
Cellular Systems Co.,
• A Delaware limited partnership providing cellular telephone service in
the Cincinnati area sued one of the limited partners, claiming that
limited partner’s decision to offer Personal Communications Services
(PCS) telephony in the same service area violated the noncompete
clause of the limited partnership agreement.
• Issue: Where a new technology allows a limited partner to compete
with the partnership without violating the literal terms of the
partnership agreement, does the partnership have any extracontractual rights against the limited partner?
Cincinnati, cont.
• Delaware law does not allow a court to add wholly new terms to a contract, to rewrite
a contract, or supply omitted provisions to a contract.
• Having said that, however, there is a limited role for the implied covenant of good faith
to supply implied terms when necessary to honor the parties’ reasonable expectations
where the obligations imposed by those implied terms were omitted, in the literal
sense, from the text of the agreement but can be inferred therefrom.
• In determining whether to imply terms in an agreement, the proper focus is on “what
the parties likely would have done if they had considered the issue involved.”
• In this case, the limited partnership agreement, which unambiguously precluded
limited partners from competing with respect to cellular telephone service but allowed
partners to engage in or possess an interest in other business ventures of every kind
and description, did not preclude limited partner from independently providing PCS,
which operated on different radio bandwidths than cellular service and was separately
regulated by the Federal Communications Commission (FCC).
In re: El Paso Pipeline Partners, L.P.
Derivative Litigation
• El Paso Corporation (Parent), a publicly traded corporation (later acquired by
Kinder Morgan) was the general partner of El Paso Pipeline Partners, L.P.
(MLP), whose units are publicly traded (NYSE symbol EPB).
• MLP held oil and gas infrastructure assets that had at the outset been
contributed to it by Parent.
• Parent, in March 2010, sold additional oil and gas terminal assets to MLP at a
price that the plaintiff unitholders considered unfair to them.
• Under the terms of the partnership agreement, the price was effectively set
by Parent (as general partner of MLP), subject to approval by a committee of
the Parent board consisting of three supposedly independent members of the
board—members whose true independence might well be doubted.
El Paso, cont.
• At the time of the sale the future business of the terminals was in
some doubt and Parent had declined to exercise an option to buy
similar assets at a lower price (measured as a multiple of EBITDA).
• Plaintiff investors claimed a violation of the express terms of the
partnership agreement and of the implied covenant of good faith and
fair dealing and sued Parent and its officers and directors in this
derivative action.
El Paso, cont.
• Summary judgment for defendants.
• The actions of Parent and its officers complied with the terms of the
partnership agreement.
• As for good faith, the court finds that there is a gap in the contract
but that its job is to figure out what the parties would have provided,
and in this case they would not have imposed a duty of good faith
and fair dealing.
• The case is consistent with the Delaware courts’ strong support for
freedom of contract in partnership law.
Chapter 3: Limited Liability Entities (479)
1. Limited Liability Companies (479) a. Formation (479)
i. Water, Waste & Land, Inc. d/b/a Westec v. Lanham (Col. 1998)(479)
b. The Operating Agreement (484)
i. Duray Development, LLC v. Perrin (Michigan App. 2010)(485)
ii. Elf Atochem North America, Inc. v. Jaffari (Del. Sup. Ct. 1999)(491)
iii. Fisk Ventures, LLC v Segal()(498)
Limited Liability Entities
• One of the most important ways in which transactional lawyers can create
value their clients is by helping them choose appropriate organizational
structures for their businesses.
• Until recently, the only important standard form contracts provided were
the corporation and the general partnership.
• In the last decade or so, a third standard form contract has been added to
this short list of options: the LLC. LLCs have been around for a couple of
decades.
• Prior to 1988, however, only a few states had adopted LLC statutes and
very few had been formed. In 1988, the situation changed dramatically.
• The Internal Revenue Service concluded that LLCs could be classified as a
partnership for federal tax purposes.
• With that development, the concept took off. Many states adopted LLC
statutes and numerous LLCs have been formed.
LLCs
• popularity of LLCs.
• They provide a standard form contract that incorporates many of the
most attractive features of partnerships and corporations.
• The LLC is a unincorporated business organization that can provide its
members with pass through tax treatment, limited liability, and the
ability to actively participate in firm management.
LLCs
• The LLC differs from a partnership—and resembles a corporation—in
that an LLC can only be created by filing articles of organization with
the Secretary of State.
• The articles of organization are comparable to corporate articles of
incorporation and are treated as such by the statute with respect to
such questions as amendment and filing.
• In addition, the LLC may adopt an operating agreement, which fulfills
many of the same functions as a partnership agreement or corporate
bylaws.
LLCs
• Typical LLC statutes provide flexibility.
• The default rule is comparable to the general partnership form, vesting
management in the LLC’s members.
• In some states, the number of votes cast by each member is voting is
determined by their proportional share in the book value of the membership
interests; in others, the partnership rule of one person one vote is used.
• In general, both of these rules are subject to any contrary provisions of the
articles of organization and operating agreement.
• The LLC thus provides substantial flexibility in structuring the firm’s decisionmaking processes.
Water, Waste & Land, Inc. d/b/a Westec
v. Lanham
• Clark and Lanham formed a Colorado LLC named Preferred Income
Investors, LLC (P.I.I.).
• Clark then contracted orally with Westec to perform engineering services
for a restaurant to be constructed.
• Clark’s business card had the letters “P.I.I.” above the address, but had no
indication that P.I.I. was an LLC.
• The county trial court found that Clark was acting as agent of Lanham and
that Westec was not put on notice that P.I.I. was an LLC.
• So the court held that Clark was not personally liable but Lanham was.
• The case then went to the district court, which reversed
Water, cont.
HELD:
• The district court erred in overturning the factual determination that
Westec was not on notice (a part of the opinion edited out) and in its
application of the notice provision of the Colorado LLC statute.
Duray Development, LLC v. Perrin
• Duray hired Perrin to do excavation for Duray’s land development project.
• Initially Perrin signed on behalf of his excavating company, Perrin
Excavating, but Perrin and Duray’s sole member, Munger, understood that
Perrin would form Outlaw Excavating, LLC and that a new contract would
be substituted for the original.
• The second contract was signed on October 27, 2004, but Outlaw was not
officially granted LLC status, and therefore did not achieve de jure status
as an LLC, until November 29, 2004.
• Duray claimed that that the excavation was botched, sued Perrin, and was
awarded a judgment of $96,367.68.
• The trial court rejected Perrin’s argument that he was protected by the
doctrines of de facto corporation and estoppel.
Duray, cont.
• Held: Perrin prevails.
• Contrary to the position of the trial court, the two doctrines apply to
LLCs as well as to corporations.
• In a portion of the opinion that was omitted, the court states that
Perrin had not presented the estoppel argument at the trial level and
that, consequently, it would not reverse the trial court on this issue.
Elf Atochem North America, Inc. v.
Jaffari
• Elf and Malek, Inc. formed Malek LLC to exploit Malek, Inc.’s solventbased maskant (used in the production of aircraft and missiles).
• There was also a distribution agreement and an employment
agreement for Jaffari (president of Malek, Inc.).
• A provision of the LLC agreement required that all disputes be
resolved by arbitration in California (where Malek, Inc. was
incorporated).
• Elf claimed that Jaffari had committed various wrongs in running
Malek LLC and filed this derivative suit against him and Malek LLC in
Delaware, claiming that the arbitration provision was unenforceable
for various reasons (starting with the strained argument that the LLC
was not itself, as an entity, a party to the agreement).
Elf, cont.
• Held: Elf loses.
• The LLC law is designed, like the limited partnership law, to
give parties considerable freedom of contract.
• There’s nothing wrong with contracting for arbitration, even in
another jurisdiction. In fact, arbitration is a good thing.
• And there’s no merit in any of Elf’s efforts to torture the language of
the Delaware LLC statute to reach a contrary conclusion.
LLPs vs. LLCs
• Deciding which kind of business association to utilize today usually
boils down to the choice between a limited liability partnership
(“LLP”) and a limited liability company (“LLC”).
• The three primary concerns for people going into business together
tend to implicate the following issues:
(1) limiting their personal liability (and the personal liability of any
investors) for the firm’s obligations;
(2) minimizing their federal income tax liability; and
(3) maintaining control of the business.
Analysis, cont.
Other types of business association are deficient in one or more of these
respects:
— A general partnership is undesirable because partners in a general partnership
are subject to personal liability for the firm’s obligations.
— A limited partnership is unsatisfactory in most states because general partners
are personally liable for firm obligations and the limited partners cannot
participate in control without risking personal liability.
— A corporation is problematic because the corporation and its shareholders
may end up paying more federal income tax collectively than if the business
were operated in unincorporated form. Corporate income is potentially taxed
twice, once at the entity level and again at the shareholder level if that income is
distributed to shareholders in the form of a dividend (“double taxation”).
• For these reasons, neither a general partnership, a limited partnership or a
corporation is likely to be the business form of choice today.
Analysis
• an LLP allows its owners to accomplish all three objectives, namely,
limited personal liability, pass-through tax treatment, and a flexible
management structure (the partners can agree on how the LLP will be
run.)
• An LLC offers the same advantages: limited liability for the owners
(“members”), pass-through tax treatment and flexible management
structure.
• Accordingly, it is appropriate to consider why a business owner would
prefer an LLP to an LLC or vice versa.
Analysis
• in 1997, the IRS announced that an LLC could ensure conduit taxation
by simply checking a box on an IRS form (referred to as the IRS’s
“check-the-box” regulation).
• Today, LLCs need not even check a box. They are granted conduit
taxation by default.
Benefits of Using an LLC
the LLC is the preferred form of business association in the United States today.
There are several reasons why the LLC eclipsed the LLP as the business form of
choice:
(1) In a state with a narrow shield LLP statute, it makes sense to opt for an LLC,
which shields partners from vicarious liability for contracts as well as vicarious
liability for torts. Why get a partial shield when you can a full one?
(2) In some states, like New York and California, only persons who provide
professional services (like lawyers and accountants) may form an LLP, so the LLC
became the vehicle of choice for nonprofessionals in those jurisdictions.
3) In many states, the LLC statute allows greater flexibility to contract around
default rules, including the rules pertaining to the fiduciary duties of members
and managers. Freedom of contract is the quintessential hallmark of an LLC.
LLC Benefits, cont.
(4) There are many fewer governance rules for LLCs than there are for
corporations. If the owners of a business want to maximize flexibility,
the LLC is likely to be the better option for their business.
(5) If a firm has only one owner, it cannot operate as an LLP since a
partnership, by definition, must have two or more persons as coowners.
Some Downsides of Using an LLC
Unlike the UPA and RUPA, the Uniform Limited Liability Company Act
(“ULLCA”) was not widely adopted, in part because most states had
enacted LLC statutes before the ULLCA was promulgated. As a result,
there is far more variation among state LLC statutes than among state
partnership statutes.
GP Important Review Concepts
Under the UPA, a partner in a general partnership is liable for the acts
of the other partners.
However, when a new partner is added to the partnership, that new
partner is only liable for the liabilities that arise after they join the
partnership.
New partners are not liable for the liabilities incurred before they
become a partner.
LLP Important Review Concepts
• A limited liability partnership is formed by filing such under statute
with the appropriate state office.
• It requires that the partnership name include LLP. These were both
present here and a valid LLP was formed.
• The benefits of a LLPis that partners are not liable for the other
partner’s acts. They are liable only for their own negligence.
• However, a partnership cannot form into a LLP to avoid liability
incurred while a general partnership. It only is a shield to liabilities
incurred as a LLP.
• We look at the partners at the time the claim arose.
c. Piercing the LLC Veil (505)
i. Tom Thumb Food Markets, Inc. v. TLH Properties, LLC (Minn. App.
1999)(unpublished
opinion)(506)
ii. NetJets Aviation, Inc. v. LHC Communications, LLC (2nd Cir.
2008)(509)
Tom Thumb Food Markets, Inc. v. TLH
Properties, LLC
• Hartmann, acting for TLH, agreed to build a building for Tom Thumb on property
owned by Smith.
• Hartmann represented that he owned the property. He did not own the
property but thought that he had a deal with Smith for development.
• Hartmann and Tom Thumb entered into a lease that had no financing condition.
• Hartmann tried to get a construction loan from a bank, but the bank wanted
financial information from Tom Thumb, which Tom Thumb delayed in providing.
• Ultimately, as the court notes near the end of its opinion, Tom Thumb did supply
the information, showing that it had a negative net worth.
• The bank denied the loan and the project fell through.
• Tom Thumb sued for damages and sought to pierce the LLC veil and hold
Hartmann personally liable.
Tom Thumb, cont.
• TLH is liable since there was no financing condition. Hartmann is not
personally liable.
• Under express terms of the Minnesotan LLC statute, the law relating to
piercing the corporate veil applies to LLCs.
• Here, however, Tom Thumb failed to establish injustice or fundamental
unfairness.
• True, Hartmann falsely represented that he owned the property, but he did
not do so with an intention to commit a fraud. He genuinely believed that
the project would fly and that Smith would contribute the land.
• Moreover, Tom Thumb was partially responsible for the failure of the
project because of its delay in providing financial information and because
it had a negative net worth. Tom Thumb lacks “clean hands.”
Netjets Aviation, Inc. v. LHC
Communications, LLC
• NetJets had a contract with LHC to provide private-jet use.
• LHC fell into arrears, wound up owing around $340,000, and was
insolvent.
• The sole member of LHC was Zimmerman, who made all the
decisions.
• LHC was essentially a vehicle by which Zimmerman made investments
and he used LHC as his personal piggy bank. Money was frequently
moved by Zimmerman to and from LHC to meet LHC’s operating and
investment needs and to meet Zimmerman’s personal needs.
Netjets, cont.
• Some payments were made directly by LHC for Zimmerman’s personal
purposes—for example, to buy a $350,000 Bentley for Zimmerman’s
personal use and to pay the expenses of maintaining his $15 million
apartment on Park Avenue.
• So NetJets goes after Zimmerman on the alter ego or veil-piercing
theory.
• The district court dismisses the claims against Zimmerman on the
somewhat bizarre theory (reference to which is deleted in the edited
version of the appellate opinion) that facts that were used in support
of one prong of the alter ego test could not be used in support of the
other prong.
Netjets, cont.
Held: There is at least enough in the pretrial record to support NetJets’s
right to a trial.
Facts supporting one prong of the alter ego test can be used as well for
the other prong. Remanded.
