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Business Associations
Professor Bradford
Spring 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. If
you have any questions about the exam or your performance on the exam, feel free to
contact me to talk about it.
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:
Question 1:
Question 2:
Question 3:
Question 4:
Question 5:
Question 6:
Question 7:
Question 8:
Range 0-8; Average = 4.19
Range 3-9; Average = 5.89
Range 0-8; Average = 6.19
Range 0-9; Average = 5.19
Range 3-8; Average = 5.81
Range 0-9; Average = 5.70
Range 3-9; Average = 6.07
Range 2-9; Average = 5.26
Total (of unadjusted exam scores, not final grades): Range 3.86-7.30; Average = 6.19
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Question 1
The court will dismiss Tom’s derivative action. Under Delaware law, a plaintiff
in a shareholders’ derivative action must plead either that he made demand on the board
or why demand was excused. Demand is excused only if the plaintiff alleges
particularized facts that either (1) the directors are not disinterested and independent or
(2) the transaction was not otherwise the product of a valid business judgment because it
violated either procedural or substantive due care. Aronson v. Lewis (discussed in Marx
v. Akers).
Demand is not excused merely because all the directors are named as defendants.
Marx v. Akers. The first allegation is insufficient.
The second allegation is also insufficient. Failure to inform would be a violation
of the duty of care and would show that the transaction was not otherwise the product of
a valid business judgment. However, there must be allegations of particularized facts
that support that conclusion. Marx v. Akers. A general allegation that the directors
violated the duty to inform is insufficient.
The allegation about Barry Boss is a sufficient allegation that Boss is not
disinterested. However, demand is excused only if the plaintiff alleges a defect as to a
majority of the directors. Marx v. Akers. The allegation that Boss controls the other four
directors is conclusory; there are no particularized facts indicating the other directors lack
independence.
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Question 2
The statement about an investor’s right to withdraw is technically correct, but
misleading. A partner in a general partnership has the right to dissociate at any time.
RUPA § 602(a). That right may not be taken away by agreement; the partnership
agreement may only require that the notice be in writing. RUPA § 103(b)(6). However,
that does not necessarily mean that the general partnership has no continuity.
Although partners have a right to withdraw, that withdrawal may be wrongful and
subject them to liability for damages. A partner’s dissociation is wrongful if it is in
breach of an express provision of the agreement or, in most cases, before the expiration
of the term or undertaking which the agreement provides for. RUPA § 602(b)((1),(2).
Partners are liable to the other partners for damages for wrongful dissociation. RUPA §
602(c).
And, if the partners have agreed to a specific term of existence, whether expressed
as a period of time or completion of a particular undertaking, a partner’s dissociation
does not usually dissolve the business. See RUPA § 801(2). The business continues in
spite of the wrongfully dissociating partner’s withdrawal.
In addition, a partner’s dissociation does not necessarily deprive the business of
the capital contributed by that partner or the value of that partner’s interest. When
dissociation is wrongful, the departing partner is not entitled to a buyout until the
expiration of the specified term or undertaking. RUPA § 701(h), unless the dissociating
partner can show that earlier payment will not cause “undue hardship to the business.”
Id.
Thus, although a partner does have a right to withdraw, the business does not
usually lose capital as a result of that withdrawal and any loss of the departing partner’s
human capital can be recovered in the form of damages. Moreover, these financial
penalties make it less likely that partners will wrongfully dissociate in the first place.
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Question 3
Dana has possible liability under two provisions of federal securities law: (1)
Section 16(b) of the Exchange Act; and (2) Rule 10b-5, adopted pursuant to section 10(b)
of the Exchange Act.
Section 16(b)
Section 16(b) imposes liability on three categories of defendants: officers,
directors, and 10% beneficial owners. See Exchange Act §§ 16(a),(b). Dana must have
fallen into one of these categories immediately prior to the transaction for it to be covered
by section 16(b). See Reliance Electric v. Emerson Electric. Dana was a director at all
relevant times, so all of her trading here is covered by § 16(b).
Section 16(b) applies to any class of equity security registered pursuant to section
12 of the Exchange Act. See §§ 16(a),(b). Image’s common stock is covered, because
it’s an equity security and it’s registered pursuant to section 12.
Dana is liable under section 16(b) if she purchased and sold the stock within any
period of less than six months for a profit. Liability under § 16(b) does not depend on the
misuse of confidential, nonpublic information, so Dana’s use of the information from
Sam is irrelevant for § 16(b) purposes. Image’s initial purchase on January 3 was within
six months of her sale on June 5. Therefore, she’s liable for her profit on the 30,000
shares sold on June 5. The profit would be 30,000 shares x ($30 - $20) = $300,000.
