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Business Associations
Professor Bradford
Summer 2010
Exam Answer Outline
The following answer outlines are not intended to be model answers, nor are they
intended to include every issue students discussed. They merely attempt to identify the
major issues in each question and some of the problems or questions arising under each
issue. They should provide a pretty good idea of the kinds of things I was looking for. In
some cases, the result is unclear; the position taken by the answer outline is not
necessarily the only justifiable conclusion.
I graded each question separately. Those grades appear on your printed exam. To
determine your overall average, each question was then weighted in accordance with the
time allocated to that question. The following distribution will give you some idea how
you did in comparison to the rest of the class:
Part I, Question 1:
Part I, Question 2:
Part I, Question 3:
Part II, Question 1:
Part II, Question 2:
Part II, Question 3:
Part II, Question 4:
Range 3-9; Average = 5.90
Range 2-8; Average = 6.85
Range 0-9; Average = 5.48
Range 2-9; Average = 5.88
Range 2-9; Average = 6.22
Range 0-8; Average = 5.04
Range 0-7; Average = 5.04
Total (of unadjusted exam scores, not final grades): Range 3.22-7.79; Average = 5.64
If you have any questions about the exam or your performance on the exam, feel
free to contact me to talk about it.
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Part I, Question 1
Traditional Fiduciary Duties of Officers and Directors
Corporate directors, such as Anne and Cal, owe fiduciary duties of care and
loyalty.
Increasing salaries
Barb might have a claim against Anne and Cal for violation of the duty of loyalty
when the board voted to increase the salaries paid to Anne and Cal. This is a clear selfdealing transaction; Anne and Cal have a personal financial interest in the amount of their
salaries. Approval of a self-dealing transaction by disinterested board members or
disinterested shareholders can cleanse a self-dealing transaction. See Del. § 144;
RMBCA § 8.61. But that didn’t occur here, so the burden is on Anne and Cal to show
fairness.
Fairness has two interrelated aspects—fair dealing and fair price. Weinberger.
There really isn’t any information in the question about how these salaries were set, so
fair dealing is problematic. The fairness of the price depends on whether Anne’s and
Cal’s salaries are comparable to what others are paid in arms’-length transactions for the
same work. If they Anne and Cal can’t show fairness, they would be liable for the
amount they are paid that exceeds the fair market value of their labor.
Firing Barb; not paying dividends
Duty of Loyalty
It does not appear that Barb has a claim for violation of the traditional duties of
directors for any of the other actions. The directors have no self-interest as to any of the
other actions. None of them benefit financially from firing Barb.
Duty of Care
Barb is unlikely to succeed in alleging a violation of the duty of care. Absent a
conflict of interest, directors’ business decisions are protected by the business judgment
rule and courts will not second-guess their business decisions. Barb will have the burden
of proof to overcome the business judgment rule.
Directors can be liable for gross negligence in failing to inform themselves before
making a decision, Smith v. Van Gorkom, but that’s unlikely to succeed here. There’s no
evidence that the board reviewed any information before it granted the raises or
considered other options before firing Barb. However, all of the directors except Art are
actively involved in the corporation as employees, and therefore are likely to be
knowledgeable about its problems.
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Directors can also be liable for no-win decisions or corporate waste—for making
decisions for which there is no rational argument that they benefit the corporation. But
that type of challenge is unlikely to succeed here. The board has a legitimate argument
that cost-cutting is necessary because of the company’s cash-flow problems. This clearly
is not corporate waste and, under the business judgment rule, a court will not secondguess how much cost-cutting is necessary or the best way to cut costs. Therefore, a duty
of care challenge is unlikely to succeed.