• Chapter 3: Limited Liability Entities, cont’d
• 1. Limited Liability Companies, cont’d
• a. Fiduciary Obligation (517)
• i. McConnell v. Hunt Sports Enterprises (Ohio App. 1999)(517)
• ii. VGS, Inc. v. Castiel (Del. Ch. 2000)(523)
• iii. Gottsacker v. Monnier (Wisconsin 2005)(530)
McConnell v. Hunt Sports Enterprises
• Hunt and McConnell and some of their cronies formed Columbus Hockey
Limited (CHL), an LLC, to bring an NHL hockey franchise to Columbus, Ohio.
• After they failed to get public financing (by a sales tax) to build an arena,
Nationwide Insurance offered to build an arena and lease it to CHL.
• Hunt, purporting to act for CHL but without authority to do so, repeatedly
rejected the Nationwide lease offer. McConnell was willing to accept the
offer.
• Ultimately, there was a meeting of the CHL members, at which Hunt and
his followers persisted in the rejection of the lease offer and McConnell
and his pals expressed support.
• McConnell and pals signed the lease offer for themselves and got the
franchise.
Hunt, cont.
• Apparently Hunt, failing to recognize that he had simply overplayed
his hand and now wanting to be in on the deal, made angry noises
and threatened to sue, so McConnell and pals sought a declaratory
judgment.
• Hunt filed an answer and counterclaims on behalf of CHL and his firm.
Hunt also filed an action of behalf of CHL in a New York state court.
Hunt, cont.
Held:
-Hunt loses every which way.
-The CHL operating agreement expresslyallowed competition and there
was no basis for finding breach of fiduciary duty or tortious
interference.
-Moreover, Hunt wrongfully acted on behalf of CHL; under the
operating agreement he needed approval from the other members and
never even tried to get it. And he acted willfully.
VGS, Inc. v. Castiel
• Castiel (using an entity called Virtual Geosatellite Holdings, Inc.) formed an LLC
(Virtual Geosatellite) and wound up with 63.46 percent of the voting interest.
• Sahagen (through his entity called Sahagen Satellite Technology Group LLC)
acquired a 25 percent interest in the LLC and Ellipso, Inc. acquired the
remaining 11.54 percent.
• The LLC was manager managed, with a three-person Board of Managers.
Castiel appointed himself and Quinn and Sahagen appointed himself.
• Sahagen had a falling out, with Sahagen accusing Castiel of mismanagement
and many of the employees of the LLC, including some of Castiel’s
“lieutenants,” siding with Sahagen.
• Quinn ultimately “defected” to Sahagen and joined Sahagen in a coup.
VGS, cont.
• The coup was accomplished by a vote, by written consent, of Quinn
and Sahagen, merging the LLC into VGS, Inc., with Sahagen, on the
day of the merger, acquiring a controlling interest in VGS, Inc. in
return for a $10 million promissory note.
• The LLC agreement provided that Sahagen’s approval was required for
a merger of the LLC, but Castiel did not have a similar veto power.
• Castiel sues to block the merger.
VGS, cont.
• Held: The court begins by rejecting Castiel’s argument that the merger, and any other action by
the LLC Board of Managers, required unanimous approval of the Board members, noting that if
that were the case, if there were any disagreement the matter would go to the members and
Castiel would prevail.
• Thus, “both Sahagen’s Board position and Quinn’s Board position would be superfluous.”
• The court holds in favor of Castiel, however, by finding that Sahagen and Quinn violated their
duty of loyalty “to the LLC, its investors and Castiel.”
• The court observes that if Castiel had had notice of the intended action, he could have blocked
it by removing Quinn from the Board of Managers.
• The Delaware LLC Act expressly provides for action by written consent “without a meeting
[and] without prior notice.”
• Despite the “literal” (and plain) language of the Act, the court states, “The General Assembly
never intended, I am quite confident, to enable two managers to deprive, clandestinely and
surreptitiously, a third manager representing the majority interest in the LLC of an opportunity
to protect that interest by taking an action that the third manager’s member would surely have
opposed if he had knowledge of it.”
Gottsacker v. Monnier
• Julie Monnier and Paul and Gregory Gottsacker formed a real estate LLC (New
Jersey LLC).
• Monnier bought a 50 percent interest, and Paul and Gregory “collectively”
bought the other 50 percent. Paul and Gregory got into a fight, and Monnier
allied herself with Paul.
• To shut out Gregory, Monnier and Paul sold the firm’s real estate to another
LLC called “2005 New Jersey.” They then sent Gregory a check for $22,000,
which they calculated to be his 25% interest in the $515,000 warehouse sold
by New Jersey LLC to 2005 New Jersey.
• Perhaps there was a mortgage on the warehouse that explains why
$515,000/4 = $22,000—the opinion does not say. They apparently kept their
own share in New Jersey LLC—though again, how they could unilaterally cash
out his interest the court does not say. After all, if Monnier and Paul could
simply cash out Gregory on a whim, they did not need to engineer this
convoluted transaction.
Gottsacker, cont.
The transaction raises two questions:
a. To transfer the property, Julie and Paul needed a vote of members
holding a majority of the interests in the firm. They claimed that Julie
held 50% and Paul held 25% -- giving them a majority. Did Paul
individually hold a 25% stake?
b. Julie and Paul obviously had a conflict of interest in the transaction.
Could they vote their interests at all?
Gottsacker, cont.
Held: Paul has a 25% stake, and he and Julie may vote--but they must
vote fairly.
Dissent: Paul and Gregory hold their 50% “collectively.” This means that
they do not each have a separate 25% stake. Unless they agree, they
cannot vote at all.
Comment: When they wrote that they held the interest “collectively,”
Paul and Gregory probably meant that they had to agree with each
other before they voted the 50%. Clearly, however, the language is not
clear.
b. Additional Capital (535)
i. Racing Investment Fund 2000, LLC v. Clay Ward Agency, Inc. (Kentucky
2010)(535)
c. Expulsion from the LLC (540)
i. Walker Resource Development Co. (Del. Ch. 2000)(540)
Racing Investment Fund 2000, LLC v.
Clay Ward Agency, Inc.,
• This case presents the planning issue of how to raise additional capital, if needed.
Racing Fund agreed to a judgment of about $70,000 in favor of Clay
Ward, paid about $13,000, then ran out of money and dissolved. The Racing Fund
operating agreement included the following provision:
The Investor Members … shall be obligated to contribute to the capital of the
Company, on a pro rata basis in accordance with their respective Percentage
Interests, such amounts as may be reasonably deemed advisable by the
Manager from time to time in order to pay operating, administrative, or other
business expenses of the Company which have been incurred, or which the
Manager reasonably anticipates will be incurred, by the Company.
Note the two aspects: (i) the manager’s discretionary right to seek (demand?)
additional contributions and (ii) the members’ “obligation” to pay.
Racing, cont.
• The trial court, in a suit by Clay Ward against Racing Fund (not against any of the
members), ordered Racing Fund to raise the amount owed by directing the
members to contribute. Racing Fund refused, was held in contempt, and
appealed.
• The Court of Appeals agreed with the trial court. Racing Fund took the case to the
Kentucky Supreme Court and prevails, with the Court emphasizing the
importance of limited liability to members of LLCs.
• As to the fact that the defendant was Racing Fund, not the members, the Court
implicitly agrees with the following statement in the Racing Fund brief:
While the Court of Appeals notes that no Judgment has been entered
against the Racing Investment members as individuals, followed to its
logical conclusion the Order has precisely that effect in that it will force
Racing Fund, which has otherwise ceased to operate, to conduct a capital
call
solely to attempt to satisfy a debt owed by the limited liability
company to a third party
Walker v. Resource Development Co.
• Randolph Walker is a cousin of former President George Bush and, it seems,
the family’s black sheep.
• Defendants William C. Baron and William J. Cox are former military officers
with useful contacts in the former Soviet Republic of Moldova and technical
expertise in the oil and gas business.
• Baron and Cox formed REDECO, a Delaware LLC, to undertake oil and gas
exploration in Moldova. They needed to raise capital of $5 million to fund their
operations.
• As the result of a chance meeting in the Four Seasons Hotel bar in Washington
D.C., Baron invited Walker to act as an agent for REDECO “for the limited
purpose of negotiating with potential investors . . . .”
• Walker apparently had the of financial sophistication that comes from old
money, even though he proved to be a ne’er-do-well with a serious alcohol
problem. Its an old story— the rough around the edges entrepreneur seduced
by the veneer of old money, culture, and fancy titles.
Walker, cont.
• Walker then introduced Cox and Baron to a couple of other key
figures: Stephen Norris, a financier with Bush administration contacts,
and defendant William C. Liedtke, an oil and gas attorney related to
ex-business partners of former President Bush.
• Walker and Norris then embarked on the first of a series of trips to
Europe, during which they discussed financing REDECO. Meanwhile,
the agency agreement between Walker and REDECO had expired,
while Leidtke had been given a membership interest in the LLC.
• By letter dated April 4, 1995, Cox announced a new ownership
structure for the LLC, in which Walker was given an 18% share and an
annual salary of $48,000.
Walker, cont.
• Walker continued wandering around Europe, desultorily negotiating with Norris, but
not doing any real work.
• He repeatedly failed to comply with requests to meet Cox in Moldova, where his
presence was “eagerly awaited” by Moldavian contacts who had “asked to meet the
cousin of the former President of the United States.”
• Apparently, he was also drinking quite heavily during this period.
• In May, Cox acting as REDECO’s managing member sent Walker a letter removing
him from “all official duties” at REDECO. Walker, however, claimed that he had
cleaned up his act and prevailed upon Norris to insist that he be reinstated.
• Consequently, Walker was formally reinstated but it seems that he did very little.
• In July, REDECO’s members finally entered into a formal Operating Agreement. Their
agreement appointed Cox as managing member, confirmed the existing ownership
structure, provided a mechanism for reducing the ownership of members who failed
to make required capital contributions, and contained a provision for the
“involuntary withdrawal” of members who, inter alia, became bankrupt,
incompetent, or died.
Walker, cont.
• In August 1995, negotiations between REDECO and Norris finally broke down for good.
• Cox, with Baron’s and Liedtke’s approval, thereupon sent Walker a letter ousting him from
membership in the LLC. As grounds, the letter referred in general terms to Walker’s poor
performance.
• The letter also demanded an additional capital contribution of $4,179.43 to cover Walker’s
alleged share of the firm’s debts.
• During the subsequent litigation, Cox alleged that Walker had a side deal with Norris that
constituted a conflict of interest justifying his expulsion.
• Walker denied that such a deal existed.
• Through a series of subsequent transactions, REDECO eventually got financing.
• As part of those transactions, the “three Bills” (Baron, Cox, and Liedtke) exchanged their
interests in REDECO for shares of a Canadian corporation.
Walker, cont.
• Held: Defendants claimed that Walker’s alleged side-deal was the reason they removed him from
the LLC.
• The Chancellor, however, concluded that the three Bills had been willing to overlook numerous
improprieties and negligence on Walker’s part so long as they believed Norris would finance the
deal.
• Once negotiations with Norris irretrievably broke down, however, they no longer needed Walker
and removed him because of his failure to find financing.
• Neither the Operating Agreement nor the statute authorize removal on these facts.
• The Chancellor begins with another reference to the overriding principle in Delaware LLC law of
freedom of contract.
• As a result, the first place one looks for an answer is the agreement—not the statute or case law.
• The parties could have included a provision authorizing expulsion of a member in their agreement,
but they had not done do.
• As the Chancellor notes, this omission is especially striking given what the parties knew about
Walker’s misrepresentations, profligate ways, and alcohol problems.
• In brief, they made their bed and now they must lie in it.
Walker, cont.
• The court further found no basis in law or equity for expulsion of an
LLC member.
• Accordingly, provided Walker is willing to pay his share of corporate
debts and make a proportionate capital contribution, he is entitled to
18% of the corporate stock into which the former REDECO interests
have been converted.
Analysis, p. 554
1. The partnerships in those cases had buy-sell provisions in their
partnership agreements authorizing the expulsion of a partner.
Consequently, Walker reinforces the point that buy-sell agreements are
an essential feature of any closely held business.
Analysis
2. Unlike the ULLCA, which provides a mechanism for a judicial buy-out,
the Delaware code does not provide a simple statutory mechanism for
buying out a member’s interest.
The closest analogy is § 603, which authorizes a member to resign.
Upon resignation, § 604 authorizes the payment of the fair value of the
resigning member’s interest.
Fiduciary Duties
Students encounter the fiduciary duties among LLC members in
McConnell.
• review the fiduciary duties among partners.
Fiduciary Duties under RUPA (1997)
• When the UPA was extensively revised in 1997, the drafters adopted more
modern terminology.
• They couched a partner’s fiduciary duties in terms of a “duty of care” and a
“duty of loyalty.”
• The duty of care embodied in RUPA (1997) § 404(c) is essentially the same
duty of care to which corporate directors are held: a partner must refrain from
engaging in “grossly negligent or reckless conduct, intentional misconduct, or
a knowing violation of the law.”
• This standard mirrors the so-called Business Judgment Rule that shields corporate
directors from personal liability for business decisions if they used due care in the
decision-making process.
• Partners will not be liable to the partnership for making a decision that works out badly
for the partnership if they made an informed decision.
• Basically, if the partners “did their homework,” they used due care. You cannot use
hindsight to judge them because “hindsight is 20/20,
Fiduciary Duties under RUPA (1997)
• First, they made it clear that “[t]he only fiduciary duties a partner owes to the
partnership and the other partners are the duty of loyalty and the duty of
care” as defined in the statute (emphasis added).
• Second, they were careful to limit the scope of these duties. The duty of care
was “limited to refraining from engaging in grossly negligent or reckless
conduct, intentional misconduct, or a knowing violation of law”
• The duty of loyalty was likewise “limited to” certain kinds of conduct, including the
appropriation of a partnership opportunity.
• Finally, RUPA (1997) eliminated a partner’s duty of loyalty in connection with
partnership formation on the theory that parties should be free to negotiate
at arm’s length before a partnership has been formed.
• The net effect of all these changes was to reduce the prospect of a partner’s
liability for breach of fiduciary duty under RUPA (1997).
RUPA (1997)
In another break with traditional partnership jurisprudence, RUPA (1997)
allows partners to limit their fiduciary duties by agreement among
themselves.
While RUPA (1997) § 103(b) does not permit partners to eliminate the duty
of loyalty or the duty of care, it allows partners to reduce the standards
prescribed in the statute within reasonable limits.
-In other words, partners can tinker with the duties of care and loyalty
as
long as the “tinkering” is reasonable but cannot eliminate them
entirely.
Some states go even further. Delaware, for example, permits partners to
eliminate both the duty of care and the duty of loyalty. Texas allows partners
to eliminate only the duty of care.