Dana is not liable for profit on her sale on August 1. That is more than six
months after the initial purchase, so there’s no matching purchase within six months of
the August 1 sale.
Rule 10b-5
Dana may also be liable for insider trading in violation of Rule 10b-5. Dana
clearly traded on the basis of material, nonpublic information; however, for that to create
liability under Rule 10b-5, Dana’s trading without disclosure of the information must
breach a fiduciary duty. Chiarella. Otherwise, the deceit required for liability under
Rule 10b-5 is not present.
Liability as a classical insider
Dana is a classical insider. She owes a fiduciary duty to Image because she’s a
director. However, unlike the situation in Texas Gulf Sulphur, Dana is not using
information acquired from Image in breach of that duty. The information came from
outside Image and her status as a director had nothing to do with it. Thus, arguably, her
use of that information does not breach a duty of confidentiality owed to Image.
However, one might argue that, as a director, she owes a duty of disclosure to Image with
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respect to any relevant information she acquires about the company, no matter the source.
Then, if she traded on the basis of that information without disclosing it to Image, she
could be liable. See O’Hagan. The argument for such a duty would be buttressed if Sam
provided the information to her only because of her status as a director of Image.
Liability as a tippee
Dana might also be liable as a tippee of someone who owes a fiduciary duty. Sam
agreed with Steve Jobs not to disclose the information until the March 1 publication date.
This agreement is sufficient to establish a duty of confidence under Rule 10b5-2(b)(1).
Sam breached this agreement by telling Dana, so Dana might be liable as Sam’s tippee
under Dirks.
For such liability to exist, Sam must have breached his duty for personal gain.
Sam did not directly gain by telling Dana. She is his friend, and Dirks says a gift can
constitute a personal gain to the tipper. But, although Sam and Dana are friends, it’s not
clear Sam is providing this information so Dana can make money through trading. He’s
apparently just telling her because she’s a director of Image.
Even if Sam revealed the confidence for personal gain, Dana is liable only if she
knew or should have known Sam breached a duty when he disclosed the information.
Dirks. It’s not enough that she know the information was confidential; she must know
that Sam is breaching his duty in revealing the information. She doesn’t know that Sam
agreed to keep the information confidential, so the question is whether she should have
known. She knew the information was nonpublic and she knew it came from Steve Jobs.
Should she have known that Steve Jobs would not provide it to Sam without a promise of
confidentiality? Or, since Sam is a reporter, would it be reasonable for her to assume that
Steve Jobs did not expect Sam to keep the information confidential?
Liability for breach of a duty to Sam
Dana could also be liable if she breached a duty of confidentiality she owed to
Sam. O’Hagan. However, she never agreed not to use the information. Thus, she would
owe a duty to Sam not to disclose only if they had a history of sharing confidences that
would let her know Sam expected this to be kept confidential. Rule 10b5-2(b)(2).
Nothing in the facts indicates any such history.
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Question 4
The internal affairs rule is a choice-of-law rule. It provides that the law of the
state of incorporation (or organization, in the case of a non-corporate entity) governs the
internal affairs of the corporation (or other entity)—no matter the location of the
company’s investors or its operations or where the lawsuit is brought. The internal
affairs rule relates only to matters of internal affairs—such as the duties of officers and
directors, governance of the corporation, and shareholder rights and powers. It does not
affect external questions outside of corporate law, such as tort or contract liability.
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Question 5
Duty of Loyalty
This decision does not appear to violate the directors’ duty of loyalty. None of
the directors was a party to the transaction or had a financial interest in the transaction
that would make this self-dealing. See MBCA § 8.60(1). Fernando was not involved in
creating the league, so he has no direct financial interest. His personal interest in
volleyball is not a financial interest of the time the duty of loyalty is concerned with.
Since this is not a director’s conflicting interest transaction, it is not subject to challenge
on self-dealing grounds. MBCA § 8.61(a).
Fernando’s push for Mega to purchase a team is probably motivated as much by
his devotion to volleyball as by his interest in making money. However, his personal
motivation for approving the purchase is probably irrelevant under Sinclair v. Levien, as
long as the decision otherwise meets the directors’ duties.
Good Faith
Another aspect of the duty of loyalty is the obligation of directors to act in good
faith. MBCA § 8.31(a)(2)(i). However, this does not appear to violate that obligation.
