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Business Associations
Professor Bradford
Fall 2012
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 II, Question 1:
Part II, Question 2:
Part II, Question 3:
Part II, Question 4:
Part II, Question 5:
Range 2-9; Average = 6.07
Range 0-9; Average = 4.97
Range 0-9; Average = 6.40
Range 2-8; Average = 5.60
Range 2-8; Average = 4.87
Range 0-8; Average = 5.22
Range 3-9; Average = 6.47
Range 2-8; Average = 4.98
Range 0-8; Average = 5.25
Total (of unadjusted exam scores, not final grades): Range 3.88-7.73;
Average = 5.45
All of these grades are on the usual law school scale, with 9 being an
A+ and 0 being an F.
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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
Directors owe a duty of care to the corporation. As a result of that
duty, they can be liable even in circumstances where they have no
personal interest or other conflict of interest.
Under the duty of care, directors can be liable both for decisions th ey
vote for and for inaction. I will discuss each of those in turn.
Decision-Making
Business Judgment Rule
If the board makes a decision, absent a conflict of interest, directors
are generally protected by a legal doctrine known as the business
judgment rule. The business judgment rule is a presumption that the
directors were fully informed and acted in the bes t interests of the
corporation. The burden is on the plaintiff to prove otherwise and,
under the business judgment rule, the courts generally defer to the
board and directors are not held liable, even if the judge thinks the
decision was incorrect.
Procedural Due Care: Failure to Inform
Directors may be held liable for decisions in two circumstances. First,
they may be held liable if they fail to adequately inform themselves
before making the decision. However, only an extreme departure will
result in liability. The standard is one of gross negligence, and courts
will not generally second-guess the amount of information directors
have, as long as they make an honest, good-faith attempt to inform
themselves about the substance of the decision.
Substantive Due Care: No-Win Transactions; Corporate
Waste
Second, directors may be held liable if the decision they make
constitutes a no-win transaction, otherwise known as corporate waste.
If the decision is so outrageous that no plausible, good faith argument
can be made that the corporate could benefit from it, directors can be
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liable. However, almost all decisions involve some plausible argument
for corporate benefit. A court, applying the business judgment rule,
will not hold the director liable just because the court disagrees about
whether the benefit of the decision exceeds its cost.
Oversight
Directors can also be held liable if the corporation suffers a loss that
the directors could have prevented by properly exercising oversight.
However, directors are not liable for all such losses.
Inattention
A director has an obligation to pay attention to corporate affairs —to
ask questions about what’s going on at the company and follow up if
any red flags or other issues arise. However, the directors are liable
for a loss only if proper attention to corporate affairs could have
prevented the loss.
Monitoring
In a public company such as the one you’re about to join, the board
of directors also has an obligation to put in place a corporate
compliance and monitoring system designed to detect wrongdoing or
business problems and bring those matters to the attention of the
board. However, the details of such a system are protected by the
business judgment rule. If the directors in good faith put a system in
place, they are not liable just because that system fails to catch a
particular problem that results in a loss. However, if the system does
bring wrongdoing to the attention of the directors, or brings to light a
red flag that justifies further inquiry, the directors can be l iable for
not following up.
Elimination of Duty of Care Liability
Most states allow corporations to limit or eliminate liability for
damages for directors’ breaches of the duty of care, and many public
corporations have done so. If such a provision has been adopted by
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the corporation you are about to join, none of the li ability discussed
above will apply.
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Part I, Question 2
There are a number of reasons why a general partnership might want
to get rid of a particular partner:
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

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The partner might not be fulfilling his professional obligations
(as in a law partner suffering ethical lapses).
The partner might not be generating sufficient profits for the
partnership or devoting sufficient attention and effort to
partnership business.
There might be personality clashes and the other partners find
themselves unable to get along with the other partner.
The partner might be stealing from the partnership or engaging
in other wrongdoing.
It might even be illegal to continue business with the partner.
For example, the partner might have been convicted of a felony
and it might be illegal for the partnership to operate the
particular business—for example, a casino—with a convicted
felon as a principal.
Partnership statutes do not include provisions allowing expulsion at
will. They typically allow a partner to be expelled judicially or by
unanimous vote of the other partners in some of these cases—for
instance, if it’s illegal to continue with the person as a partner, or if
the partner is engaged in certain kinds of wrongdoing. But judicial
expulsion is not an option in the other situations. And, even in cases
where expulsion is possible under the default rules, a contractual
provision would be less burdensome.
