1
Business Associations
Professor Bradford
Fall 2014
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 I, Question 4:
Part I, Question 5:
Part I, Question 6:
Part II, Question 1:
Part II, Question 2:
Part II, Question 3:
Part II, Question 4:
Part II, Question 5:
Range 0-9; Average = 2.75
Range 2-9; Average = 5.20
Range 2-9; Average = 6.11
Range 3-8; Average = 7.32
Range 0-9; Average = 4.00
Range 0-9; Average = 4.96
Range 2-8; Average = 6.54
Range 0-8; Average = 6.50
Range 2-8; Average = 5.82
Range 3-9; Average = 5.86
Range 3-8; Average = 5.61
Total (of unadjusted exam scores, not final grades):
Range 3.17-7.34; Average = 5.45
All of these grades are on the usual law school scale, with 9 being an
A+ and 0 being an F.
2
If you have any questions about the exam or your performance on the
exam, feel free to contact me to talk about it.
3
Part I, Question 1
The Delaware Supreme Court has indicated that the duty of good
faith is violated by only three types of conduct: (1) when the director
acts with an actual intent to harm the corporation; (2) when the
director acts with an intent to violate the law; or (3) when the director
“intentionally fails to act in the face of a known duty to act,
demonstrating a conscious disregard for his duties.” In Re The Walt
Disney Company Derivative Litigation.
The first case is likely to be extremely rare. Directors seldom take
action with an actual intent to harm the corporation. The second case
is probably more common, but still rare—where the director
intentionally violates the law.
The third case is very limited. It’s not enough that the director acted
carelessly or even in a grossly negligent manner. To be liable for
acting in bad faith, a director must “knowingly and completely fail to
undertake . . . [his or her] . . . responsibilities.” Lyondell Chemical Co.
v. Ryan. Thus, as long as the director takes some action to fulfill a
particular responsibility, he will not be liable for acting in bad faith.
4
Part I, Question 2
Anna probably has no remedy, unless she can convince the court to
extend the special fiduciary duties that some courts have applied to
closely held corporations.
Breach of the Agreement with Elsa
When Elsa urged the board to fire Anna, she violated Paragraph 4 of
her second agreement with Anna. Unfortunately, that second
agreement is probably unenforceable.
Generally, power to manage the corporation, including the power to
hire and fire employees, rests in the board of directors. See MBCA §
8.01(b). The board’s power is subject to any limitation in the articles
of incorporation or in an agreement authorized under MBCA § 7.32.
Elsa’s promises concerning Anna’s employment are not in the
articles. And the agreement is not authorized by section 7.32.
This agreement would fail under section 7.32 for two reasons. First, a
shareholder agreement is authorized by § 7.32 only if all the
shareholders approve it. MBCA § 7.32(b)(1). Only Anna and Elsa
were parties to this agreement. Second, an agreement otherwise
authorized by § 7.32 is not effective if the corporation is a public
corporation. MBCA § 7.32(d). Frozen is a public corporation because
its stock is listed on the New York Stock Exchange. MBCA §
1.40(18A).
Absent statutory provisions like section 7.32, shareholder agreements
that attempt to usurp the board’s management power and exercise
that power directly—in this case, the power to hire and fire officers
and set their salaries—are often held unenforceable. See McQuade v.
Stoneham.
The first agreement is enforceable. It does not interfere with the
power of the directors in any way. Absent a restriction in the arti cles,
5
shareholders are free to sell their shares on whatever terms they
choose.
Breach of the Directors’ Fiduciary Duties
The board of directors is not liable for a breach of fiduciary duty, at
least not under the ordinary fiduciary duties applicable to a ll
corporations.
Duty of Care
The directors have a duty to inform themselves adequately before
making any decision. Smith v. Van Gorkom. But the problem says to
assume that the directors adequately informed themselves before
firing Anna and cutting the dividend, so there’s clearly no violation
of this procedural duty of care.
The directors’ decisions are also unlikely to violate the substantive
duty of care. Directors’ decisions are protected by the business
judgment rule. The directors violate the substantive duty of care only
if their decision involves a no-win transaction for which there is no
rational argument for corporate benefit. See Joy v. North.