Fiduciary Duties of Shareholders in Closely-Held Corporations
Some, but not all, jurisdictions hold that shareholders in closely-held corporations
such as this owe fiduciary duties to each other akin to those of partners in a general
partnership. See, e.g., Donahue v. Rodd Electrotype. Barb’s argument will be that
shareholders in a closely held corporation have an expectation of a return on their
investment. See Hollis v. Hill. Her firing, coupled with Kaolin’s no-dividend policy,
denied her all return on her investment. Unlike the other shareholders, who continue to
draw salaries, she gets nothing. This looks very similar to Hollis v. Hill, which also
involved the firing of one of the shareholders and a no-dividend policy. The court in that
case ordered the court to pay dividends. Thus, if the State of Pound accepts the Donahue
type of fiduciary duty, Anne and Cal might be liable.
However, Wilkes, decided by the same court that decided Donahue, indicated that
action could be defended on the basis that there was a legitimate corporate purpose. See
Hollis v. Hill. Here, the company needs to cut cost to deal with a cash-flow problem. A
similar argument succeeded in Zidell v. Zidell, but that case involved a shareholder who
voluntarily resigned, rather than being fired. And Anne’s personal animosity towards
Bard seems to have affected the decision. Moreover, Barb can argue that there are less
drastic means of dealing with the cash flow problem that don’t involve denying her a
return—covering the shortfall, at least on a temporary basis, by dipping into the
company’s substantial cash reserves; or reducing the salaries of all three employees
proportionately.
Involuntary Dissolution/Oppression
Barb might also argue that Anne’s actions constitute oppression, and are therefore
grounds for involuntary dissolution of the corporation under a statutory provision similar
to § 14.30(a)(2)(ii) of the MBCA (if Pound has such a provision). Courts generally
interpret “oppression” to cover actions similar to those that would constitute violations of
the Donahue type of fiduciary duty—in the words of one court, violation of principles of
fair dealing. See Giannotti v. Hamway.
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Part I, Question 2
Adam is entitled to cast a total of 600 votes.
Genome has cumulative voting, which means shareholders are entitled to multiply
the number of votes their shares would otherwise have by the number of directors for
whom they are entitled to vote, and allocate that total number of votes as they wish. See
RMBCA § 7.28(c). Absent cumulative voting, Adam would have 200 votes: he owns
100 shares and each Class Y share is entitled to two votes per share. However, three
directors are being elected at the next election, so Adam’s total number of cumulative
votes would be the 200 votes he would otherwise be entitled to times the 3 directors up
for election, or 600 total votes.
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Part I, Question 3
The basis for this argument is the idea that contract creditors have an opportunity
to protect themselves. Before entering into a contract with a corporation, third parties
may check the company’s finances and demand personal guaranties if they feel the
corporation has inadequate resources. They can take the potential risk of nonpayment
into account in deciding whether to enter into the contract and at what price. Piercing the
veil gives them a better deal (with less risk) than what they anticipated when they entered
into the contract.
Tort creditors, on the other hand, are involuntary. Victims of torts do not
ordinarily have an opportunity to evaluate a corporation’s finances before the tort and
decline to participate if they are worried about the risk of not being compensated. The
self-protection argument doesn’t make sense, for example, in the case of a pedestrian
being hit by a corporation’s truck.
However, some torts arise out of consensual relationships. When I buy a
defective product or hire someone to perform a service that is performed negligently, I
have the same opportunity that a contract creditor does to evaluate the corporation’s
finances and to demand a personal guaranty. Thus, the appropriate distinction is not
really tort vs. contract, but between consensual vs. nonconsensual transactions.
Even with this modification, however, the argument is a little overblown. First,
piercing is often justified in part on the basis of post-transaction changes. For example,
one factor sometimes used to justify piercing is “siphoning assets,” where the
corporation’s principal removes funds from the corporation after the obligation is
incurred. A consensual creditor cannot know that this is going to happen and the removal
of funds changes the risk that the contract creditor anticipated.
In addition, in many consensual transactions, self-protection really isn’t much of
an option. In some cases, information about the corporation may be unavailable. In other
cases, the price of the product or service may not justify the time and effort necessary to
check out the corporation and seek a personal guaranty; the cost of self-protection
exceeds the possible loss. Finally, a consumer may be faced with a standard form
contract where no personal guaranty would be given even if sought. But, of course, in
that case, the consumer could always just refuse to deal with the corporation.