Even if there were no expulsion provision in the partnership
agreement, the other partners could get rid of the partner by
dissociating from the partnership and forming a new partnership
without that partner. However, if the partnership is a term
partnership, that dissociation would be wrongful and expose the other
partners to liability for damages. Even if the partnership is at will and
dissociation would not be wrongful, liquidation of the partnership
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business would be disruptive. Expulsion of the partner is much more
efficient.
The problem with expulsion clauses from a partner’s standpoint is the
possibility that they might be used opportunistically or in bad faith.
For example, the other partners might expel the partner just before
some profit-making activity the partner has been engaged in is about
to come to fruition. In this way, they could deprive the partner of the
return from his efforts. Or the other partners might use the expulsion
power in a way that is inconsistent with the expectations of the
partners. For example, if everyone knew when the person was made a
partner that he was an irascible jerk no one could get along with, and
they made him a partner anyway, it hardly seems fair to expel him for
that reason—especially if he has done things in reliance on becoming
a partner for which he would now not be fully compensated.
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Part I, Question 3
In a self-dealing transaction, the concern is that the interested
director is effectively on both sides of the transaction. He has control
over the corporation, but he also has a personal interest in the
transaction that might affect how he exercises his judgment on behalf
of the corporation. Because of that personal interest, the director
might push the corporation into a transaction that is not in its best
interests. However, a self-dealing transaction might still be beneficial
to the corporation, so we don’t want to completely bar such
transactions.
Disinterested directors have no personal interest in the transaction. If
they approve it, presumably, in their judgment, it is in the best
interests of the corporation. We respect their decision for the same
reason we ordinarily respect directors’ decisions under the business
judgment rule. Absent a conflict of interest, their decision is entitled
to the same presumption of propriety as in any other business
decision.
But their decision is trustworthy only if they are aware of all mat erial
facts relating to the director’s interest and the underlying transaction.
If they’re unaware of the conflict of interest, they might not give it
the special scrutiny it deserves—to determine, for example, if the
director’s interest has somehow affected the process of negotiating
and approving the transactions or the terms of the deal. And,
obviously, they need to know the material facts of the transaction
itself if their decision is to be worthy of deference, just as we expect
them to inform themselves before deciding in ordinary business
judgment situations.
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Part I, Question 4
A.
Under the default rules of the MBCA, Smith will be able to elect all
five of the directors and, absent Smith’s cooperation, Jones will not
be able to elect any.
Unless the articles of incorporation otherwise provide, directors are
elected by plurality voting; the candidate for each position who
receives the most votes is elected. MBCA § 7.28(a). Shareholders do
not have a right to cumulate their votes. MBCA § 7.28(b). Thu s, if
Smith and Jones do nothing to change the default rules, Smith ’s
candidate will win each position by a 55%-45% vote.
B.
There are several possible ways to change that result and guarantee
board representation for Jones.
1. Cumulative Voting. One possibility is to provide for cumulative
voting, where the total number of votes available to each shareholder
is the number of directors to be elected multiplied by the number of
shares. Shareholders may then split those total votes in any way they
wish. In this case, with 45% of the shares and five directors to be
elected, if Jones cast his cumulative votes intelligently (dividing his
total votes equally among two candidates), he should be able to elect
two of the five directors.
2. Classes of Stock. Another alternative would be to provide for two
classes of stock and allow each class the exclusive right to vote for
certain positions on the board. For example, Smith could be issued
Class A shares and the Class A shares could have the exclusive right
to elect three board members. Jones could get Class B shares, with
Class B shareholders given the exclusive right to elect the other two
board members. Since Jones would be the only Class B shareholder,
whoever he votes for would win the two Class B slots.
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3. Voting Agreement. Another possibility would be to use a voting
agreement, with each shareholder agreeing to vote for the candidates
each shareholder proposes for the requisite number of positions. For
example, the voting agreement could provide that Smith would
submit a list of three names and Jones would submit a list of two
names and Smith and Jones would each agree to vote their shares for
those five names.
4. Voting Trust. The same result could be accomplished with a voting
trust. Smith and Jones could convey their shares to a trustee, with the
trustee instructed to vote the shares for three people nominated by
Smith and two people nominated by Jones.