Here, the board has a rational argument that withholding dividends
benefits Frozen. The company almost failed in a prior downturn and
they believe a greater reserve is needed. That’s a legitimate corporate
purpose and, under the business judgment rule, the courts will not
second-guess that rationale.
The firing resulted from a policy dispute. That is also a rational basis
for the board’s decision, so a court is unlikely to second-guess the
board.
Duty of Loyalty
The directors have not violated their duty of loyalty. Neither the
decision to fire Anna nor the decision to quit paying dividends results
in any personal benefit to any of the directors, including Elsa, or
6
anyone related to them. Absent some sort of self-interest, there can
be no duty of loyalty violation.
The Special Duty in Closely Held Corporations
Some, but not all, courts have held that the shareholders in closely
held corporations owe each other strong fiduciary duties akin to those
owed to each other by general partners. See Donahue v. Rodd
Electrotype; Hollis v. Hill. Anna’s only possible argument is for an
extension of that special duty to this public corporation because of
her unique circumstances.
The circumstances that led Donahue to create the special fiduciary
duty in closely held corporations also apply here. Because of the
transfer restriction, Anna has no market for her shares, even though
the shares are publicly traded, so her only return will come from
dividends or employment by the company. And Elsa, with 40% of the
corporation’s stock, has the power to control the corporation and
deny her any return.
Anna’s case is similar to Hollis v. Hill, where the controlling
shareholder fired the plaintiff and the corporation refused to pay
dividends. The court held that this frustrated the plaintiff ’s legitimate
expectation of a return on his investment and therefore violated the
fiduciary duty of the controlling shareholder.
However, in a subsequent case, Wilkes v. Springside Nursing Home, the
court that decided Donahue indicated that the defendant could
prevail if he could show that the corporate action served a legitimate
business purpose and the plaintiff could not show that that purpose
could be achieved by a less disruptive means. Here, building up a
reserve for an economic downturn might be a legitimate business
purpose, but that is not an argument for firing Anna. A less disruptive
means would be to eliminate dividends, but keep Anna as CFO. T here
seems to be no good cause for firing Anna. There was just a policy
disagreement.
7
The real question, however, is whether a court would be willing to
extend this special fiduciary duty to a public corporation.
8
Part I, Question 3
This sale will have three effects on Gamma’s balance sheet.
First, Gamma has $50,000 more cash, so the asset Cash will increase
by $50,000.
There will be two changes in the Equity section of the balance sheet.
First, the total par value of the stock sold (1,000 shares x $2.00/share
= $2,000) will be added to whatever Gamma calls the stated capital
account for the preferred stock, probably just Preferred Stock.
Second, the remaining amount of the sales price ($50,000 - $2,000 =
$48,000) will be added to the Additional Paid-In Capital account.
9
Part I, Question 4
Delaware is an opt-in state for preemptive rights, but Guardian’s
articles provide for preemptive rights, so it has opted in.
Peter Quill is therefore entitled to exercise his preemptive rights when
Guardian sells the additional 200,000. Preemptive rights g ive an
existing shareholder such as Peter the right (but no obligation) to buy
the same proportion of shares he currently owns (10,000 out of
100,000 = 10%) on the same terms and conditions that Guardian is
selling them to others. Thus, Peter is entitled t o buy 10% of the
200,000 shares being sold, or 20,000 shares, for a price of $15 cash
per share.
10
Part I, Question 5
Liability for insider trading under Rule 10b-5 is conditioned on
breach of a fiduciary duty to the source of the information. Chiarella.
Lucius owes no fiduciary duty to Rowling or Rowling ’s shareholders,
so he is not liable for “classical” insider trading, as in Texas Gulf
Sulphur.
Lucius is probably not a “temporary insider” of Rowling within the
meaning of fn. 14 of Dirks. He is in a contractual relationship with
Rowling, but that contract, to sell drilling pipe, does not involve a
special confidential relationship pursuant to which he was given
access to the information solely for Rowling’s corporate purposes.