The obligation of good faith is violated in two ways. Walt Disney Company Derivative
Litigation. First, it’s a violation of good faith to intentionally harm the corporation.
There’s nothing of that sort here. Second, it’s a violation of the obligation of good faith
to consciously disregard one’s duties to the corporation. But this requires a knowing and
complete failure of the directors to undertake their responsibilities, not just a bad or even
grossly negligent decision. Lyondell Chemical Co. v. Ryan. The directors here analyzed
the opportunity before approving the purchase. It might not be a good decision, but they
did not totally neglect their duties.
Duty of Care
Procedural due care: the duty to inform
The duty of care has two aspects, one procedural and one substantive. First, the
directors must adequately inform themselves before making a decision. MBCA §
8.31(a)(2)(ii)(B); Smith v. Van Gorkom. The standard is gross negligence. Smith v. Van
Gorkom. The directors here don’t appear to have been grossly negligent in informing
themselves. They listened to a lengthy presentation by the organizers of the volleyball
league and they also considered financial projections prepared by Mega’s finance
department. Moreover, the question indicates a “lengthy discussion” by the directors
before the decision was made.
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Substantive due care: corporate waste
The directors’ substantive decisions are protected by the business judgment rule.
A decision that does not involve a conflict of interest will be overturned on substantive
grounds only if it is a no-win transaction, sometimes called corporate waste. Essentially,
this means a decision for which there is no plausible case that it’s in the best interests of
the company. See Joy v. North; MBCA § 8.31(a)(2)(ii)(A).
This transaction does not appear to fall into that category. Financial analysts have
not reacted positively to the investment in PVL teams, but Mega’s own study indicates
that it could be profitable. One analyst says risk-free government bonds might be more
profitable (and obviously less risky). If this were unquestionably true, this might be a nowin transaction: the corporation would be getting a riskier, lower return than the risk-free
alternative. But this is merely one person’s forecast and the board is not required to
accept this forecast. Mega’s internal report predicts a possible 5-10 percent return, with
the risk of some loss. Under the business judgment rule, it’s up to the board to weigh the
possibilities and, as long as there’s a plausible claim that the decision is in the best
interests of the company, the court will not second-guess the board’s judgment. This
seems within the range of a reasonable business judgment, so the board will not be liable
for a breach of the duty of care.
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Question 6
Preemptive rights give an existing shareholder the right to purchase additional
stock when the corporation issues new stock. The second transaction does not trigger
preemptive rights; Small is repurchasing shares and preemptive rights apply only when
Small is selling shares. However, Small is issuing shares in the first transaction, which
triggers Calvin’s preemptive rights.
Since the articles grant preemptive rights to Calvin, he has an option to purchase
the shares offered to Ned in proportion to Calvin’s ownership of Small stock. See MBCA
§ 6.30(b)(1). However, this is an option on Calvin’s part. He has the right to purchase
the shares, but is not obligated to, if he doesn’t want to.
Since Calvin currently owns 1/10 of the outstanding shares, he is entitled to
purchase 1/10 of the 200 new shares Small is issuing, or 20 shares. The terms of the
purchase will be the same as those offered to Ned, $600 a share. See MBCA §
6.30(b)(1). Thus, Calvin may buy 20 of the 200 shares Small is issuing, for a total price
of $12,000.
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Question 7
A member of a LLC does not have authority to act on behalf of the LLC merely
by virtue of being a member. RULLCA § 301(a). Instead of specifying when action on
behalf of an LLC binds the LLC, the RULLCA defers to principles outside the Act, i.e.,
agency law. RULLCA § 301(b). Under general principles of agency law, La Comida is
liable on the lease only if Arnie had some type of authority to sign it on behalf of La
Comida. That authority may be actual, apparent, or implied. RSA § 140.
It is not clear if Arnie had actual authority to sign the bowling alley lease. The
operating agreement authorized him to lease a building for a restaurant, but not for a
bowling alley. See ¶ 3 of the operating agreement. The members’ action at the March 1
meeting raises two issues: (1) did their action validly authorize La Comida to operate a
bowling alley; and (2) if so, did that also authorize Arnie to lease the bowling alley.
In a member-managed LLC, matters arising in the ordinary course of business are
decided by majority vote. RULLCA § 407(b)(3). Matters arising outside the ordinary
course of business must be decided unanimously. RULLCA § 407(b)(4). Unanimity is
also required to amend the operating agreement. RULLCA § 407(b)(5).