Given the variation among state partnership statutes, you should check to
see which approach your state follows.
1. Limited Liability Companies, cont’d a. Dissolution (555)
i. The Dunbar Group, LLC v. Tignor (Va. 2004)(555)
ii. Investcorp, L.P. v. Simpson Investment Co. (Kan. 1999)(560)
iii. R & R Capital, LLC v. Buck & Doe Run Valley Farms, LLC (Del. Ch.
2008)(564)
iv. Fisk Ventures, LLC v. Segal (Del. Ch. 2009)(568)
The Dunbar Group, LLC v. Tignor
• Robertson was the sole member and manager of Dunbar.
• Tignor had a 50% interest in X-Tel, Inc. and was its president.
• Dunbar (Robertson) and Tignor formed XpertCTI, LLC (Xpert); each owned 50%
and both were managers. Xpert developed and sold software for telephone
systems.
• Robertson was Mr. Inside (development of the software and operation of the
firm) and Tignor was Mr. Outside (marketing and sales).
• Xpert had a substantial contract with Samsung. This contract was for 3 years,
with one-year renewals unless terminated by 90-day notice.
• The Xpert operating agreement provided that if one member committed a
breach, the other could seek an order dissociating that member. It also
provided, however, that “terminat[ion]” of a member “shall not cause
dissolution of the Company.”
Dunbar, cont.
• Tignor behaved badly. He diverted Xpert funds to X-tel, made it impossible
for Robertson to write checks, terminated Robertson’s email account,
evicted
Robertson from the X-tel premises that he had been renting, etc.
• Robertson sought a court order to dissociate Tignor, under Virginia Code §
13.1-1040.1(5).
• Tignor responded by seeking dissolution under § 13.1-1047.
• The trial court granted Robertson’s request and ruled that the LLC would
continue until the termination of the Samsung contract and then would be
dissolved. Robertson (Dunbar) appealed the order providing for dissolution
upon termination of the Samsung contract.
Dunbar, cont.
Held: The expulsion of Tignor is upheld.
• The dissolution order is reversed: the statutory language authorizing
judicial dissolution requires a showing that “it is not reasonably
practicable to carry on the business.”
• That showing was not made; the business can be run effectively with
Tignor as a passive investor and Robertson running the show.
• The lower court (Chancellor) was inconsistent in concluding that there
should be no dissolution as long as the Samsung contract was in effect
and at the same time concluding that thereafter it would not be
“reasonably practicable” to continue.
Disassociation - LLCs
• the default rule for a member’s dissociation is that a person has the
power to dissociate as a member at any time, rightfully or wrongfully,
by withdrawing as a member by express will.
• operating agreement can vary this default rule.
• it is quite common for LLC operating agreements to prohibit a
member from voluntarily dissociating.
Investcorp, L.P. v. Simpson Investment
Co.
• The Simpson family owned an LLC used as an investment vehicle. The family had a
falling out, which resulted in some members withdrawing.
• The withdrawing Simpsons left one member of their group behind (the Moran trust).
• The basic problem was that the operating agreement apparently had a huge gap. In
the event of a withdrawal, the firm seems to have the option but not the obligation
to purchase the interests of the withdrawing members. The withdrawing Simpsons
would be left with an economic interest only, which effectively creates a lock-in
situation.
• The withdrawing Simpsons got around this problem by leaving the Moran trust
behind and relying for protection on a statutory provision requiring unanimous
consent to continue the business of a dissolved partnership.
• As with all unanimity requirements, the threat of a hold-out by the minority gives
the minority considerable bargaining leverage. In this case, the Moran trust vetoed
an attempt by the other remaining Simpsons to continue the business.
• The withdrawing Simpsons then sought dissolution of the LLC.
Investcorp, cont.
Held: The firm was dissolved by the withdrawal of the withdrawing
Simpsons.
The Moran trust could properly veto the attempt to continue the
business.
The withdrawing Simpsons remain members of the LLC during the
dissolution entitled to participate in the dissolution process.
R&R Capital v. Buck & Doe Run Valley
Farms
• Several members of seven race horse LLCs lost confidence in their
manager. They sued to dissolve the firm.
• The manager replied that they had waived the right to dissolve the
firms.
• They countered that the waiver was void as against public policy.
R&R, cont.
Held: The waiver is good. Freedom of contract triumphs in Delaware
LLC law.
• Although the inability of the members to dissolve the firm might
seem to make them more vulnerable, the Delaware law of good faith
and fair dealing protects them.
Fisk Ventures, LLC v. Segal
• Gentrix is an LLC founded by Andrew Segal to commercialize patented
biotechnologies.
• As the company’s finances eventually settled out, Segal received $500,000
worth of Class
• A membership units. Fisk Ventures LLC, a venture capital firm run by H. Fisk
Johnson, bought $842,000 worth of Class B units.
• Passive investors purchased several hundred thousand dollars worth of Class C
units.
• Under Gentrix’s LLC operating agreement, a 75% supermajority of the
management Board is required to take any action.
• The original 4 person Board had expanded to 5 members. Johnson had 3
representatives on the Board, while Segal had two.
• Due to the supermajority requirement, however, Johnson’s representatives
could not effect Board action with the cooperation of at least one of Segal’s
representatives.
Fisk Ventures
Gentrix’s operating agreement provided two mechanisms by which the LLC
could be dissolved: (1) voluntary dissolution pursuant to a 75% vote of the
membership interest units or (2) a decree of judicial dissolution under § 18-802 of
the Delaware code. Citing Delaware’s principle of affording “the maximum
amount of freedom of contract, private ordering and flexibility to the parties
involved” in an LLC, the Court holds that the contract limits the scope of their
dissolution rights.
Issue: Had the relationship between Johnson and Segal deteriorated to the
point at which it was no longer “reasonably practicable to carry on the business in
conformity with a limited liability company agreement”?
Fisk Ventures
Held: Three fact patterns pervade the case law on this issue: “(1) the
members’ vote is deadlocked at the Board level; (2) the operating
agreement gives no means of navigating around the deadlock; and (3)
due to the financial condition of the company, there is effectively no
business to operate.” None of the factors is individually dispositive, but
not all must be present.
On these facts, however, all three factors were present and a judicial
decree of dissolution was therefore appropriate.
1. Securities Regulation Issues (575)
a. Great Lakes Chemical Corp. v. Monsanto Co. (D. Del. 2000)(575)
b. Koch v. Hankins (9th Cir. 1991)(589)
Great Lakes v. Monsanto
Facts:
• Monsanto and STI formed NSC as a Delaware LLC and put their
Nutrasweet business in it.
• In 1999, they sold NSC to Great Lakes. Great Lakes’ argument: During
the negotiations leading to the sale, Monsanto and STI did not
adequately disclose the activities of a Korean competitor to NSC,
Daesang.
• As a result, it bought NSC pursuant to overly optimistic projections.
Inter alia, Monsanto and NSC violated Rule 10b-5.
Great Lakes, cont.
Facts: Monsanto and STI formed NSC as a Delaware LLC and put their
Nutrasweet business in it.
• In 1999, they sold NSC to Great Lakes. Great Lakes’ argument: During
the negotiations leading to the sale, Monsanto and STI did not
adequately disclose the activities of a Korean competitor to NSC,
Daesang.
• As a result, it bought NSC pursuant to overly optimistic projections.
Inter alia, Monsanto and NSC violated Rule 10b-5.
Great Lakes, cont.
Held: Great Lakes loses on a 12(b)(6) motion, since the interests in NSC are
not securities.
• More specifically: (1) An interest in an LLC is not “stock.”
• (2) The interest in this LLC is not an “investment contract.”
• This follows from both (a) the fact that Great Lakes bought 100 percent of the
equity—hence, it did not invest in a “common enterprise,” and (b) the fact that Great
Lakes retained the right to fire NSC managers without cause and to dissolve NSC—
hence, it did not earn its returns “solely from the efforts of others.”
• (3) Because the interest is not an “investment contract,” it is not an
“interest commonly known as a security” either.
Koch v. Hankins
• Plaintiffs are physicians and dentists who sunk anywhere from $23,000 to
$500,000 into general partnerships formed to purchase jojoba farm land.
(Jojoba is a shrub whose seeds produce a commercially valuable wax.)
• As seems to be typical of these agricultural schemes, the 35 nominally separate
partnerships in fact were subdivisions of a single large plantation.
• Each partnership purportedly owned an 80 acre plot within the 2700 acre
plantation.
• As also seems to be typical, the partnerships employed a common operator
who did the actual work.
• When the project failed, the plaintiff-investors sued, alleging various securities
law violations.
• The issue presented is whether an investment in a general partnership is a
security for purposes of those statutes.
• The trial court granted summary judgment to the defendants on that issue.
Koch, cont.
Held: Reversed. Plaintiffs have raised triable issues of fact as to whether their
interests in these general partnerships were investment contracts and,
accordingly, a security.
Rationale: Where a security is specifically listed in Securities Act § 2(1), the task
of defining the instrument as a security is fairly simple.
Example: Absent highly unusual circumstances, corporate stock is a security. But
what if you’re dealing with something that’s not listed in the statute; e.g.,
partnership interests in worm farms?
In SEC v. W.J. Howey Co. 328 U.S. 293 (1946), the Supreme Court announced a
three pronged standard for determining whether an unconventional commercial
relationship would be deemed an investment contract and, accordingly, a
security: [1] a contract, transaction or scheme whereby a person invests money,
[2] in a common enterprise, [3] and is led to expect profits solely from the efforts
of the promoter or a third party.
Koch, cont.
• As applied in this case, there obviously was an investment of money.
• The common enterprise requirement was also met.
• Two types of commonality may satisfy this requirement. Horizontal commonality
looks to the relationship between the individual investor and the other investors who
put money into the scheme. In order for horizontal commonality to exist there must
be a pooling of interests; in other words, everybody’s money must go into the same
pot. E.g., shareholders of a corporation. Vertical commonality looks to the
relationship between the investor and the promoter of the scheme. It requires that
the investor and the promoter of the scheme be involved in a common enterprise.
But you need not have any pooling of interests by multiple investors. Circuits are split
as to whether vertical commonality satisfies the common enterprise requirement,
although the Ninth Circuit’s prior precedents had accepted vertical commonality as
sufficient.
In any event, there was a pooling of funds within each general partnership.
Koch, cont.
• In most cases, the expectation of profits part of this prong is not very
important. Even in tax shelter arrangements, investors expect to benefit
through shielding some of their income from taxes.
• Rather, as in this case, litigation typically centers on the question of how
literally we should take the requirement that profits be realized “solely from
the efforts of others”?
• As a matter of state partnership law, all general partners have equal
management rights. Thus, if we read the “solely” prong literally, it would seem
unlikely that that prong will be met in a general partnership.
• Virtually no court reads that phrase literally, however; in particular, virtually no
court has ever taken the word “solely” seriously.
• The critical inquiry is whether the efforts made by those other than the
investor are the undeniably significant ones, those essential managerial efforts
that determine the success or failure of the enterprise.
Koch, cont.
• A split in the circuits persists as to how this standard should be applied to a
general partnership.
• Some courts use a bright line standard that says that because partners have
under the UPA (1914 and 1997) a legal right to control the firm, a general
partnership interest is never a security.
• In Williamson v. Tucker, 645 F.2d 404 (5th Cir. 1981), by contrast, the Fifth Circuit
held that you look beyond the bare scope of partnership law and consider the
economic realities. A security might be present if (1) the partnership agreement
deprives one or more partner of his legal control rights, essentially leaving him
in the position of a limited partner; (2) the investor is so inexperienced or
unknowledgeable in business affairs as to be incapable of exercising his or her
legal rights; or (3) the investor is so dependent on some unique entrepreneurial
or managerial ability of the promoter that the investor cannot exercise
meaningful partnership powers.
• In Koch, the Ninth Circuit adopted the Williamson standard.
Koch, cont.
• As applied to the facts at bar, the first factor tilted in favor of the defendants,
because the plaintiff-investors had considerable nominal power over the
enterprise.
• As to the second factor, the court found the record inadequate to determine
the plaintiffs’ sophistication or expertise. A remand on that issue was therefore
required.
• As to the third prong, the court thought it tipped in favor of the plaintiffs,
because it would be nearly impossible for the investors to replace the
operator.
Note: The broader point of the case is that the securities laws have a wide reach
and that the scope is sometimes indeterminate, requiring the application of
common sense about what Congress had in mind—which in turn has led to some
rather subtle distinctions and refined formulations.
Partnership Hypo
Andy was looking for a building suitable for an auto repair business. Bob owned such a
building, and together they opened an auto repair business which they named Sunrise
Auto Repair. Andy provided the tools, equipment, and expertise, and Bob provided the
building. They agreed to split the revenues equally after all costs were deducted.
Sunrise Auto Repair was a success. After only one year they hired Carl, another
mechanic, to help with the workload. Carl was paid 15% of the amounts charged to
customers, but only on the work that he did. After Carl was hired, Sunrise accounted for
its revenues in the same fashion as before except that Carl's 15% was included as one of
the costs.
A year later, Sunrise was ready to expand, but needed more capital to do so. David paid
Sunrise $30,000 in exchange for 10% of the company's net profits for five years. The
revenues were thus to be divided during the next five years as follows: gross revenues,
less all costs including payment to Carl, to be split 10% to David, 45% to Andy, and 45%
to Bob. None of these agreements has been reduced to writing.
Discuss the potential partnership issues among the parties to these agreements.
CORPORATIONS
• distinction between publicly traded corporations and those that are
closely held.
• of the 5 million or so corporations in the United States, only about
50,000 are publicly traded and of those, only about 10,000 are on a
major exchange.
• most lawyers who represent corporations will represent closely held
companies, not publicly traded ones.
“Closely Held” Corporation
A "closely held corporation" is a company where a small number of individuals own
the majority of the shares, meaning the ownership is concentrated among a limited
group, often family members, and the stock is typically not traded publicly on a
stock exchange; essentially, it's a private company with a restricted shareholder
base.
Key points about closely held corporations:
Limited shareholders: Only a few individuals hold a significant portion of the
company's stock.
Private ownership: Shares are not publicly traded on a stock market.
Family businesses: Often, closely held corporations are family-owned businesses.
Less formal operations: Due to the small number of owners, they may have less
stringent management structures compared to publicly traded companies.