Lucius is also not liable as a tippee of Harry, an insider. To be liable
as a tippee, Harry, the tipper, must breach a fiduciary duty for
personal gain in providing the information to Lucius. Dirks. Harry did
not intend to give the information to Lucius, so he obviously didn’t
do so for personal gain. If he had, Lucius would be liable only if he
knew or should have known of the breach, but that ’s irrelevant
because there was no breach of fiduciary duty.
The only other possibility is if Lucius himself breached a fiduciary
duty to Harry in acquiring the information. O’Hagan. Lucius stole the
information, but there was no fiduciary relationship between Lucius
and Harry. Engaging in contract negotiations does not create a
fiduciary relationship.
Justice Burger’s dissent in Chiarella said theft of the information was
sufficient for insider trading liability, but neither the majority in
Chiarella nor O’Hagan so held. Thus, unless the courts accept Burger’s
position and hold that theft of information is sufficient under Rule
10b-5, even absent a breach of fiduciary duty, Lucius would not be
liable.
11
Part I, Question 6
A financial inability defense seems to make sense. I f a corporation is
not financially able to take an opportunity, the director has not
harmed the corporation in any way by taking it. Since the corporation
could not take the opportunity, it would be no better off if the
director foregoes taking the opportunity.
The issue is how best to determine whether a corporation is
financially able to take an opportunity. If the director presents the
opportunity to the corporation, we will know definitely whether it
can or cannot finance the opportunity. If it can’t come up with
financing, then the director can take it.
If we don’t force the director to first present the opportunity to the
corporation and allow a financial ability defense, we must decide at
trial whether the company would have been financially able to take
the opportunity. This hypothetical, after-the-fact testimony cannot
possibly be as accurate as actually giving the corp oration the chance
at the time of the opportunity. We will be mistaken in some cases. If
so, the director would not be liable in some cases where the
corporation actually was harmed.
12
Part II, Question 1
Limited partners are not ordinarily personally liable for the
obligations of the limited partnership. RULPA § 303(a). They may be
liable if they participate in control of the business, but only to
“persons who transact business with the limited partnership
reasonably believing, based upon the limited partner’s conduct, that
the limited partner is a general partner.” Id.
Spock is making all business decisions for Enterprise, so he ’s probably
participating in control of Enterprise’s business. But, even if he is,
Khan, the accident victim, did not enter into a transaction with the
limited partnership reasonably believing Spock was a general partner.
Khan, an accident victim, did not choose to enter into a transaction
with Enterprise at all, much less do so believing Spock was a general
partner.
13
Part II, Question 2
Olivia is not liable to Sam’s Supply.
Gretta clearly is an agent of Olivia. Olivia manifested her consent to
have Gretta act on her behalf by hiring her and Gretta manifested her
consent to be Olivia’s agent by accepting the job. See Restatement
(Second) of Agency § 1(1). However, Olivia is bound on the contract
only if Gretta had actual, apparent, or inherent authority to purchase
the jack, RSA § 140, and Gretta had no such authority.
Actual authority
Gretta had no actual authority. Actual authority is created by
“written or spoken words or other conduct ” of the principal that
cause the agent to believe that the principal desires her to act. RSA §
26. Olivia did not say or do anything which, reasonably interpreted,
caused Gretta to believe that Olivia wanted her to purchase the jack.
Apparent authority
Gretta had no apparent authority. Apparent authority results from
words or conduct of the principal that reasonably cause the third
party to believe the agent is authorized to act. RSA § 27. Gretta’s
statement that she had authority is irrelevant, because that ’s not by
the principal.
Olivia said nothing to Sam that would lead him to believe Gretta was
authorized to purchase the jack. RSA § 27. Olivia allowed Gretta to
wear an Olivia’s uniform, but a uniform alone should not lead anyone
to believe the person is authorized to enter into a contract. Most auto
mechanics and many other types of employees wear uniforms,
without having any authority to enter into contract s. At most, the
uniform should lead Sam to believe that Gretta was an agent of
Olivia, which she was, but not that purchasing the jack was within
her authority.
Inherent authority
14
Gretta also had no inherent authority. It is not inherent in the
position of auto mechanic that one can buy equipment for the shop.
The only power inherent in the position of mechanic is the power to
repair cars, and possibly to bill for that work.