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Part II, Question 1
Is This a Partnership?
Ames’s liability depends on whether the relationship between Ames and Bates is
a general partnership or an employer-employee relationship. The answer to that question
is unclear, although this is more likely than not a partnership. A partnership is an
association of two or more persons to carry on as co-owners a business for profit. RUPA
§ 202(a). Healthy Mexican is a for-profit business and Ames and Bates are two persons,
but are they co-owners? Two usual elements of co-ownership are sharing profits and
control over the business, and Bates has both. Section 202(c)(3) says someone who
shares profits is presumed to be a partner. However, this presumption does not apply if
the profit-sharing is part of an employee’s wages. RUPA § 202(c)(3)(ii). And, whether
or not he’s a co-owner, Bates as a manager-employee would have to have the authority
given him by Ames. One additional fact points toward partnership: Ames told Bates he
“won’t have to put up any money.” That comment makes sense only if Bates was to be
an owner, where a capital contribution might otherwise be expected; employees don’t
have to contribute capital.
Employer-Employee Relationship
If Bates is an employee of Ames, hired to manage the restaurant, then Ames and
Healthy Mexican are probably not bound to the contract. As an employee, Bates would
be an agent of Ames. He can bind the principal, Ames, contractually through actual,
apparent, or inherent authority. Restatement (Second) of Agency § 140. Bates clearly
has no actual authority—action in accordance with the principal’s manifestation of
consent. RSA § 7. Ames’s grant of authority to buy equipment clearly excluded
anything that has touched meat, and Bates agreed to that restriction.
There also is no apparent authority. Apparent authority is created by actions or
words from the principal, Ames, to the third party, Seller. RSA § 8. Ames has not
communicated in any way with Seller and Seller has had no prior dealing with Ames or
Healthy Mexican that might produce apparent authority.
Inherent authority arises from the position—in this case, from Bates’s position as
manager of the restaurant. An employee manager of a restaurant might have inherent
authority to buy equipment; if so, Ames could be liable. However, a typical restaurant
manager probably isn’t expected to buy capital equipment. In addition, even if there
would otherwise be inherent authority, Ames has expressly eliminated that authority, at
least as to equipment that has touched meat.
General Partnership
If Ames and Bates are partners, then the partnership is probably liable pursuant to
§ 301 of the RUPA. As a partner, Bates is an agent of the partnership, Healthy Mexican.
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RUPA § 301(1). As an agent, Bates can bind the partnership if he has actual, apparent, or
inherent authority, as discussed above. In addition, the partnership is liable for Bates’s
actions “apparently carrying on in the ordinary course the partnership business or
business of the kind carried on by the partnership.” RUPA § 301(1). Although Bates may
not be apparently carrying on in the ordinary course the business of Healthy Mexican,
because of its “no meat” restriction, he is apparently carrying on business of the kind
carried on by the partnership—a Mexican restaurant. Thus, Healthy Mexican is bound
under § 301(1) unless Seller knew that Bates lacked authority to order this equipment;
nothing in the problem indicates that Seller knew Bates could not buy equipment that had
touched meat.
If the partnership is liable, Ames is also individually liable. RUPA § 306(a).
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Part II, Question 2
Liability in the Absence of the Operating Agreement
Absent the provision in the operating agreement, Acme would almost certainly be
liable for breaching a fiduciary duty to Zappa and the other members. A member in a
member-managed LLC such as Zappa owes fiduciary duties of loyalty and care.
RULLCA § 409(a). The duty of loyalty includes an obligation to refrain from competing
with the company, RULLCA § 409(b)(3), and to refrain from taking a limited liability
company opportunity. RULLCA § 409(b)(1)(C).