CORPORATIONS, CONT.
o Of approximately 5,000,000 corporations in the US. Less than 50,000 are publicly
traded, even in the most rudimentary way.
o In 1955, institutions held approximately 23% of outstanding shares in publicly
traded corporations. By 1990 they held more than 50% of such shares and continue
to do so.
o institutional holdings break down approximately as follows:
# of shares held (in mils) % of publicly held shares
Private pensions 679,000. 19.9
Public pensions 283,000 8.3
Mutual funds 246,000 7.2
Insurance Cos. 235,000 6.9
Banks and trusts 314,000 9.2
Foundations/endowments 62,000 1.8
Publicly Traded Corporations
• shareholders in publicly traded corporations typically have only an
diminished relationship to their corporations.
• This is partly due to the fact that public capital markets provide an easy exit
opportunity and millions of shares and thousands of shareholders in each
publicly traded corporation change each day.
• In addition, most of the shareholders in publicly traded corporations own
only an infinitesimal percentage of the corporate stock.
• They therefore have little incentive to be actively engaged in monitoring
the corporation, much less in participating in its affairs.
• In fact, shareholders in the secondary market, particularly retail
shareholders, typically buy shares not because they have some connection
or affinity to the company but for their view of its profit potential, often,
short-term potential.
The Nature of the Corporation
• The same is not normally true of shareholders in closely held
corporations.
• some of the practical differences that exist between closely held and
publicly traded corporations:
• in most cases, a pre-existing relationship between closely held shareholders
• the percentage of personal wealth shareholders normally invest in each type
of corporation
• the cost of setting up and maintaining each type of enterprise
• the limited exit strategy in closely held situations
• the problem of dispute resolution in closely held corporations
Dartmouth College
Marshall and Story both recognized a corporation as an artificial
person.
They saw it as a contractual creation by virtue of the fact that it comes
into being only by various people signing (or agreeing to the terms of) a
charter stating what the corporation will do and how it will be
governed
The Purpose of the Corporation
• the basic rule that business corporations are run to make a profit for
their shareholders.
• This precept is challenged by the Ford and A. P. Smith cases.
• In each, the courts uphold the profit maximizing ideal but in very
different ways.
Dodge v. Ford Motor Co.
• Plaintiffs, minority shareholders, claim the reduction in dividends to
finance facilities and to produce lower priced cars was unlawful.
• They seek an injunction to stop Ford from carrying out its stated
policy.
Ford, cont.
Court holds several corporate fundamentals:
1. The court first restated the general principle that the directors of a
corporation control it and have the sole power to declare a
dividend. Courts will not interfere with this power unless there is
fraud or the board’s refusal to declare a dividend amounts to an
abuse of discretion or a breach of good faith.
2. a corporation’s main purpose is to earn profit for the benefit of its
shareholders and that the directors must pursue this goal.
A.P. Smith Mfg. Co. v. Barlow
• the board adopted a resolution to donate $1,500 to Princeton.
• Some shareholders opposed the resolution and Smith brought a declaratory
judgment action seeking to uphold the donation.
• At trial O’Brien, the company’s president, testified that he thought the
donation to be a sound investment and that the donations created a
favorable environment for Smith’s business operations. He also said that
donations to liberal arts institutions aid business in general by assisting in the
free flow of properly trained personnel.
• The defendant shareholders claim that the company’s certificate of
incorporation does not expressly authorize the contribution and the company
does not possess any implied power to do so under common law.
• They argue that the current New Jersey statutes that authorize such
donations cannot be applied to a corporation that was created before the
enactment of such statutes, as was Smith.
A.P. Smith, cont.
• The court held that the company could make the donation. It stated that
the purpose of early corporations was both the public one of managing
trade and the private one of profit for shareholders.
• The early rule was that corporations could not use corporate funds for
philanthropic uses unless it would benefit the corporation.
• Today, however, most societal wealth is in the hands of corporations, not
individuals, and charitable donations by these corporations are necessary
and should be encouraged.
• Corporations have made such donations for many years.
• Modern conditions require corporations to continue to engage in
charitable activities to retain the good will of their communities. It is
thought to be good public relations and good citizenship.
Concepts of “managerialism” and “valuism”
• Valuism is the idea that maximizing short term stock price is the goal of
management.
• Managerialism - the idea of corporate reinvestment and long-term
growth.
• Many have argued that the massive corporate failures at the beginning
of this decade were the result of managements’ huge overemphasis on
short term stock price.
• In the extreme, this precipitated the criminal activities in Enron and the
loss of billions of dollars of value for stockholders, workers and local
communities.
Who Counts Within the Corporation?
• Examine various other constituencies in the life of a corporation,
including workers, preferred shareholders, and creditors.
• The question is what duties, outside of contract, if any, does a
corporation owe to these players.
Steinway v. Steinway & Sons
• Steinway & Sons had a plant in New York City and 400 acres of vacant
land in Long Island.
• The company needed to expand so it built a new plant and an
adjoining company town on its Long Island property, complete with a
school, a church, and a library.
• This was done so that its highly skilled and long-tenured employees
could live near the plant and have some basic amenities close by.
• Steinway moved almost all its manufacturing to the Long Island plant
and a majority of employees moved to the town.
• Plaintiff shareholder contends that the expenditures for the town and
the amenities were improper.
Steinway, cont.
• The expenditures were proper.
• The court stated that the question was whether the expenditures were
authorized, directly or implicitly, by the charter.
• It also pointed out that, given the need for expanded production facilities, the
transfer of the manufacturing to Long Island was a reasonable business decision.
• Since most of the company’s workers, which the company strongly desired to
retain, would have to relocate to an area with otherwise limited residential
facilities or amenities, the expenditures to build the town were also a
reasonable adjunct to the expenditure to move the plant.
• It was in the company’s interest to provide for the well-being of its employees in
order to promote and preserve an efficient production system.
• One must look at the scheme as a whole, not at each individual expenditure.
Simons v. Cogan
• Hansac and Knoll merged leaving Knoll as the surviving corporation.
• Knoll’s minority shareholders were eliminated through a cash-out
tender offer. The holders of Knoll’s convertible debentures (long-term
debt instrument) were precluded by the terms of the merger from
converting their debentures into common stock. They could, however,
convert the debentures into cash or retain the debenture at a new,
higher, interest rate.
• The complaint alleged that Cogan, as Knoll’s controlling shareholder,
breached his fiduciary duties to the debenture holders by not
maintaining the conversion feature or by not negotiating with a
representative of the debenture holders to arrive at the conversion
value of the debentures.
Simons, cont.
• The court upheld Chancery’s ruling dismissing the claim.
• The court stated that debenture holders have only contractual rights and are not
owed fiduciary duties. A convertible debenture is a credit instrument that is
convertible into equity, but it is not an equity instrument as is a share of stock.
• The court held that “before a fiduciary duty arises, an existing property right or
equitable interest supporting such a duty must exist.” The mere “expectancy”
raised by the convertibility feature is not enough to create the required fiduciary
duty.
• Without such a duty, the claimant is owed only those duties established by
contract.
• Unlike the situation with the holders of preferred stock (as we will examine in the
next case) there is no residual fiduciary duty owed to debt holders. Their rights
are purely contractual.
Jedwab v. MGM Grand Hotels, Inc.
• MGM and Bally agreed to a merger whereby MGM shareholders will
receive cash for their stock.
• MGM’s majority shareholder agreed with Bally to vote in favor of the
merger.
• Plaintiff is a minority preferred shareholder in MGM and seeks to
enjoin the merger on the grounds that the merger terms constitute a
breach of the duty to deal fairly with MGM’s preferred shareholders.
• The corporation claimed that the only duties owed to the preferred
shareholders were the “contract” duties provided for in the charter
and sought to have the claim dismissed.
Jedwab, cont.
• The court denied the motion to dismiss.
• Plaintiffs claimed that directors have a fiduciary duty in a merger to
apportion merger consideration fairly among classes of the company’s
stock.
• Defendants argued there are no special duties owed to preferred
shareholders because all of their rights are contractual.
• The court held that defendants’ argument is flawed. Preferred shares are
entitled to be treated in the same manner as all other shares of stock
except to the extent of the preferences or restrictions provided
contractually through the charter.
• Therefore, the preferred shareholders are generally owed the same
fiduciary duties as common stockholders and may be entitled to greater (or
lesser) duties depending upon the contractual rights associated with their
shares.
Distinction between the contract-like rights of
preferred shareholders and the residual
fiduciary rights that corporations owe to all
shareholders.
• preferred shareholders have all the rights of common shareholders
except those that the charter specifically adds or takes away.
• why don’t preferred shareholders don’t have the same rights as
common shareholders?
• They trade some of those rights in exchange for less risk-their preferential
treatment concerning dividend distributions and/or distributions upon
liquidation.
• The position of preferred shareholders is located between that of creditors
and that of common shareholders when it comes to the risk assumed.
Burwell v. Hobby Lobby Stores, Inc.
• Hobby Lobby is a closely held corporation that objected to HHS’s
demand, pursuant to the Affordable Care Act, that the corporation
provide its employees with health insurance coverage, including
coverage for contraception methods.
• Such coverage violated the religious beliefs of the company’s
principals. The company claimed exemption from the particular ACA
requirements under the Religious Freedom Restoration Act of 1993
(RFRA).
• Largely on the basis of statutory construction, the court rejected
HHS’s argument that the principals forfeited their RFRA protection by
conducting business as a corporation.
Hobby Lobby, cont.
• The majority opinion pointed out that RFRA defined corporations as
persons but stated that “the purpose of this fiction is to provide protection
for human beings.”
• It responded to claims by HHS and the dissent that corporations, as
corporations, were incapable of exercising religion by stating that HHS and
the dissent did not provide any “persuasive” explanation for that position.
• The Court said it is clear that nonprofit corporations can be protected by
RFRA.
• While the beliefs of publicly traded corporations (actually, their
shareholders) may be difficult to ascertain, the same cannot be said for
closely held corporations.
• Thus, since the beliefs of controlling shareholders can generally be
ascertained, they can be treated more like the affinity group nonprofits,
that is, extensions of individuals, than publicly traded corporations, where
beliefs of individuals are, generally speaking, at best opaque.
Hobby Lobby, cont.
Dissent: by Ginsburg.
• Ginsburg quotes John Marshall to the effect that a corporation is “an
artificial being, invisible, intangible, and existing only in the
contemplation of law.” I
• In nonprofits, members join in support of the corporation’s mission.
The same cannot be said of for-profit corporations.
• Thus, the shareholders’ beliefs are irrelevant to the corporate
intention.
The Role of the Corporation in Public
Life
• Corporations have assumed an ever-greater position in society.
• They aggregate great wealth and often wield great economic and
political power.
• Ex. - small town or city where there is one or only a few major
employers.
Charter Township of Ypsilanti v.
General Motors Corporation
• GM had operated two plants in Ypsilanti since 1977 and the town had given
the plant significant tax benefits over the years.
• In 1991, GM announced that it was closing one of its plants and moving the
operations to Texas.
• The town filed a claim to enjoin the plant closing arguing that it breached a
contract awarding the benefits, misrepresentation, and unjust enrichment.
• The trial court found that no contract had been created, but that GM had to
maintain some operations at the plant on the grounds of promissory estoppel.
• The promise upon which this is based was that GM would maintain operations
at the plant if it received a tax abatement from the town, which the town
granted.
GM, cont.
• The court reversed stating that the trial court’s finding of a promise was
clearly erroneous.
• The court found that representations of job creation are a statutory
prerequisite for an abatement application and that mere assurances of jobs
cannot be evidence of a promise.
• Moreover, uses of puffery in seeking a concession do not necessarily
amount to a promise.
• All of GM’s statements offered as evidence of a promise were simply
expressions of GM’s hopes or expectations of continued employment at
the plant.
• GM’s statements concerning continued operation of the plant were clearly
qualified by factors other than just being granted the tax abatement.
• The court further stated that even if a promise were found, reliance on that
promise would not have been reasonable.
Legal Structure of the Corporation
Separate legal entity:
A corporation is considered a "legal person" distinct from its owners, allowing it to engage in business activities
without personal liability for the shareholders.
Shareholders:
The owners of a corporation are called shareholders, who hold shares of stock representing their ownership stake.
Board of directors:
A group of individuals elected by shareholders to oversee the corporation's management and make major decisions.
Officers:
Individuals appointed by the board of directors to manage the day-to-day operations of the company, such as the
CEO, CFO, and COO.
Limited liability:
Shareholders are generally not personally liable for the corporation's debts and obligations.
Formation process:
To establish a corporation, articles of incorporation must be filed with the state government, outlining details like the
company name, purpose, and structure.
Board of Directors
• as corporations get bigger and more diverse, it is practically
impossible for a relatively small board to manage all its affairs or even
to effectively monitor those affairs.
• distinguish between inside and outside directors
• strong trend toward outside directors including the NYSE rule on this
point.
Board of Directors – Public Corporations
• While the law gives virtually unlimited power to the board (with
formulations such as “the affairs of the corporation shall be conducted by
or under the authority of the board”) the reality is largely otherwise.
• In large, publicly traded corporations, the board is rather small, usually
between 10 and 15 members, most of whom are not employed by the
corporation. They meet 10 or 12 times per year for a few hours per
meeting.
• Under these circumstances they cannot be expected to, and do not,
actually run the corporation’s business affairs. That is left to management,
the officers and high-ranking executives employed by the company.
• The board makes major decisions and sets, to some extent, the policy of
the corporation.
• Boards have, in recent years, monitored the top management more closely
which has created a bit more accountability but, for the most part, it is
management that runs the corporate affairs.
Board of Directors – Closely-Held Corporations
• directors are typically also the officers and shareholders of the
corporation and the functions of these layers of control get blurred.
• In fact, many states, by statute, permit the elimination of the board
altogether.
• These realities result in a great deal of informality.
• Principals typically talk to each other on a regular basis and make decisions by
consensus more often than by formal votes.
• There are often strong family or social ties, often intergenerational, which can
lead to great deference or, in some cases, great conflict.
Authority of the Board of Directors
• A corporation's board of directors has the power to manage the company's affairs, including
appointing officers, approving transactions, and setting goals.
• The board is responsible for the company's legal obligations and for ensuring that the company
operates in the interests of its shareholders and other stakeholders.
Powers of the board of directors
Appoint and remove officers: The board has the power to appoint and remove the company's officers.
Approve transactions: The board approves fundamental transactions, such as mergers and acquisitions,
stock issuances, and amendments to the company's charter.
Set goals: The board sets the company's long-term strategic direction and goals.
Replace executives: The board can replace executives who don't meet expectations.
Responsibilities of the board of directors
Act in the company's best interest: The board must act diligently and in the best interest of the
corporation.
Adhere to principles of fairness: The board must adhere to principles of fairness, transparency, and
accountability.
Ensure the company operates lawfully: The board must ensure that the company operates lawfully.