15
Part II, Question 3
Is This a Director’s Conflicting Interest Transaction?
The truck purchase is a director’s conflicting interest transaction
within the meaning of MBCA § 8.60(1)(iii). Dan knew at the time of
the transaction that a related person “was a party [to] or had a
material financial interest” in the transaction.
Ned, is the spouse of Dan’s niece, and is thus a related person under §
8.60(5)(ii), which covers the director’s “niece . . . (or any spouse
thereof).” As a result of his majority ownership of Mega Mercedes,
Ned has a financial interest in the transaction. If Ned’s interest
“would reasonably be expected to impair Dan’s objectivity,” it’s a
material financial interest. MBCA § 8.60(4).
Mega Mercedes is controlled by Dan, a related person. Therefore,
Mega Mercedes is itself a related person. See MBCA § 8.60(5)(iv). It
is a party to the transaction, making it a director’s conflicting interest
transaction.
Dan could nevertheless avoid liability for this transaction if this falls
within one of the three prongs of § 8.61(b).
Approval by Qualified Directors
Section 8.61(b)(1) does not seem to apply. The other directors are
clearly qualified directors; they have no interest in the transaction and
no material relationship with Dan. MBCA § 1.43(3). However,
although the board authorized Dan to negotiate the transaction, they
never actually approved the terms of the deal, as required by §
8.62(a).
Approval by Qualified Shareholders
Section 8.61(b)(2) also does not help. A shareholder vote was taken,
but that vote does not meet the requirements of section 8.63(a),
which requires approval of the transaction by a majority of the
qualified shares after full disclosure. Neither Dan’s shares nor the
16
shares of his mother are qualified shares. Dan’s shares are held by a
director who has a conflicting interest. MBCA § 8.63(c)(A). And his
mother’s shares are held by a related person of the director. MBCA §
8.63(c)(B). His mother is a related person under § 8.60(5)(ii)
(“parent”). Excluding those shares, the vote of the qualified shares
was actually 45-45%, so there was no majority approval, as required
by § 8.63(a).
Fairness
Dan can avoid liability if he can establish that the transaction was
“fair to the corporation.” MBCA § 8.61(b)(3). That determination
must take into account both fair dealing and whether the transaction
was “comparable to what might have been obtainable in an arm ’s
length transaction.” MBCA § 8.60(6). The burden of proving fairness
is on Dan.
There is evidence that a similar truck could have been obtained from
Ford for $15,000 less, but that doesn’t necessarily establish an unfair
price because the directors decided to purchase a Mercedes truck, not
a Ford. That decision was made by a majority of the qualified
directors, so the decision to choose that brand was not tainted. See
MBCA § 8.62. The real question is whether a comparable Mercedes
truck could have been obtained for a better price in an arm ’s length
transaction.
As to fair dealing, Dan disclosed his interest in the transaction, but
his involvement in the negotiations is not helpful.
17
Part II, Question 4
Sydney is dissociated from the partnership. He has the power to
dissociate at any time by express will Revised Uniform Partnership
Act § 602(a). When he said, “I quit,” that gave the partnership notice
of his express will to withdraw, as required by § 601(1).
His dissociation is not wrongful. Dissociation is wrongful only if it is
in breach of the partnership agreement or, in the case of a term
partnership, before the expiration of the term. RUPA § 602(b). At
first glance, the amendment to the agreement seems to establish a
term and this comes before the expiration of that term. If that
provision were valid, Sydney’s dissociation would be wrongful under
RUPA § 602(b)(2)(i). The exception in § 602(b)(2)(i) would not apply
because Lucie’s dissociation was pursuant to § 601(3), not one of the
sections listed in § 602(b)(2)(i).
However, the amendment of the partnership agreement is ineffective.
The default rule is that the partnership agreement may be amended
only with the consent of all of the partners. RUPA § 401(j). An 18 -7
vote is not sufficient. This rule may be changed by the partnership
agreement, since § 401(j) is not listed in § 103(b), but the question
says there’s nothing else relevant in the partnership agreement , so
there is no provision allowing for non-unanimous amendment.