Operation of a bowling alley does not require an amendment of the operating
agreement, as the operating agreement itself allows the LLC to engage in other business,
provided the members approve it. The question is whether the decision to operate a
bowling alley is in the ordinary course of business. The operating agreement authorizes
the LLC to operate a restaurant, and leasing a bowling alley is probably not in the
ordinary course of business for a restaurant. However, the agreement also authorizes
“any other lawful business” authorized by the members. But does this make everything
part of the ordinary course of the partnership’s business, thereby requiring only a
majority vote, or does this still contemplate the statutory default rule of unanimity to add
other business? The agreement is ambiguous.
If the 3-2 vote was sufficient to authorize operating a bowling alley, it’s still not
clear that Arnie was authorized to lease it. The operating agreement only gave him the
authority to lease a restaurant, and the members on March 1 did not specifically authorize
him to lease anything else. Is there enough in that vote, reasonably interpreted, to cause
Arnie to believe that he was authorized to lease the bowling alley? See RSA § 26.
Perhaps. Arnie could argue that he was already authorized to lease the restaurant and,
when they voted to change the business of the LLC to operating a bowling alley and said
nothing more, it was reasonable to believe that the authorization to lease automatically
transferred to the bowling alley.
If the 3-2 vote was not sufficient to authorize operating a bowling alley, then,
obviously, Arnie had no actual authority to lease one on behalf of the LLC. The LLC
was still limited to operating a restaurant only.
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If Arnie has no actual authority, it’s hard to see an argument for apparent
authority. See RSA § 8. Arnie said he had authority, but a communication by the agent
himself cannot create apparent authority. Weber did not communicate with anyone other
than Arnie. He read the operating agreement, which could be treated as a communication
from the LLC, but nothing in the operating agreement would give Weber the impression
that Arnie was authorized to lease a bowling alley. In fact, it would do just the opposite:
it indicates that Arnie is only authorized to lease a restaurant.
Implied authority is also unlikely to exist, because RULLCA § 301 itself negates
any inference that a member has implied authority merely because he’s a member. And
nothing in the grant of authority to lease a restaurant implies authority to lease a bowling
alley as well.
Thus, if Arnie does not have actual authority as a result of the March 1 vote, La
Comida is probably not bound on the lease.
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Question 8
Shareholders of MBCA corporations such as Murk have the right to obtain certain
books and records of the company. See MBCA § 16.02.
Under MBCA § 16.02(a), any shareholder may obtain the corporate records listed
in section 16.01(e) by giving written notice to the corporation. No further showing is
required. Unfortunately for Gail, the comment log would not fall within any of the items
listed in section 16.01(e): the articles of incorporation; the bylaws; board resolutions
relating to classes of shares; and records of shareholder meetings.
Therefore, to obtain the comment log, Gail must turn to section 16.02(b). To
obtain documents under section 16.02(b), Gail must show that her demand was in good
faith and for a proper purpose and, in her request, she must describe her purpose and the
records she wishes to inspect. MBCA § 16.02(c).
The MBCA does not define “proper purpose,” but courts generally construe the
phrase to mean a purpose related to one’s interest as a shareholder. Determining the
effect of corporate policies on the company’s profitability and communicating with
shareholders about electing different directors seem to be proper purposes. If Gail’s sole
aim were to publicize her environmental cause or to change the company’s policies
purely for political reasons, her purpose might not be proper, but she has tied her request
to the profitability of the company and her interest as a shareholder. Moreover, the
documents she wants are directly tied to that purpose. She seems to meet the
requirements of section 16.02(c).
The problem is that the documents she wants don’t seem to fit into any of the
categories of documents that shareholders may inspect under section 16.02(b). These
clearly aren’t board or shareholder meeting minutes. MBCA § 16.02(b)(1). And
consumer complaints don’t seem to qualify as accounting records, MBCA § 16.02(b)(2);
they are not part of the financial statements and they would not be used to prepare the
financial statements. An accountant would never need to review these records. And, of
course, the log is not a record of shareholders. MBCA § 16.02(b)(3). Therefore, although
she has a proper purpose, Gail is not entitled to this particular record under section 16.02.
There is another possibility. Section 16.02 doesn’t affect “the power of a court,
independently of this Act, to compel the production of corporate records for
examination.” MBCA § 16.02(e)(2). Thus, even if Gail is not entitled to these records
under section 16.02, the court may still grant her access to these records, if the court feels
it is appropriate.