People ex rel. Manice v. Powell et al.
(p. 67)
• The relator was a director of Atlantic Terra Cotta Company and was
removed from his position and replaced in a special election. He is
seeking to be reinstated as a director.
• The lower court denied the reinstatement holding that “As a director [the
relator] was but an agent of the corporation...If wrongfully removed
before the expiration of the period for which he was elected, he is
entitled to recover if damages have resulted; but he cannot insist upon
being retained in a fiduciary relation towards the stockholders against the
latter's wishes.”
Powell, cont.
• On appeal the court held that a director is not an ordinary agent.
• Directors are rather like trustees for the shareholders. It is the directors,
not the shareholders, who are empowered to act for the corporation.
• Difference between a true agency and the relationship between
directors and their corporations.
• An agent is one who acts on behalf of another and under the other’s control but
directors, while acting on behalf of the corporation, are not under its control.
• Rather, the directors (as a board) control their corporations. Neither the officers
nor the shareholders are legally entitled to control the actions of individual
directors nor the board.
• The shareholders have the indirect ability to remove directors but while they are
serving, directors have full power over the activities of the corporation.
• While stockholders elect the directors, after doing so the stockholders have no
legal say in how the company is run.
Grimes v. Donald
• This case involves employment agreements by which Donald was to
run the company free from the interference of the board. If the board
did interfere, Donald could claim a constructive termination of his
contract which would give him substantial financial benefits.
• Grimes, a shareholder, claimed that the contract was an abdication of
the board’s duty to manage.
• The case addresses the substantive issue and then goes on to discuss
the differences between a direct and a derivative suit.
Derivative Litigation
• distinction between derivative suits, brought in the interest of a
corporation, and direct suits to vindicate a shareholder’s individual
rights.
• The distinction is not always evident but there are significant consequences
depending on which way a court rules.
Tooley v. DLJ
• The case involved a contractual arrangement where the controlling
shareholder was going to exchange its shares with Credit Suisse for a
combination of stock and cash. CS was then going to acquire the
remaining shares of DLJ through a tender offer and then merge DLJ
into a CS subsidiary.
The transaction was delayed due to two contractually permitted
extensions and plaintiffs, DLJ shareholders, brought a direct class action
claiming DLJ’s board had breached fiduciary duties by delaying the
transaction, thereby harming them to the extent of the time value of
the delayed consideration.
Tooley, cont.
• On the substantive matter, the court upheld the Chancery Court’s granting
of defendant’s motion to dismiss.
• However, it stated that Chancery had undertaken an improper analysis
(using applications of what the Supreme Court recognized as its own
“erroneous” jurisprudence) to resolve the direct/derivative dichotomy.
• The SC therefore went on to set out the new method to be used to answer
such questions. “That issue must turn solely on the following questions:
(1) Who suffered the alleged harm (the corporation or the suing
stockholders, individually); and
(2) who would receive the benefit of any recovery or other remedy (the
corporation or the stockholders, individually)?”
Derivative vs. Direct Suits
Derivative Suit
• lawsuit filed by a shareholder on behalf of the corporation itself, alleging that
corporate management has harmed the company.
• shareholder acts as a representative of the corporation to recover damages
for the company
• often have stricter procedural requirements than direct suits, such as a
demand to the board of directors to take action before filing a lawsuit, as the
shareholder is essentially trying to "step into the shoes" of the corporation.
Direct Suit
• lawsuit filed by a shareholder to address a personal injury or claim against the
corporation, seeking damages directly to the shareholder, not the company as
a whole.
• shareholder seeks compensation for their own personal losses.
The Fiduciary Duties of Directors
The Duty of Care - Kamin v. American
Express Company
• As an investment, American Express acquired, in 1973, shares of DLJ, a publicly traded
corporation, at a total cost of $29.9 million. The market value of those shares had dropped by the
time of the litigation, to approximately $4 million.
• The Amex Board then declared a special dividend pursuant to which its shares of DLJ would be
distributed in kind to Amex shareholders.
• Plaintiffs contend that if Amex were to sell the DLJ shares on the market, it would sustain a capital
loss of $25 million, which could be used as an offset against its taxable capital gains on other
investments. Such a sale would result in tax savings for the company of approximately $8 million
to go along with the amount received in the sale of the shares. The failure of the board to do
so was a breach of its duty of care.
Kamin, cont.
Holding:
• Courts will not interfere in corporate decision-making except in
extraordinary circumstances.
• Mere errors of judgment are not sufficient to allow judicial intervention.
• The question
of whether a dividend is to be declared and, if so, how it is to be paid, are
exclusively matters of business judgment for the Board of Directors.
• A complaint that merely alleges that some course of action other than that
pursued by the Board of Directors would have been better gives rise to no
cognizable cause of action.
Business Judgment Rule
• The standard of care appears to be that if the board engages in
reasonable consideration of its options and takes action that it
reasonably believes is in the best interests of the company, its
decisions will be upheld by the business judgment rule.
• It looks much like a negligence standard.
• With boards, however, errors of judgment are not typically penalized
by the courts. Instead, the courts give even greater deference to
boards than to others.
• They seem to require, essentially, gross negligence (whatever that is)
before finding a breach of duty.
In re Caremark International, Inc.
Derivative Litigation
• This case arises on a motion to approve a proposed settlement of a
derivative suit.
• Caremark had a variety of businesses in the health services field. It
received a good deal of its income from government reimbursements.
• A federal law prohibited making payments to Drs. For referrals of patients
covered by federal insurance. Caremark had various payment agreements
with doctors who did refer such patients.
• While Caremark believed that its actions were legal, it realized that the
payments raised questions about whether they violated the prohibition.
Investigations into these practices began and resulted in indictments and a
plea bargain involving large payments by Caremark.
• Thereafter, plaintiffs sued claiming that these losses resulted from the
directors’ lack of monitoring Caremark’s operations.
Caremark, cont.
• While prior case law seems to state that directors have no duty to act absent
suspicion of wrongdoing and have no obligation to install a system to “ferret out
wrongdoing,” the court clarified the situation.
• Directors do have a duty to ensure that appropriate corporate monitoring and
reporting systems are established and maintained.
• What those systems look like is for the board to decide and its decision would
normally be protected under the business judgment rule.
• Here, the Caremark board had already established a set of procedures and a
functioning committee to oversee compliance.
• Concerning the liability of Caremark directors’, there is no evidence that they knew of
any violations of law and the board appeared to have been generally well-informed
and it reasonably relied on various reports. There is no evidence that the directors
neglected their oversight function.
Caremark, cont.
• question is how can a board, made up of approximately 12 people who meet 1012 times per year for 3 hours per meeting be cognizant of what is happening in a
company with 50,000 employees in 300 offices in 25 countries. This raises the
question of what directors actually can do in today’s decentralized, multinational
public companies.
• requirement of a monitoring system. The court makes clear its position that one
size need not fit all and that it gives boards the authority to fashion a system to fit
the needs of its company. Thus, very different looking systems can be approved
by various boards and accepted by the courts.
• If the board has put in place a system after due deliberations and, nevertheless,
wrongdoing occurs, it will not be liable if the members did not have actual
knowledge of the wrongdoing. Their decision as to monitoring system will be
protected by BJR and the system will protect them.
Stone v. Ritter (p.155)
• Plaintiffs (Stone) bring a derivative suit against directors of AmSouth
in which they claimed demand was excused.
• AS ran a bank that held trust accounts for two individuals who had
run a Ponzi scheme for which they were eventually indicted and pled
guilty.
• AS was then fined and paid civil penalties for failure properly to
monitor and report suspicious banking activities in connection with
the scheme.
• AS did have in place a compliance system for these kinds of activities,
and no director was charged with knowing (or constructive
knowledge) of the actual wrongful activities.
Stone, cont.
• The plaintiffs have not pled facts sufficient to excuse demand.
• More importantly, the court approves the Chancery Court’s holding in Caremark.
• However, the court discusses the issue of good faith rather than due care.
• Given the monitoring system that was in place, the court, quoting its decision in
Disney, says liability could arise only when there is a failure of good faith.
• A failure to act in good faith may be shown, for instance, where the fiduciary
intentionally acts with a purpose other than that of advancing the best interests
of the corporation, where the fiduciary acts with the intent to violate applicable
positive law, or where the fiduciary intentionally fails to act in the face of a known
duty to act, demonstrating a conscious disregard for his duties.
• The case develops more fully the holding in Caremark. It approves of Caremark’s
standard concerning the board’s obligation to monitor. “only a sustained or
systematic failure of the board to exercise oversight — such as an utter failure to
attempt to assure a reasonable information and reporting system exists — will
establish the lack of good faith that is a necessary condition to liability.”
Marchand v. Barnhill
• Blue Bell Creameries is a manufacturer of ice cream and has production plants in
several states.
• The company suffered a listeria outbreak which required the company to shut
down its plants, lay off about a third of its workforce, and recall all its products.
• This resulted in a large loss for Blue Bell and led to a Caremark claim against,
among others, Blue Bell’s board. The suit is based on the board’s failure to have in
place a system to monitor food safety at Blue Bell’s plants.
• Plaintiffs claimed that this failure continued in the face of the federal and several
state food safety agencies pointing out significant health risks based on Blue Bell’s
operations. Management was aware of these repeated warnings but, apparently,
never informed the board of the risks identified based on various government
inspections.
• Minutes of board meetings reveal no specific discussions of food safety and only
very limited discussion of company operations at all.
Marchand, cont.
• The Supreme Court reversed Chancery’s dismissal of the Caremark
claim. It found that the board had set up no committee to monitor
food safety, a critical element of Blue Bell’s business, nor made any
attempt to develop a system to monitor food safety.
• The court rejected defendants’ argument that the heavy federal and
state regulatory regimes applicable to Blue Bell, and with which
largely complied, were an adequate substitute for a monitoring
system.
• The absence of a system would be a breach of good faith and,
therefore, a breach of loyalty.
Marchand, cont.
• This case is in line with Caremark and Stone. Here, “red” and “yellow”
flags were raised to management, yet the board took no action to
create or implement a monitoring system concerning an issue, food
safety, that was central to Blue Bell’s wellbeing.
Duty of Loyalty
• It requires, as a general matter, that whenever the interests of a
fiduciary come into conflict with those of his or her corporation, the
fiduciary must place the corporation’s interest above his/her own.
• While the general umbrella of “corporate interests first” is the rule,
there are several subsets of its application:
1. self-dealing – avoid personal interests in transactions
2. interlocking directorates – a fiduciary in two different corporations that are
interacting with each other is accused of favoring one over the other. That is,
the fiduciary is putting one corporation’s interests over the other. The favored
corporation is often the one in which the fiduciary has a financial (or the
greater financial) stake.
3. corporate opportunity – can’t usurp corporation opportunities
Meinhard v. Salmon (p. 191)
• Salmon was negotiating with Gerry for a lease for the Hotel Bristol. At the
same time, Salmon was negotiating with Meinhard to provide capital to run
the leased property.
• A 20-year lease in Salmon’s name arose from the Gerry negotiations and a 20year joint venture arose from the negotiations with Meinhard. The venture
was very successful and with 4 months remaining on the lease, Gerry
approached Salmon, the only party he was aware of concerning the lease, with
a new leasing proposition.
• The proposition involved the same site as well as several adjoining parcels. The
new lease would also involve a much larger outlay and had the potential to last
for a much longer period.
• Salmon accepted the proposal, which was to go into effect upon the expiration
of the existing lease, for himself without telling Meinhard anything about it.
• When Meinhard discovered the new lease, he sued to obtain a share of the
new deal.
Meinhard, cont.
• joint venturers owe to each other a duty of loyalty. In this case, the
breach was not disclosing the new proposal to Meinhard.
• Gerry, Cardozo states, offered the proposal only to Salmon because
he believed Salmon held the lease alone.
• Had Gerry known of the venture, Cardozo assumes he would have
offered the deal to the venture.
• The breach of the duty, at least to disclose, results in a constructive
trust, for the benefit of Meinhard, being established for the new
undertaking.
Meinhard, cont.
• This case is more difficult than it seems. If the venture had been a
corporation, there would be little doubt that Salmon would have
taken a corporate opportunity.
• But this organization was not corporate, nor was it, in one sense, a
partnership. It was a joint venture with a fixed end date- the
expiration of the lease. The new lease was not to take effect until the
original lease, and therefore, the venture, had expired.
• Andrews’ dissent.
• He distinguishes the joint venture, with its finite termination date and limited
scope (the Bristol Hotel site), from a partnership, whose business might go on
indefinitely and on a much more expansive scale.
Bayer v. Beran (p. 200)
• Based on regulatory changes that affected its products, the Celanese
Company, a publicly traded corporation, decided for the first time to
use a radio ad campaign which would cost approximately $1 million
per year.
• The company commissioned studies and reports and decided to
sponsor a program of fine music. The CEO’s wife, Jean Tennyson, a
well-known opera singer, was consulted about the program and she
suggested several performers including herself as potential
participants. All were hired for the program.
• Plaintiffs say that the directors breached their duty of care in
adopting the music program and their duty of loyalty for hiring the
president’s wife.
Bayer, cont.
Duty of Care Claim
On the duty of care claim, the court said that had Tennyson not been involved, there would be no
issue. This would be a garden-variety BJR matter.
Since she was involved, the court needed to take a closer look at the transaction. The court found
that the decision to do a fine music program and to advertise on the radio was made after carefully
evaluating outside studies, the amount to be spent was reasonable, and the implementation was
handled by an outside expert advertising firm. There was no breach of care.
Duty of Loyalty
• there was no breach of the duty of loyalty.
• Tennyson was a competent singer; her compensation was similar to the compensation of other
artists; and she received no more favorable billing or exposure than the other artists. The program
fulfilled its purpose – to advertise the company.
• The mere fact that Tennyson was the president’s wife does not disqualify her. It merely requires a
closer look. Here, the court said, it was unlikely that the president would spend $1,000,000 for his
wife to earn an extra $24,000.
Sinclair Oil Corp. v. Levien
• Sinclair was a holding company. It owned 97% of Sinven nominates and
controls all of Sinven’s directors. Levien was a minority shareholder of
Sinven.
• According to plaintiff, from 1960-66 Sinclair caused Sinven to pay out very
large dividends allegedly due to Sinclair’s need for cash.
• P also claimed that Sinclair failed to give Sinven various corporate
opportunities and that it caused Sinven to contract to sell oil to another
Sinclair subsidiary, International, and then caused the contracts to be
breached, to Sinven’s detriment.
• These actions, according to Levien, breached Sinclair’s (as controlling
shareholder) duty of loyalty.