Sydney’s dissociation results in a dissolution of the partnership; it
must be wound up. If the amendment to the agreement were ef fective,
this would be a term partnership; since none of the conditions in §
801(2) are met, it would not dissolve, and Sydney would be relegated
to the buyout in § 701. But, since the amendment is ineffective and
there’s nothing else in the partnership ag reement about termination,
this is a partnership at will. It was dissolved when Sydney expressed
his will to withdraw. RUPA § 801(1). It may continue now only for
purposes of winding up. RUPA § 802(a). Sydney is entitled to
participate in that winding up, since he did not wrongfully dissociate.
RUPA § 803(a). The partnership must discharge its liabilities, then
18
pay Sydney and the other partners the net amount in their partnership
accounts. RUPA § 807(a),(b).
19
Part II, Question 5
There are two possible arguments for imposing liability on Marty. He
might be liable as an unauthorized agent or a court might pierce the
veil of the LLC to make Marty personally liable as a member.
Liability as an Agent
Marty has no power to act as an agent for Gamma solely because he
is a member. RULLCA § 301(a). In a member-managed LLC like
Gamma, the power to control the conduct of the LLC is vested in the
members, who act by majority vote. RULLCA §§ 407(b)(1),(3).
If a majority of the members have given Marty authority to act o n
behalf of Gamma (or if Gamma’s operating agreement bestows such
authority on Marty), then Marty would not be personally liable. An
agent is not liable on a contract when acting for a disclosed principal.
Restatement (Second of Agency § 320. Enterprise is clearly disclosed
as the principal in the contract. See RSA § 4(1). Thus, Marty is not
directly liable for signing the contract, assuming he was authorized to
do so.
However, Fact 5 indicates that Marty often takes action without the
formal approval of Gamma’s members. An agent purporting to act on
behalf of a principal makes an implied warranty of authority.
Restatement (Second) of Agency § 329. If Marty had no actual
authority to enter into this contract, he would be liable to Petra for
breach of this warranty. However, the contract was made a year ago.
The equipment has been delivered and Gamma appears to have
accepted liability, so it’s not clear that the breach of warranty (as
opposed to the non-payment) has caused any harm to Petra.
Piercing the Veil
Members of an LLC are not personally liable for the debts of the
LLC. RULLCA § 304(a). However, courts have generally been willing
to pierce the LLC’s veil and hold members individually liable in
appropriate cases. See In Re Suhadolink.
20
Many of the facts listed should be irrelevant to the court ’s decision
whether to pierce the veil of Enterprise and hold Marty liable.
One of the factors courts look to in deciding whether to pierce the
corporate veil is a failure to follow corporate formalities. However,
the statute specifically provides that the LLC ’s “failure . . . to observe
any particular formalities relating to the exercise of its powers or
management of its activities” shall not be a ground for piercing the
veil. RULLCA § 304(b). That would seem to make Facts 4, 5, and 6
irrelevant for purposes of piercing.
Fact 7 should also be irrelevant. The LLC is a pass-through tax entity,
so this pass-through treatment should not be grounds for piercing the
veil.
Fact 2, by itself, also provides little reason to pierce the veil. In the
corporate context, courts often indicate that being a majority
shareholder, or even the sole shareholder, of a corporation is not by
itself sufficient reason to pierce the veil. Absent some sort of
misconduct, a 70% owner like Marty is entitled to the same limited
liability protection as any other member.
Members can be liable for their own conduct, but nothing in Fact 3
would impose such liability on Marty, assuming he had authority. The
signature line makes it clear that Marty was acting as an agent for
Gamma.
That leaves only Fact 1 as a potential basis for piercing the veil. I n the
corporate setting, courts typically do not pierce solely for
undercapitalization. See DeWitt Truck Brokers. It’s also not clear that
this is undercapitalization. Although DeWitt recognizes a continuing
obligation to adequately capitalize the corporation, some courts focus
only on capitalization at the inception, and nothing in Fact 1
indicates that the initial capitalization was inadequate. If a member is
going to be liable solely because the LLC lost money and no longer
has sufficient funds to pay the debt, then the general rule of limited
liability would be meaningless.
21
A court is unlikely to pierce Gamma’s veil and impose liability on
Marty.