By any standard, this would be an LLC opportunity. See, e.g., Broz. It’s clearly
within Zappa’s line of business—Zappa’s line of business is buying, selling, and leasing
commercial real estate in Dallas, and this is commercial property in Dallas. Prez became
aware of the opportunity while he was working on behalf of Zappa, and it’s clear that the
opportunity was meant to be offered to Zappa, not to Prez or Acme. Zappa is financially
able to exploit the opportunity, as far as we know. Moreover, the opportunity was not
presented to the LLC and rejected. See Northeast Harbor Golf Club; Broz. In fact,
Acme and Prez didn’t even disclose they were taking the opportunity, another factor
consistent with a breach of the duty of loyalty. See Meinhard v. Salmon.
The Effect of the Operating Agreement
The operating agreement, if enforceable, would clearly eliminate any liability that
Acme and Prez would otherwise have. It attempts to completely eliminate any liability
for competition or taking a corporate opportunity.
RULLCA § 110(c)(4) says, that, subject to subsection (d) through (g), the
operating agreement may not eliminate the duty of loyalty. However, § 110(d)(1) says
the agreement may “restrict or eliminate” the duties in 409(b)(3) and 409(b)(1), the two
duties potentially applicable here. Therefore, the agreement would appear to be
enforceable if the provision in question is “not manifestly unreasonable.” In determining
whether such a provision is manifestly unreasonable, the court should consider only the
circumstances existing at the time the provision was adopted, not what happens
subsequently. RULLCA § 110(h)(1). The court may invalidate the provision only if it is
“readily apparent” that the objective of the term is unreasonable or the term is an
unreasonable means of achieving that objective. RULLCA § 110(h)(2).
The provision’s objective is to allow the members to continue their separate
businesses without having to share opportunities with the LLC. But is allowing pursuit
of an opportunity that was offered to the LLC itself a reasonable means of achieving that
objective? In other words, is the provision overbroad? For what it’s worth, Beta’s
counsel reviewed and edited the agreement before signing it and Capri’s president also
read the agreement; the parties should not be surprised by this disclaimer of liability.
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Moreover, all three members are businesses with at least $5 million in assets, so these are
not unsophisticated parties.
Good Faith and Fair Dealing/Disclosure
Members in a member-managed LLC owe each other a contractual obligation of
good faith and fair dealing in exercising any rights under the operating agreement.
RULLCA § 409(d). That obligation may not be eliminated by contract. RULLCA §
110(c)(5), although the standard for measuring performance of the obligation may be
specified. RULLCA 110(d)(5). Even if Acme has a right under the operating agreement
to take corporate opportunities, taking opportunities that were offered to Zappa without
disclosure to the other members might violate the obligation of good faith and fair
dealing, depending on how broadly a court is willing to construe that obligation.
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Part II, Question 3
Dismissal of a derivative action is governed by § 7.44 of the RMBCA. The basic
requirements are in 7.44(a): the recommendation to dismiss must be made by “one of the
groups specified in subsection (b) or subsection (e)”. That group must have determined
“in good faith” “after conducting a reasonable inquiry” that the derivation action is not in
the best interests of the corporation.
Composition of the Board
Subsection (e) deals with court-appointed panels, so it’s not at issue here.
Therefore, § 7.44 requires dismissal only if the board falls within subsection (b). No
committee was appointed, so (b)(2) does not apply. The question, therefore, is whether
(1) qualified directors constitute a quorum of the board and (2) a majority of those
qualified directors decided that dismissal was in the best interests of the corporation.
RMBCA § 7.44(b)(1).
For purposes of § 7.44, the term “qualified director” includes any director who
does not have a material interest in the outcome of the proceeding and does not have a
material relationship with a person who has such an interest. RMBCA § 1.43(a)(1). A
material interest is an actual or potential benefit or detriment. RMBCA § 1.43(b)(1). All
of the directors are named as defendants, but that does not constitute a material interest.
RMBCA § 1.43(c)(3). The only person here who appears to have a material interest is
Anne, because of her ownership of 20% of Maruka; this made the Maruka transaction
clear self-dealing on her part. Thus, Anne is not a qualified director.
Bob and Dan appear to have material relationships with Anne, a person who has a
material interest. Therefore, they would also not be qualified directors. Bob, Anne’s son,
has a familial interest that would reasonably be expected to impair his objectivity.