Sinclair, cont.
• The first question in the case is what standard is to be used to evaluate Sinclair’s
conduct. Sinclair argued for the BJR while Levien argued for intrinsic fairness.
• The Court stated that the business judgment rule does not apply to a situation
where a parent is on both sides of a transaction with its subsidiary and appears to
have benefitted to the detriment of the subsidiary’s minority stockholders. In that
situation, transactions will be analyzed for intrinsic fairness.
• The Court then found that the dividends were not self-dealing because Levien and
the other shareholders received the same pro rata benefit from the dividend as
Sinclair. Similarly, plaintiff failed to show that any business opportunities had come
to Sinven that Sinclair had usurped. Sinclair, itself, was entitled to apportion
opportunities that came to it according to its business judgment.
• On the other hand, the contract between Sinven and International was self-dealing
and subject to the intrinsic fairness test because Sinclair caused Intl. (which was
wholly owned by Sinclair) to breach the contract to the detriment of Sinven.
Corporate Opportunity Cases
• The corporate opportunity doctrine, a key aspect of fiduciary duty, prevents directors,
officers, and controlling shareholders from seizing business opportunities that rightfully
belong to the corporation for their own benefit, requiring them to first disclose and
tender such opportunities to the company.
Key Principles of the Corporate Opportunity Doctrine:
Fiduciary Duty:
The doctrine stems from the fiduciary duty of loyalty, which requires those in positions of
trust to act in the best interests of the company.
Opportunity Belonging to the Corporation:
The doctrine applies when a business opportunity is within the corporation's line of
business, and the corporation has an interest or expectancy in it.
Disclosure and Tender:
Fiduciaries must first disclose and tender any such opportunity to the corporation before
pursuing it for their own benefit.
Broz v. Cellular Information Systems,
Inc. (p. 234)
• Broz was the president and sole owner of RFB Cellular and was also a director of CIS.
A licensing opportunity was presented to Broz as a fiduciary of RFBC while CIS was
specifically not offered the opportunity.
• The offeror did not know of Broz’ relationship with CIS. PriCellular, another mobile
phone operator, was in the process of acquiring CIS and was also interested in
obtaining the opportunity that had been offered to Broz.
• When Broz received the offer, he spoke individually with CIS directors and executives
about their interest in it and they all said they were not interested in it. He did not,
however, formally present the opportunity to the full CIS board.
• PriCellular was close to consummating its purchase of CIS and it was actively bidding
for the purchase of the offered license. PriCellular and Mackinac agreed to a
revocable option for PriCellular to buy the license, but Broz outbid PriCellular and
was able to purchase the license for RFBC.
• Nine days later, PriCellular completed its deal to buy CIS which it then caused to sue
Broz.
Broz, cont.
• The Court held that Broz did not usurp a corporate opportunity. The Court
reasoned that Broz became aware of the Michigan-2 opportunity in his
individual capacity. CIS was not financially capable of buying the license (it
was bound by contractual restrictions based on its emerging from
bankruptcy) and CIS did not have an expectancy in the license (they were, in
fact, divesting licenses they held).
• As to Broz’ failure to present the license to the CIS board-that would be
required only if the offer had been a corporate opportunity. Since it was not,
there was no requirement of presentation.
• As to the PriCellular interest, Broz was not under a duty to consider its
interests because its acquisition was speculative. In fact, the closing of its
purchase had been delayed because PriCellular’s financing had fallen through
and it had to resort to junk bond financing.
Energy Resources Corp., Inc. v. Porter
(p. 244)
• Porter was VP and chief scientist at ERCO. He went to a conference in DC to
deliver a paper and while there, he met with two colleagues from Howard
University. That meeting led to the Howard professors proposing a joint
project by Howard and ERCO be submitted to the Department of Energy for
funding.
• This was done but, later, the Howard professors expressed concern that
ERCO might try to claim the enterprise as its own and suggested that
Porter form his own company to take the place of ERCO in the project.
• Porter then formed EEE which replaced ERCO in the DOE project. Porter
continued to work at ERCO but cut himself off from the DOE project. He
told the ERCO execs that ERCO was not going to get the DOE grant.
• When Howard got the grant, Porter resigned from ERCO (although he
stayed on as a paid consultant for a period of time).
Porter, cont.
• Porter usurped a corporate opportunity.
• He claimed that the Howard project stopped being a corporate
opportunity for ERCO when Howard refused to deal with ERCO.
• The problem with the defense is that Porter never afforded ERCO the
chance to convince Howard to change its mind or to offer Howard better
terms or for ERCO to create a joint venture with Porter. Porter kept
everything a secret.
Brown (concurring): It appears that the advice given by counsel was either
unwise or of questionable competence, or both, especially if one has in
mind that the client has stated on the record that "I knew I was in a ticklish
position, [and] sought advice of counsel." When lawyers have the
opportunity to keep their clients at least at the moral level of the
marketplace, they have a public duty to avail themselves of it.
Compensation and Waste
Compensation
There is a conflict of interest when the board passes on its own
compensation or on that of senior executives, many of whom may be
on the board.
Waste
a decision by the board that is beyond one that a reasonable person
could have reached. It transfers corporate assets or services for a
grossly inadequate consideration or purchases goods or services at an
excessive price. As such, it is outside of BJR protection.
Lewis v. Vogelstein (p. 250)
• Mattel shareholders approved a stock option compensation plan for
the company’s directors. The Plan makes a one-time grant of 15,000
options to each director and gives them subsequent grants each year
they are re-elected.
• Plaintiffs challenge the plan on two grounds.
• First, that the proxy statement was misleading because it did not include an
estimated present value of the options, and
• second that the option grants are excessive compensation and constitute a
waste of corporate assets.
Lewis, cont.
• There is no duty to include an estimate of the present value of the options,
but the grants could be a waste of corporate assets.
• As to the duty to disclose, first, there are special problems associated with
“soft information” like valuation estimates. None of the numerous
valuation models is exact.
• Further, while it may be good corporate policy to make such disclosures,
that policy does not translate into a fiduciary duty. The disclosure duty is
satisfied by disclosing all relevant terms and conditions and any extrinsic
facts bearing on the issue. If a more detailed disclosure is desirable, it
should be left to the experts at the SEC.
Lewis, cont.
• On the issue of waste, the court restates the waste standard–a grant
of corporate assets for a consideration that is so small as to be such
that no reasonable board could have approved the transaction.
• Delaware had historically imposed an intermediate scrutiny test for
Exec. Compensation; was there sufficient consideration and was it
likely that the consideration running to the corporation would be
received.
• That test gave way to a test designed to determine whether a
reasonable, disinterested board could have adopted a particular
compensation plan. If so, that adoption was entitled to BJR
protection. If not, the adoption is waste.
Sanders v. Wang (p. 262)
• The CA board adopted a key employee stock ownership plan (KESOP)
and the shareholders ratified it at their annual meeting in 1995. It
authorized the compensation committee to grant up to 6 million shares
to employees, but did not allow the committee to adjust the number to
account for splits or other transactions.
• In 1998, after several splits and stock dividends, the committee granted
more options than had been authorized. The total shares granted was
alleged to be equal to the 6 million but adjusted for the stock splits
• Defendants claim the committee had discretion in administering the
KESOP and could exceed the grant limit to account for the splits.
Sanders, cont.
• On a preliminary matter, no demand on the board was necessary in this
derivative suit because the grant of options beyond the plan limit raises a
reasonable doubt that the transaction was a valid exercise of business
judgment.
• The board violated an express KESOP provision. The terms of the plan are
clear and unambiguous and could not lead to the conclusion that the board
had the authority to award the excess shares.
• There is no provision in this agreement (although there had been such
provisions in other plans adopted by this board) permitting stock splits to
be reflected when making the grants.
• This creates a prima facie case of breach of duty or waste. The nature of
the breach and the remedy must await trial.
Demand Refusal, Demand Excused and
Special Committees in Derivative
Litigation
This section brings us back to derivative suits. We have previously
discussed the difference between a direct and a derivative suit. This
section assumes suits are derivative and looks at one of the rules
concerning them, the requirement (or excuse) of demand.
Marx v. Akers (p. 276) – Demand
Refusal
• Plaintiffs allege that IBM’s board awarded excessive compensation to
its directors and executives, three of whom were directors. Plaintiffs
did not make a demand on the board.
• The trial court dismissed the case because plaintiffs did not establish
demand futility and the Appellate court affirmed.
Marx, cont.
New York has a demand requirement for derivative cases. The purpose
is to discourage strike suits - “[a] suit (esp[ecially] a derivative action),
often based on no valid claim, brought either for nuisance value or as
leverage to obtain a favorable or inflated settlement.
• It also allows boards to get rid of cases that have no merit-to correct
abuses before cases get to court.
• To prove demand futility, plaintiffs must allege particularized facts
that shows the board was not independent (or that apparently
independent directors were dominated); that the board was not fully
informed about the decision; or that the transaction was not a valid
exercise of business judgment. These are separate inquiries.
Marx, cont.
• As to plaintiffs’ two claims, the court said demand was not excused as to the
compensation of the executives (even though three were directors).
• Since only three of the 18 directors are inside directors, approval of their
compensation was not an interested party transaction. The complaint has no
particularized facts about a lack of information or process.
• On the other hand, demand was excused for the part of the complaint pertaining
to compensation for the outside directors because 15 of the 18 directors are
outside directors. This does constitute an interested party transaction.
• However, the Court held that the plaintiff had not stated a cause of action
regarding director compensation. New York law allows directors to set their own
compensation and the allegation that the compensation is excessive is just
conclusory. Particularized facts, not conclusions, need to be included in the
complaint.
How derivative suits are fashioned
and the procedure to institute them
1. Pre-Suit Demand:
Requirement:
Before filing a derivative suit, a shareholder must generally make a "pre-suit demand" on the corporation's board of directors, outlining the complaint and the alleged wrongdoing.
Content:
The demand should clearly explain the specific issues and why the shareholder believes the board has breached its fiduciary duty or harmed the company.
Board's Response:
The board then has a period of time to consider the demand and decide whether to take action, potentially including filing a lawsuit against the wrongdoers.
Demand Futility:
A shareholder may be excused from making a demand if they can demonstrate that a demand would be futile, meaning the board is unlikely to take appropriate action.
2. Filing the Lawsuit (If Demand is Refused or Excused):
Filing:
If the board refuses to take action or if a demand is deemed futile, the shareholder can then file a derivative suit on behalf of the corporation.
Standing:
The shareholder must have owned stock in the company at the time of the alleged wrongdoing to have standing to sue.
Representation:
The shareholder must represent the interests of the corporation and all shareholders, not just their own.
Notice:
The shareholder must provide notice to other shareholders, allowing them to join the suit.
Derivative Suit Procedure
3. Board's Response and Special Litigation Committees (SLCs):
Board's Investigation:
The board may investigate the claims and potentially form a Special Litigation Committee (SLC) to investigate the matter.
SLC's Role:
The SLC, composed of independent directors, can then make a recommendation to the board on whether to pursue or dismiss the lawsuit.
Dismissal:
If the SLC recommends dismissal and makes a required showing, the case may be dismissed.
4. Litigation:
Normal Civil Action:
Once the lawsuit is filed, it proceeds like any other civil action.
Shareholder's Role:
The shareholder, acting on behalf of the corporation, presents the corporation's case, arguing that the board acted improperly.
Management's Response:
The management will respond by arguing that their actions were proper or protected by the business judgment rule.
Remedies:
If successful, the shareholder derivative suit will result in damages or other remedies being awarded to the corporation, not the individual
shareholder.
The Position of Minority Shareholders
in Closely Held Corporations
• Minority shareholders in CHCs are in a difficult position. They have no
simple exit strategy and are often subject to the whims of the majority
shareholder(s).
• litany of difficulties for a minority shareholder: a lack of ability to elect directors or to
influence corporate decision making; a large degree of personal wealth invested; a
lack of an exit strategy; a lack of control over financial accoutrements.
• While fiduciary duties apply in CHCs, the cost of litigation and difficulty of
proving breach of duty make shareholder suits a generally inefficient
remedy.
• This section will look at ways minorities can protect themselves, the duties
that shareholders have to each other in CHCs, the rights they have, and the
judicial remedies for violations of those rights.
Shareholder Voting and Control
• Cumulative voting is a type of voting system that helps strengthen the
ability of minority shareholders to elect a director. This method allows
shareholders to cast all of their votes for a single nominee for the board of
directors when the company has multiple openings on its board.
• In contrast, in "regular" or "statutory" voting, shareholders may not give
more than one vote per share to any single nominee.
• Ex. - if the election is for four directors and you hold 500 shares (with one
vote per share), under the regular method you could vote a maximum of
500 shares for each one candidate (giving you 2,000 votes total—500 votes
per each of the four candidates). With cumulative voting, you are afforded
the 2,000 votes from the start and could choose to vote all 2,000 votes for
one candidate, 1,000 each to two candidates, or otherwise divide your
votes whichever way you wanted.
Proxies
• A proxy vote is a ballot cast by one person or firm for a company's
shareholder who can't attend a meeting, or who doesn't want to vote
on an issue.
• Prior to a company's annual meeting, eligible shareholders may
receive voting and proxy information before a shareholder vote.
• Rather than physically attending the shareholder meeting, investors
may elect someone else to vote in their place.
• A person designated as a proxy will cast a proxy vote in line with the
shareholder's directions as written on their proxy card.
Articles of Incorporation
• Articles of incorporation is the documents filed with a government
body (usually the state) that signifies the creation of a corporation.
• In the U.S., articles of incorporation are filed with the Office of the
Secretary of State where the business chooses to incorporate.
• Broadly speaking, articles of incorporation include the company's
name, type of corporate structure, and number and type of
authorized shares.
• While the articles of incorporation are used almost exclusively outside
of the company, other documents such as bylaws, operating
agreements, or business plans are more useful internally.
Corporate Bylaws
• Bylaws are the rules that govern how a company is run and one of the
first items to be established by the board of directors at the time a
company is started.
• The bylaws need not be filed with the state agency. They are used
within the company as a guide for efficient operations.
• Drafting the bylaws is often considered the board of directors’ first
action as a business entity. Company bylaws are more detailed, as
compared to the Articles of Incorporation.
Components of Corporate Bylaws
1. The Board of Directors
The bylaws should contain information on the board of directors, as it is the governing
body of the organization, including its duties and powers. The information specifies things
like the number of years a member can stay on the board and the number of members
needed to form a quorum. The bylaws also define the procedure to be followed when
replacing a member or a corporate officer.