No matter which of these devices was chosen, the economic and
other rights could remain the same, with Smith having 55% of the
economic interest and Jones the other 45%.
Whatever device is chosen, Jones needs to be careful to include
provisions that would keep Smith from changing the allocated power.
Smith should not be able to amend any of the article provisions in
question without Jones’s concurrence, or Smith could eliminate
whatever protection Jones is given by majority vote. Also, there need
to be restrictions on the issuance of additional stock. If Smith can , by
majority vote, issue additional stock to himself or a confederate,
Smith could upset the percentages and Jones would capture fewer
directors through cumulative voting or Jones might find himself no
longer the only Class B shareholder entitled to elect the two
“minority” directors.
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Part II, Question 1
The pizza oven clearly is partnership property belonging to
Leonardo’s. Cookie contributed it to the partnership as a capital
contribution, so it is no longer Cookie’s individual property. RUPA §
204(b)(1). Cookie acknowledged this in the contract itself by making
the contract of sale on behalf of Leonardo ’s.
The question is thus whether Cookie had sufficient authority to bind
Leonardo’s to liability on the contract. If so, Arnie, Bettie, and
Cookie are also liable for the obligation of the partnership. RUPA §
306(a). If not, Arnie and Bettie are not liable because they have done
nothing individually that would obligate themselves.
The partnership is bound to the contract if Cookie had actual
authority to make the conveyance. See Restatement (Second) of
Agency § 140(a). The partnership agreement gives Cookie authority
to “make ordinary decisions related to cooking,” but denies him any
other agency authority. The question is whether disposal of the oven
is an “ordinary decision related to cooking.” If it is, then Cookie had
actual authority to execute the contract and the partnership is bound.
The oven is clearly “related to cooking,” but disposal an important
piece of capital equipment hardly seems like an ordinary cooking
decision. It’s arguable, but this language probably doesn’t give Cookie
authority to sell the stove.
The partnership could also be liable if Cookie had apparent authority.
See Restatement (Second) of Agency § 140(b). As they were leaving,
Arnie and Bettie, the only two other partners, indicated that Cookie
could “take care of ” Emeril on their behalf. Apparent authority is
based on conduct by the principal, in this case the partnership. Arnie
by himself cannot bind the partnership, but Bettie ’s assent by nodding
is probably sufficient to indicate her agreement with the statement.
The question is whether these words, reasonably interpreted, would
cause Emeril to believe that they consented to have Cookie sell the
stove. Restatement (Second) of Agency § 27. Probably not. These
words were spoken in the context of a tour of the restaurant, and a
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reasonable person would probably only interpret them to mean that
Cookie could give the tour, not that Cookie could sell the restaurant ’s
equipment.
The partnership could also be bound if Cookie had inher ent
authority—if the power to sell equipment was inherent in the job of
cook. See Restatement (Second) of Agency §§ 140(c), 8A. That theory
is unlikely to succeed. Most cooks do not have the authority to sell
cooking equipment and the sale of cooking equipment is not
necessary to perform the job of cook. Moreover, the partnership
agreement expressly denies to Cookie any agency authority beyond
making decisions related to cooking.
Finally, the partnership could be liable under § 301(1) of RUPA. The
partnership is bound if Cookie was apparently carrying on in the
ordinary course the partnership business and Emeril did not know
that Cookie lacked authority.
This provision probably does not make the partnership liable. The
RUPA does not define “ordinary course of business,” but the
partnership’s routine, day-to-day business is selling food, not selling
pizza ovens. Selling the cooking equipment is an extraordinary event
outside of the partnership’s regular operations. On the other hand, to
function, the partnership must buy kitchen equipment; selling that
equipment, although less usual, is just the converse of buying it. But
this unusual transaction is probably not in the ordinary course of
business. If that’s correct, then RUPA § 301(1) does not make the
partnership liable for Cookie’s actions. The partnership would be
liable under § 301(2) only if the sale was authorized by the other
partners, which it was not.
Therefore, the partnership is not liable, and Arnie, Bettie, and Cookie
are not liable for the contract as general partners of the partnership.
Cookie is nevertheless liable. A person who purports to make a
contract on behalf of someone who he has no power to bind, is liable
for breach of an implied warranty of authority. Restatement (Second)
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of Agency § 329. Cookie is liable to Emeril for breach of this
warranty.