RMBCA § 1.43(b)(2). Dan has an employment relationship with Omega and Anne, as
CEO, is his boss. Because of the risk of losing his job if he votes against Anne, he
appears to have an employment relationship that would reasonably be expected to impair
his objectivity. RMBCA § 1.43(b)(1).
Anne and Ellen are qualified directors; their nomination by Anne is not enough to
disqualify them. RMBCA § 1.43(c)(1). However, since only two of the five directors are
qualified, there is not a quorum of qualified directors. A quorum is a majority or a
greater number specified in the article. RMBCA § 8.24(a)(1).
Note that all of the qualified directors actually voted in favor of dismissal,
meeting the requirement in the first part of § 7.44(b)(1), but the second requirement—that
the qualified directors constitute a quorum—is not satisfied.
Good Faith; Reasonable Inquiry
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The board’s work appears to satisfy the other requirements: they did a thorough
investigation and there’s no evidence of bad faith. Omega paid $10,000 above Maruka’s
usual price, and thus suffered a loss that it could probably recover from Anne, but there’s
still a legitimate justification for not suing—the potential damage to the business caused
by bad publicity. But because the board doesn’t fall within subsection 7.44(b), the court
is not required to dismiss the derivative action.
Dismissal Outside of Section 7.44
Section 7.44 only indicates when the court is required to dismiss. The Official
Comment makes it clear that § 7.44 is not exclusive. However, the common law would
probably not justify dismissal, either. One of the prerequisites for dismissal when the
court is reviewing the actions of a special litigation committee is that the committee
consist of disinterested and independent directors. See Auerbach; Zapata. The body
making the decision here did not consist of a majority of disinterested and independent
directors, so a court is unlikely to defer to its decision.
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Part II, Question 4
Exclusion 1
Exclusion 1 clearly does not apply here. Generally, mandatory resolutions that
restrict the authority of the board of directors are improper under state law. See, e.g., CA,
Inc. v. AFSCME. However, Del. § 112 specifically allows the bylaws to provide for what
this proposal seeks—including shareholder nominees in the company’s proxy materials.
Shareholders have the power under Delaware law to unilaterally amend the bylaws, Del.
§ 109, and Del. § 112 makes the substance of this bylaw amendment appropriate.
Exclusion 3
Exclusion 3 may apply. A proposal is improper under Exclusion 3 if the proposal
or the supporting statement is contrary to other proxy rules, including Rule 14a-9, the
antifraud rule. The statement that the board “has done a poor job of managing the
company” is a matter of opinion, so it should not be a violation of Rule 14a-9. At most,
the SEC might force James to add something to indicate it is only his opinion. However,
the second sentence of the supporting statement implies that the existing directors, unlike
the proposed replacements, do not care about the company and its shareholders. Unless
there is some basis for thinking there’s a lack of concern, this could be false or
misleading. The Supreme Court has indicated that the directors’ states of mind might be
material in appropriate circumstances. See Virginia Bankshares. Thus, this could be a
materially misleading statement, although its materiality is questionable.
Exclusion 4
Exclusion 4 clearly does not apply here. James has a personal grievance against
the company as a result of his firing, but this proposal does not relate to that grievance in
any way. It’s a general proposal about the nomination of directors. Exclusion 4 doesn’t
ask why a shareholder is submitting a proposal, just whether the proposal itself addresses
a personal claim or grievance or is designed to result in a special benefit for that
particular shareholder. The proposal will benefit James, who owns more than the
required 3%, but it will also benefit any other shareholder who accumulates 3% of the
stock.
Exclusion 8
Exclusion 8 probably bars this proposal. The question is whether, to be excluded
by Exclusion 8, the proposal must relate to a particular election to office or if it suffices
that the proposal relates to elections in general. This proposal does not relate to any
particular election—i.e., an attempt to bar a particular director from being elected this
year. But it does relate to elections in general, and Exclusion 8 excludes any proposal
that relates to “a procedure for such nomination or election”.