2. Statement of the company’s purpose
The statement of the company’s purpose is helpful, especially for the board of
directors, because it sets the path that the company should tread. It identifies why
the company was formed in the first place. With such a statement, even a change
in leadership should not affect the nature of the company’s operations because its
objectives have already been identified. It may also be helpful in attracting
investors because they will be able to easily understand what the company is about
just by looking at the bylaws.
Components of Corporate Bylaws
3. Management structure
Change in management is inevitable in every organization, but its management structure is already defined in the bylaws. They also
make clear the procedure for filling a higher vacant position in a way that will not disrupt the company’s leadership.
4. Information about the company
One of the most basic parts of the bylaws is the identifying information of the company. This includes such things as its registered
name and address, and whether it is a private or a public company.
5. Shareholder and board meetings
The bylaws should indicate when shareholder meetings are held and how each shareholder is to be notified of these meetings. Also
indicated should be how often and where board meetings are to be held.
6. Call for other meetings
The bylaws set the rules on how meetings are called and scheduled, as well as how they should be conducted. This provides a way for
the board to remain updated on the company’s status and to address issues that concern the organization.
7. Contract and loan approvals
The company should also put in place a set of rules for approving contracts and loans and other processes that the company may
engage in.
Example - Michigan Corporate Bylaws
https://www.northwestregisteredagent.com/corporation/michigan/byl
aws
Shareholders Agreements
• Optional Document
• A shareholders' agreement, also called a stockholders' agreement, is an
arrangement among shareholders that describes how a company should be
operated and outlines shareholders' rights and obligations.
• The agreement also includes information on the management of the
company and privileges and protection of shareholders.
• The shareholders' agreement is intended to make sure that shareholders
are treated fairly and that their rights are protected.
• It also allows shareholders to make decisions about what outside parties
may become future shareholders and provides safeguards for minority
positions.
Ringling Bros.-Barnum & Bailey
Combined Shows, Inc. v. Ringling (p.
384)
• Edith Ringling and Audrey Haley each held 315 shares of the company
and John North held 370 shares. Elections were governed by
cumulative voting.
• There was a shareholders agreement in place between the Ringlings
and the Haleys that required the parties to meet to discuss how to
vote and, if they couldn’t agree, to submit the issues to a designated
arbitrator.
• Prior to a shareholders meeting to elect directors, the parties could
not agree on a slate and the arbitrator ruled in favor of the Ringling
slate. Haley refused to vote as the arbitrator decided.
Ringling Brothers, cont.
• The agreement was upheld, and the court found that the Haleys had
breached it.
• The agreement, however, did not empower the arbitrator to vote the
parties’ shares.
• The remedy the court granted, contrary to the Ringling’s wishes, was
that Haley’s shares should not be counted in the voting.
Lehrman v. Cohen (p. 391)
• The Lehrmans and Cohens each owned 50% of Giant Foods. Disputes arose
between the two families.
• To help avoid deadlocks, the families amended the articles to create a new
class of stock, AD, entitled to elect a fifth director. The articles declared
that the AD stock would not participate in dividends or in liquidation
(beyond its $10 par value).
• The Cohens and the AD stock then elected Danzansky, the AD shareholder,
president of the company.
• Lehrman claims the creation of the AD stock was illegal (as an
impermissible voting trust) and that the election of Danzansky as president
violates the deadlock-breaking agreement.
Lehrman, cont.
• The creation of the AD stock was not the creation of a voting trust. There is
no separation of voting rights from other attributes of the stock.
• While the creation of additional shares will dilute the voting rights of
existing shares, that is not the same thing as a voting trust. The Cohens and
Lehrmans maintained complete control over voting their classes of stock.
• It is not illegal to have stock that has no property interest in the company.
The statute allows the shareholders great latitude in creating a capital
structure and this was done through the Articles of Incorporation.
• Finally, the deadlock-breaking agreement is not illegal because there is no
policy against a stockholder agreement concerning deadlocks. This was not
a delegation of directorial duty, but of stockholder voting.
Ramos v. Estrada (p. 407)
• Ramos owned 50% of Broadcast Corp. (BC) and the other 50% was sold in 10% increments to
5 other couples, one of whom was the Estradas.
• BC merged with Ventura 41, and became Television Inc. Each company was to own half of the
new company’s shares, with BC having the right to elect 5 of the 9 directors.
• Under a shareholder agreement, the BC group shareholders were required to consult with
each other concerning the election of directors. If a consensus couldn’t be reached, each
shareholder was required to vote for the directors upon whom a majority had agreed. Failure
to honor the agreement constituted an election by the defecting shareholder to sell his/her
shares to the others at a formulaic price which was well below market.
• Ramos was elected president and Estrada was elected as a director. In 1988 at a directors
meeting, Tila Estrada voted with the Ventura 41 directors to remove Ramos as president and
replace him with a Ventura 41 member.
• A week after the directors meeting, the BC group met but the Estradas failed to attend
despite receiving notice of the meeting. The BC group decided to elect a slate of directors
that did not include the Estradas. The Estradas then unilaterally declared the shareholder
agreement null and void.
Ramos, cont.
• The court held that the Estradas’ cancellation letter constituted a breach of
the agreement, and thus, an election to sell their shares.
• The court stated that the agreement was a valid shareholder voting
agreement that was binding on the Estradas.
• Further, the forced sale provisions are not unconscionable or oppressive
because Tila Estrada is an experienced businesswoman who understood
the term and the agreement was not procured by wrongful conduct.
• The agreement was unanimously adopted by the shareholders after a full
and fair opportunity to consider it.
• The Estradas violated the agreement, fully aware of the consequences of
their actions.
Rosiny v. Schmidt (p. 413)
• A series of shareholder agreements, some of which were drafted by or included Edward
Rosiny, the father of the plaintiffs.
• The original agreement was made between Rosiny Sr., McGuire, and Schmidt and contained
a right of first refusal for the transfer of shares with a purchase price of either their book
value (in one iteration it was market value) or $200 a share, whichever is greater.
• The 1981 agreement in question here was identical to the original agreement with the
exception of the named parties. The current parties were Rosiny’s sons, Ms. Priddy,
(Schmidt’s widow) and McGuire.
• The Rosiny sons obtained their shares from their mother which transfer was initiated by
Kwalwasser, the company’s accountant and manager (as well as a family friend of the
Rosinys). The transfer did not comply with the shareholders agreement then in effect. There
had been several interim transfers of shares that also did not comply with the agreement
although all the shareholders knew of and approved the interim transfers.
• Upon the death of Priddy and McGuire, the Rosiny’s seek to enforce the agreement at the
contract price of $200 per share while the market value was significantly higher.
Rosiny, cont.
• The Court upheld the agreement.
• The decedents had not been deceived despite the $200 per share buyout
provision being far from their true value. The decedents owned 50% of the
company and could have sought to sell corporate assets or dissolve the
corporation, thus terminating the agreement, but they did not, despite
having professional assistance.
• The decedents had meaningful choice about signing the current
agreement. There had been three similar previous agreements which they
had signed over 25 years.
• While shareholders in a close corporation owe a duty of good faith to one
another, there is no requirement that they explain shareholder agreements
to each other.
Rosiny, cont.
Dissent: This agreement became grossly one-sided when the Rosiny sons replaced
their mother as shareholders.
• The original agreement and two of the amendments had signatories of
approximately the same age and the risks of the agreement were spread evenly
among them. When the sons were added, the risks fell very heavily on Priddy and
McGuire due to the great disparity in age between them and the sons.
• The sons were then able to purchase their shares at $200 a share rather than
their market value (more than $40,000 a share). The history of amendment
suggested to defendants that the buyout provisions had been effectively
modified.
• Moreover, there was no clear understanding by defendants of the meaning of
“book value” while plaintiffs clearly understood it and understood that the
defendants had a different understanding of the term and of the contract.
• Equity demands that plaintiffs have clean hands, and, in these circumstances, it is
up to them to show it.
Shareholders’ Ability to Bind Directors
• Shareholders can bind themselves to act in certain ways concerning
decisions within their authority.
• In a close corporation, when the shareholders are also the directors,
to what extent can they, as shareholders, bind director action.
• Theoretically, they should not be able to do so since shareholders and
directors have, in the abstract, different interests to protect.
• This may be less the case in CHCs. Over time, the courts (and
legislatures) have recognized the unique situation of CHCs and
modified some of the traditional corporate rules to accommodate the
differences.
McQuade v. Stoneham (p. 426)
• Stoneham was the majority stockholder in baseball’s New York Giants.
McQuade and McGraw each purchased 70 of Stoneham’s 1,306
shares.
• They entered into a shareholders agreement in which they agreed to
use their best efforts to elect each other as directors and to appoint
each to a specified corporate position at a specified salary.
• Stoneham was president, McGraw VP, and McQuade treasurer.
McQuade remained treasurer for 9 years until, after a falling out with
Stoneham, he was replaced.
• In apparent violation of the agreement, Stoneham caused Bondy to
be elected to succeed McQuade.
McQuade, cont.
• Shareholders cannot act to control directors in the exercise of their
independent business judgment and directors cannot abrogate their
judgment because of agreements entered into as shareholders.
• Since the contract precludes the board from changing officers,
salaries, or policies except by consent of the contracting parties, the
contract is void.
• Further, McQuade was a city magistrate at the time of the contract
and the law prevents magistrates from engaging in other professions
at the same time.
McQuade, cont.
Concurring: Judge Lehman argues that the reality of closely held corporations with
a majority shareholder is that the directors are subject to election by that majority.
• If the directors displease the majority shareholder, those directors will be
replaced. Thus, the directors have an incentive to satisfy the majority interests.
What can be done by an individual can be done by a group acting in concert.
• Thus, the reality is that shareholders often do informally control directors’ action.
We should recognize that reality.
• Here, no one argued that McQuade was incompetent or was harming the
corporation. There are no shareholders complaining about these provisions.
• The removal of McQuade was the result of personal issues, not corporate ones.
• However, because McQuade was a city magistrate and the stature prohibited
magistrates from engaging in any other business, the judgment should be upheld.
McQuade, cont.
• This case sets the classical baseline of director independence and
shareholder incapacity to bind their decisions.
• Of course as Judge Lehman intimates, shareholders in closely held
corporations do this all the time.
• In closely held corporations, the directors and shareholders are often the
same people. The lines between their functions blurs and informality
reigns.
• Subsequent cases say things like CHCs are just incorporated partnerships.
• Furthermore, CHC statutes today often provide for the possibility of
limiting board authority or of eliminating the existence of the board itself.
Clark v. Dodge (p. 433)
• Clark owns 25% and Dodge 75% of two companies that make
pharmaceuticals using a secret formula. Dodge was not active in the
business.
• Clark was the manager, and he alone knew the secret formula.
• Clark and Dodge enter an agreement stating that Clark was to remain
the manager as long as he was “faithful, efficient and competent.” He
was to receive 1/4 of the profits and no unreasonable salaries were to
be paid to others so as to materially reduce the profits.
• Clark was to share the formula with Dodge’s son. He does so but
eventually is ousted.
Clark, cont.
• The agreement is valid.
• A contract should not be held illegal if its enforcement does not injure
anyone. Further, where the directors are the sole shareholders and they all
enter into the agreement, and the creditors and public are not harmed,
there is no reason not to enforce such an agreement.
• Here, Clark was to serve while faithful, efficient, and competent. No
unreasonable salaries were to be paid to anyone and Clark was to receive
1/4 of the profits.
• As to this latter point, the court read this to mean those profits after all
expenses and reasonable reserves were paid or set aside.
• Given these provisions, any invasion of the directors’ powers was
negligible.
Shift from McQuade to Clark
• burgeoning recognition of how closely held corporations work,
together with the lack of harm to the public or to creditors due to the
agreement.
• This latter is assured, in part, by the circumscribed provisions; faithful
efficient and competent, no unreasonable salaries, and the court’s
limitation on distribution of profits.
• This case represents a significant move from McQuade. Shareholders
now, under certain circumstances, can ind the action of directors.
Fiduciary Duties of Shareholders in
CHCs
Just as shareholders in CHCs, due to their unique position in the
corporate world, have some right to bind directors, they also have
some duties to each other distinct from any duties that shareholders
might have in publicly traded corporations (which tend to apply only to
controlling shareholders).
In all corporations - the one word answer to the question “what is the
role of shareholder in running a corporation” is “vote.”
Fiduciary Duties of Majority and Minority
Shareholders in Corporations
• Fiduciary duties can also apply to any person or entity that has the ability
to direct the affairs of the company, such as a majority shareholder.
• Most of the time, when talking about fiduciary duty to the company, it
means what is in the best interests of the shareholders and usually that
means the majority shareholder, if there is one.
• In a privately held company with only a few shareholders, it may be easier
to identify the majority shareholder and act accordingly.
• Many companies only have one owner, so there is no distinction between
the company and the shareholder.
• However, in other companies, including those with outside investors or a
lot of smaller investors, there is no clear majority owner.
Fiduciary Duties of Majority Shareholders
• Majority shareholders in a corporation are those who own more than
50% of the shares in the corporation.
• Because of their voting power, they have significant control over the
corporation’s operations and policies.
• majority shareholders have a fiduciary duty to the corporation and
the minority shareholders.
• Sometimes the fiduciary duty is expanded to creditors if the company
is in financial trouble.
Fiduciary Duties of Majority Shareholders
• This duty requires that majority shareholders act in the best interests
of the corporation and consider the interests of minority
shareholders, though this does not mean that they cannot act in their
own best interests.
• This includes refraining from engaging in self-dealing or using their
position to unfairly advantage themselves.
• Majority shareholders should also be careful about taking any action
that would harm the corporation, such as making decisions that
would reduce the value of the shares held by the minority
shareholders compared to the value of the majority shareholder.
Fiduciary Duties of Majority Shareholders
• One common situation where the duty of loyalty is implicated is in
transactions between the corporation and a controlling shareholder.
• Such transactions are subject to heightened scrutiny by the courts. The
controlling shareholder must show that the transaction was entirely fair to the
corporation and its minority shareholders, and that the terms of the
transaction were negotiated in good faith. Majority shareholders may be able
to avoid this issue by having independent board members or the minority
shareholders approve the related party transaction.
• Another common situation is when the majority shareholder wants to sell the
business and the minority shareholders may disagree. The majority
shareholder can typically sell the business and may even be able to force the
minority owner to sell as well.
• What the majority shareholder should avoid is having the minority shareholders treated
differently from themselves in the sale.
Fiduciary Duties of Minority Shareholders
• Minority shareholders, by contrast, own less than 50% of the shares
in a corporation. They have less control over the corporation’s
operations and policies, but they still have a voice in certain decisions.