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Part II, Question 2
Draft Statute:
(a) It shall be unlawful to purchase or sell any security on the basis
of material nonpublic information in any of the following
circumstances:
1. If the person purchasing or selling the security is an
officer, director, employee, or temporary insider of the
company whose security is being traded and the
nonpublic information is obtained from within that
company;
2. If the person purchasing or selling the security obt ained
the information in breach of a fiduciary duty that the
person owed to the source of the information and the
person does not disclose to the source of the information
the intention to purchase or sell the security on the basis
of the information;
3. If the person purchasing or selling the security obtained
the information from another person and
a. The other person providing the information, or
the ultimate source of the information, provided
the information to the person purchasing or selling
in breach of a fiduciary duty owed by the other
person and that breach of fiduciary duty involved
a personal gain to the tipper; and
b. The person purchasing or selling the security
knew or should have known that the information
was provided in breach of a fiduciary duty for
personal gain.
(b) The person providing the information in breach of a fiduciary
duty in a situation that meets the requirements of paragraph
(a)(3) shall also be liable.
(c) For purposes of paragraph (a)(1), “temporary insider” means
anyone working for the company in a situation where
1. The company expects the nonpublic information to be
kept confidential; and
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2. The relationship between the temporary insider and the
company requires, or at least implies, a duty of
confidentiality.
(d) For purposes of paragraph (a)(3), “personal gain” means a
pecuniary or reputational benefit or an intent to provide a gift
to another person.
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Part II, Question 3
Since there is nothing relevant in the certificate of organization or the
operating agreement, the default rules of the ULLCA apply.
1. Arnie is dissociated from the LLC.
Arnie has the power to dissociate as a member at any time by
withdrawing by express will. ULLCA § 601(a). He is dissociated
when the LLC has notice of his express will to withdraw. ULLCA §
602(1). Arnie’s statement that he is quitting and no longer wants to be
part of the business is sufficient to constitute dissociation.
2. Arnie is liable for damages for wrongful dissociation.
Arnie’s dissociation is wrongful. It is not in breach of an express
provision of the operating agreement, ULLCA § 601(b)(1); the
operating agreement says nothing about dissociation. But it is a
withdrawal by express will that occurs before the termination of the
LLC. ULLCA § 601(b)(2)(A). Because of the wrongful dissociation,
Arnie is liable for any damages the LLC suffers as a result of his
withdrawal. ULLCA § 601(c).
3. The LLC is not dissolved.
The LLC continues to exist. A single member’s dissociation does not
result in dissolution, unless the operating agreement says so. See
ULLCA § 701(a)(1). Ordinarily, the LLC dissolves only if all
members consent. ULLCA § 701(2). That has not happened here, nor
have any of the other events specified in § 701 .
4. Arnie’s rights as a member cease.
Arnie no longer has a right to participate in the management of the
LLC. ULLCA § 603(a)(1). His fiduciary duties to the LLC cease with
respect to any matters occurring after his dissociation. ULLCA §
603(a)(2). However, any obligation he incurred while he wa s a
member continues. ULLCA § 603(b).
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5. Arnie has the rights of a transferee.
Arnie is not entitled to a buyout of his membership interest. He
continues to own his interest in the LLC, but his status is the same as
a transferee. ULLCA § 603(a)(3). He is not entitled to participate in
management and control of the business or, in most cases, to access
the books and records of the LLC. ULLCA § 502(a)(3). Arnie is
entitled only to receive any distributions to which he would otherwise
be entitled. ULLCA § 502(b).
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Part II, Question 4
1. Beta is covered by the proxy rules
The federal proxy rules apply only to solicitations “with respect to
any security . . . registered pursuant to section 12” of the Exchange
Act. Securities Exchange Act § 14(a)(1). Beta’s common stock is
registered pursuant to section 12 and Jones is soliciting the common
shareholders, so the proxy rules apply.
2. Jones’s letter is a proxy “solicitation
To be subject to the proxy rules, Jones’s letter must be solicitation, a
term defined in Rule 14a-1(l).
Jones’s letter clearly is a solicitation within the basic definition. Jones
did not furnish the shareholders with a proxy form or ask them to
execute a proxy, so 14a-1(1)(i) and (ii), don’t apply, but the letter falls
within subsection (iii), which includes “other communication to
security holders under circumstances reasonably calculated to result
in the procurement, withholding, or revocation of a proxy.” Jones’s
letter to the shareholders is likely to affect whether those shareholders
give management their proxies to vote for the incumbent directors or,
if they have already given management their proxies, whether they
revoke them.