• In general, minority shareholders owe no duty to the corporation or
the majority shareholder when making their decisions.
Fiduciary Duties of Directors who are Majority
Shareholders
• In many corporations, the majority shareholder is also a member of the board of
directors and may also be an officer, such as the CEO. This can create conflicts of
interest, as the director may be tempted to use their position to benefit themselves
at the expense of the corporation and the minority shareholders.
• In addition to the duty of loyalty, directors have a duty of care and must exercise the
same level of care that a reasonably prudent person would under similar
circumstances.
• Directors who are also majority shareholders must be careful to avoid any selfdealing or other conflicts of interest. They must act in good faith, with the best
interests of the corporation and its shareholders in mind, and must disclose any
potential conflicts of interest. If a conflict of interest arises, they must recuse
themselves from any decision-making process that would be affected by the conflict.
• Even if a director isn’t the majority owner (or representing one), any director who has
an interest in a matter before the board should consider whether they can be
independent to exercise their duty of loyalty to the company. Often, boards will have
independent directors who can act when other directors have conflicts.
Fiduciary Duties of Shareholders in
CHCs
• Controlling shareholders of closely held corporations owe the other shareholders and the
company a fiduciary duty.
• A breach of this duty can lead to harsh consequences. For example, a shareholder or the
company can seek to remove a shareholder who breaches their fiduciary duty.
• The following are some of the fiduciary duties shareholders in a closely held corporation
may owe other shareholders and the corporation;
• Duty to act in good faith
• Duty to be honest
• Duty to be loyal
• Duty not to compete
• Duty of fair dealing
Fiduciary Duties of Shareholders in
CHCs
The following are some of the breaches that are common in closely
held corporations;
Paying those in control excessive compensation
Excluding a shareholder from corporate information
Not following corporate formalities in notice and holding of meetings
Denying a shareholder access to inspect records
Diversion of corporate opportunities
Physically locking out a shareholder who is an employee
When Can Shareholders Inspect Corporate
Records?
• Since informed shareholders are more likely to vote intelligently,
shareholders should have the right to inspect corporate records.
• Both common law and most corporate statutes recognize shareholders’
rights to gain information by inspecting corporate records.
• The issue in shareholder information rights is typically whether the
shareholder has a “proper purpose.”
• A proper purpose is one that is related to a role that shareholders play.
• Obtaining information about the identity of, and addresses for, other
shareholders in order to urge other shareholders to vote for Shemp for
director is a proper purpose. Obtaining the same information to urge other
shareholders to vote for a state senator is not.
When Do Shareholders Vote?
• Shareholders vote at shareholder meetings. Since typically directors are
elected each year, shareholders meet each year to vote on directors. Such
meetings are called annual meetings of shareholders.
• Additionally, shareholders might be called to a special meeting to vote on
certain corporate matters such as amendments to the articles of
incorporation, mergers, sales of substantially all of the assets, or
dissolution. These corporate actions requiring shareholder approval are
commonly referred to as “fundamental corporate changes.”
• Shareholders don’t get to decide whether to amend the articles or merge
or sell assets or dissolve. Rather, when shareholders’ vote on amendments
to the articles, mergers, sales of assets, or dissolution, they are merely
voting on whether to approve decisions made by the board of directors to
amend, to merge, to sell or to dissolve.
Galler v. Galler (p. 436)
• Brothers Ben and Isadore Galler each owned half, 110 shares each, of
Galler Drug Co.
• They each sold 6 shares to Rosenberg. The brothers then entered into
an a greement in 1955 statingthat: they and their wives would be the
4 directors of the company; that the minimum dividend would be
$50,000 provided certain financial benchmarks were met by the
corporation; that upon the death of a brother his wife will select a
replacement director; and that his estate shall receive as death
benefit a total of twice his annual salary payable monthly over five
years.
• When Ben died, Isadore reneged on the agreement.
Galler, cont.
• The agreement was valid. Shareholder voting agreements are usually upheld.
• Also, several agreements that appear to violate the letter of the Business
Corporation Act (which gives management responsibilities to directors) have still
been upheld where there is no apparent public injury, no injury to a minority
interest, and no prejudice to creditors. Here, there is no injury to a minority
interest (Rosenberg has not complained about the agreement) and no injury to
the public or creditors (dividends are to be paid only if there is a substantial
capital cushion and the salary continuation agreement is not unusual in nature or
unreasonable in amount or duration).
• There is no valid reason to hold the agreement void just because it violates the
letter of the law.
• The purpose was to provide financial security for the families, which is valid, and
the provisions here do not require invalidation.
Galler, cont.
• Galler continues the liberalizing trend of Clark.
• Here, unlike Clark, there was a minority shareholder who was not part
of the agreement, and the court did not seem to care.
• He did not complain about the agreement and there was no visible
harm to anyone.
Donahue v. Rodd Electrotype Company of New
England, Inc. (p. 445)
• Harry Rodd was the majority shareholder and Donahue’s late
husband was an employee and minority shareholder. As Harry was
phasing out of the business, he distributed some of his shares among
his children.
• In 1970, Harry’s sons wanted him to retire. They executed a plan to
allow Harry to sell 45 of his remaining shares to the corporation.
• Donahue did not learn of the transaction until a shareholders meeting
sometime thereafter. Donahue then sought to sell her shares to the
corporation for the same price as Harry but was not allowed to do so.
• Subsequently, the corporation made offers to buy Donahue’s shares
at a lower price, but Donahue refused such offers.
Donahue, cont.
• Close corporations afford majority shareholders the opportunity to
abuse and freeze-out minority shareholders.
• They are more like incorporated partnerships where the shareholders
rely on the honesty and good faith of their colleagues for the proper
functioning of the business.
• Therefore, shareholders in a CHC owe the same fiduciary duties to
each other as do partners in a partnership, that is, the utmost good
faith and loyalty. This is a higher standard than is applied to directors.
Donahue, cont.
• While a corporation is legally allowed to purchase its own shares, when it
involves purchasing the shares only of a member of the controlling group a
serious potential problem may arise. The sale creates two situations
beneficial to the controlling shareholder and not available to the minority.
• First, it creates a market for the shares where, by definition, one does not
otherwise exist.
• Second, it gives the majority access to corporate assets for personal use, a
benefit not available to the minority.
• Thus, to meet their fiduciary obligations, the majority must offer the same
opportunity to the minority. The court below may enter an order by which
the corporation must buy an equivalent number of Donahue’s shares or
order Rodd to return the money to the corporation in exchange for the
return of his stock.
Donahue, cont.
• Note that the court states in fn. 40 that the holding is not limited to
majority shareholders. There may be times where the minority can
take advantage of an “unsuspecting” majority.
• in fn. 41, the court says “this opinion governs only their actions
relative to the operations of the enterprise and the effects of that
operation on the rights and investments of other stockholders. We
express no opinion as to the standard of duty applicable to
transactions in the shares of the close corporation when the
corporation is not a party to the transaction.”
Wilkes v. Springside Nursing Home, Inc. (p.456)
• Wilkes and 3 others each own 25% of Springside. Each was a director
and employee of Springside.
• After a falling out, Wilkes was discharged as an employee and
removed as an officer and director although there was no indication
that Wilkes was performing unsatisfactorily.
• The other investors remained in place and drew salaries.
Wilkes, cont.
• While the court recognized the special duties between shareholders in closely held
corporations, it also recognized that shareholders had a right to “selfish ownership.” They
are entitled, as shareholders anywhere, to pursue their own financial interests.
• Thus, it retreated a bit from Donahue.
• The court set out a test for when a shareholder claims injury at the hands of his or her
colleagues:
• Once the harm is shown, the defendants have the opportunity to show there was a
legitimate business purpose for their actions. If they do so, the plaintiff may show that
there was a less harmful (to the claiming shareholder) alternative to the action the
majority took.
Wilkes retreats from the absolute duty of Donahue to a modulated duty that tries to
balance what the court sees as the legitimate interests of the majority. It recognizes a duty
with limitations.
• While there is still a significant duty, utmost good faith and loyalty, owed by shareholders
to each other, that duty is constrained by the concept of selfish ownership.
Sugarman v. Sugarman (p. 462)
• Leonard, the defendant, is the son of Myer and the plaintiffs are the
grandchildren of Samuel who were among the founders of the
company.
• Leonard, Myer, and Hyman, Samuel’s son and the plaintiffs’ father,
were all officers and directors. Leonard now owns 61% of the
company and Hyman’s children own 22%.
• Plaintiffs claim that Leonard breached his fiduciary duties by paying
himself excessive compensation, by paying his father (but not Hyman)
an excessive pension, by not hiring (or by firing) Hyman’s children, by
not declaring dividends, and by offering to buy plaintiffs’ stock at a
grossly inadequate price, all in an effort to freeze them out.
• The trial court found in favor of the plaintiffs.
Sugarman, cont.
• Neither overcompensation nor an offer to buy stock at an inadequate
price by themselves constitute a freeze-out, but both can be part of
freeze-out plan.
• The essential finding, according to the Court, was that Leonard took
actions that were designed to freeze plaintiffs out of the financial
benefits that they would have ordinarily received from the company.
• The offer to buy the stock at an inadequate price was the “capstone”
of the plan. The excessive compensation and pension could be
elements of corporate waste, a derivative claim, as well as a direct
claim of freeze out.
Ingle v. Glamore Motor Sales, Inc. (p. 468)
• In 1966, Ingle was an employee and then also became a minority
shareholder of Glamore Motor Sales.
• A shareholders agreement gave Glamore the right to repurchase
Ingle’s shares if Ingle ceased to be an employee for any reason.
• Ingle was also elected as a director. Ingle was then fired in 1983 and
Glamore notified him of his intent to repurchase Ingle’s shares.
Glamore then installed his sons in the business.
• Ingle claims that his status as a minority shareholder prevented him
from being fired without cause.
Ingle, cont.
• Ingle has no right not to be fired. Ingle was an at-will employee and
there is no implied obligation of good faith and fair dealing in at-will
employment.
• The fiduciary duties that exist between shareholders do not extend to
the employment context when the employment pre-dated the
shareholding and where there is an agreement to terminate the
shareholding if the employment ceases.
• Dissent: The dissent argued that this was a freeze-out of a minority shareholder
and that the shareholder has a claim for breach of fiduciary duty owed to him by
the majority shareholders. This is not a wrongful termination claim but a breach
of duty claim.
Federal Securities Laws
• The primary federal securities statutes are the Securities Act of 1933
(“33 Act”) and the Securities Exchange Act of 1934 (“34 Act”).
• Rule 10b-5 – a rule promulgated by the SEC pursuant to section 10(b)
of the 34 Act.
• Rule 10b–5 prohibits making a false or misleading statement of
material facts in connection with the purchase or sale of securities.
Starting a Corporation
• When a person contracts on behalf of a corporation that does not yet exist, it’s a pre-incorporation
contract
• Promoters
Ex. - Larry, Moe, and Curly are planning to open a barbecue restaurant as a corporation, Bubba’s
Barbecue Corp (BBC). They want to be sure that they can lease the desired space from T before incurring
the expense of forming a corporation. Accordingly, Moe signs a lease with T on behalf of BBC, a not yet
existing corporation.
(1) Moe is called a “promoter”, i.e., a person who contracts on behalf of a corporation that does
not yet exist;
(2) Promoters are personally liable on such contracts, even if they sign the contract on behalf of
the not yet existing corporation;
(3) Promoters are not agents. Recall that an agent acts on behalf of a principal. Even principled
promoters have no principals, since they are acting on behalf of a corporation that does not yet exist
(e.g., promoter can’t act as an agent of the corporation prior to incorporation);
(4) The corporation is not liable on the contract until it ratifies the contract;
(5) Promoters remain personally liable on the contracts even after the corporation is formed and ratifies
the contract. Promoters are relieved from liability only when the other party to the contract so agrees.
Promoters
• Promoters are involved in the first steps of forming corporations in
procuring commitments for capital and other instrumentalities that will be
used by the corporation after formation. Upon incorporation, promoters
owe a fiduciary duty to corporations and to those persons investing in
them.
• if a person acts on behalf of a corporation, knowing that there has been no
incorporation, the person is jointly and severally liable for any obligations
incurred.
• A promoter can avoid liability if she can establish that the other party to a
preincorporation the agreement (1) knew that the corporation did not
exist; and, (2) expressly agreed to look solely to the corporation when it
was ultimately formed for performance under the agreement.
Promoters
• A promoter’s liability on pre-incorporation agreements continues after the
corporation is formed, even if the corporation adopts the contract and
benefits from it.
• Novation The promoter’s liability can be extinguished only if there is a
novation an agreement among the parties releasing the promoter and
substituting the corporation.
• To clearly establish a novation, the third party should expressly release the promoter
after the corporation has adopted the contract.
If No Novation - When a promoter is liable on a pre-incorporation contract and the
corporation adopts the contract but no novation is agreed upon, the promoter may
have the right to indemnification from the corporation if she is subsequently held liable
on the contract.
Starting a Corporation
• Larry, Moe and Curly might also decide that they need additional
committed investors before they incur the expenses of creating a
corporation. And so they persuade Shemp to offer to buy BBC stock
when it is incorporated.
• Shemp has made an offer—not a contract. It can’t be a contract
between Shemp and the corporation—the corporation does not yet
exist. Under common law, offers are freely revocable.
• Shemp’s offer is a “subscription” - pre-incorporation subscription
offers are irrevocable for six months unless otherwise provided.
Starting a Corporation
A de jure corporation is one created as a result of compliance with all legal
requirements of the state of incorporation.
• incorporation is complete upon the issuance of the certificate of incorporation.
• A corporation must be legally incorporated before it can enter into a binding contract or transact
any business.
de facto corporation - an entity must operate with corporate characteristics, even without full
compliance with incorporation statutes, by demonstrating a good faith attempt to incorporate, a
relevant incorporation statute, and actual use of corporate powers
3 elements to form:
1.) a law under which a corporation could be formed,
2.) a bona fide attempt to form the corporation pursuant to that law - must have made a genuine
effort to comply with the incorporation requirements, even if there were some technical errors or
omission
3.) an attempt to use or exercise corporate power - The entity must operate as if it were a
corporation, engaging in activities like entering contracts, hiring employees, and acquiring property.
Starting a Corporation
Corporation by Estoppel
• a third party may be prevented from denying the corporate status of
an entity if they have dealt with it as a corporation, even if it is not a
de facto corporation.
• arises when individuals, acting as if they are a corporation, lead
others to believe they are a corporation, and those others rely on that
belief to their detriment. This principle prevents those individuals
from later claiming they were not a corporation to avoid legal
obligations.