The letter does not fall within any of the exceptions to the basic
definition in Rule 14a-1(l)(2). The only potentially applicable
exception is (2)(iv)—a communication by the security holder stating
how he intends to vote and the reasons therefor. The letter arguably
does more than (2)(iv) allows, but it might fall within this language, if
you interpret it broadly. However, a (2)(iv) communication must also
come within one of the subparagraphs, (A), (B), or (C). Subsection
(A) does not apply because the letter is not in any of the public
forums specified: public forums, press releases, broadcast media,
newspapers, magazines, or other publications disseminated on a
regular basis. It’s not within (B) because Jones doesn’t owe a
fiduciary duty in connection with voting to all the Beta shareholders.
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And it’s not in (C) because it’s not in response to any unsolicited
request from those shareholders. Thus, Jones’ letter does not fall into
any of the 14a-1(l)(2) exceptions.
3. Jones’s letter falls within the Rule 14a-2(b)(1) exemption.
Ordinarily, a proxy solicitation would have to be accompanied by a
proxy statement that has been filed with the SEC. Rule 14a-3(a)(1).
However, Jones is excepted from this requirement, and most of the
other proxy rules, because he falls within Rule 14a-2(b)(1). Although
his letter is a solicitation, he is not in any way seeking the power to
act as proxy for anyone else and he has not furnished a proxy form to
anyone. Thus, he doesn’t have to worry about Rule 14a-3 and most
of the other proxy rules.
4. Jones could be liable under Rule 14a-9.
Rule 14a-2(b)(1) does not exempt soliciations from Rule 14a-9. See
Rule 14a-2(b), opening clause (14a-9 not listed). Jones appears to
have violated Rule 14a-9, which prohibits false or misleading
statements of material facts in connection with proxy solicitations.
Jones’s letter included a false statement—that Doe was convicted of
an honor code violation. To create liability under Rule 14a-9, the
false statement must be of a “material fact.” A fact is material “if
there is a substantial likelihood that a reasonable shareholder would
consider it important in deciding how to vote.” Virginia Bankshares
(citing TSC Industries). Doe’s integrity is something of vital interest to
shareholders voting for directors. A reasonable shareholder would
undoubtedly consider such an issue important, unless it was so long
ago that it would be discounted. Even then, it might still be important
to shareholders. Therefore, Jones could be liable for proxy fraud.
If Doe was elected in spite of the false statement, Jones would not be
liable to private plaintiffs because there would be no damages.
However, Jones could still be liable if the SEC sued.
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If Doe was not elected, Jones could be liable to private plaintiffs. A
plaintiff would not have to show that Jones’s statement was actually
relied on by anyone in voting, just that the shareholders he solicited
were an essential link in not electing Doe—in other words, that their
votes were necessary. Virginia Bankshares. Jones solicited all the
shareholders, and those shareholders’ votes were necessary to elect
someone other than Doe. The essential link test is met .
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Part II, Question 5
A.
As if December 1, Beta may pay a maximum of $2,615,000 in
dividends.
Under Delaware law, a company may pay dividends out of its surplus
(or, if it has no surplus, out of the net profits for the current and prior
fiscal years). Del. § 170(a). Beta has a surplus, so the second test does
not apply. (In any event, the question does not provide any
information about the company’s profits.) Surplus is defined as the
excess of the company’s net assets over its capital, meaning stated
capital. Del. § 154. Net assets, in turn, are defined as the amount by
which total assets exceed total liabilities. Del. § 154 .
As of Dec. 1, Beta has net assets of $3,166,000 - $351,000 =
$2,815,000. The amount of capital is the amount in the Common
Stock account, $200,000. Thus, Beta’s surplus is $2,815,000 – 200,000
= $2,615,000.
B.
Beta has $15,000 more cash as a result of the stock sale, so its Cash
account will increase by $15,000 to $2,609,000. Its liabilities won’t
change, so Shareholders’ Equity will increase by $15,000. The par
value of the stock (1,000 shares x $1 per share par value = $1,000)
will be added to the Common Stock account. The Additional Paid-In
Capital Account will increase by the remaining $14,000.
C.
Whether to pay dividends, and the amount of dividends to pay, is a
business judgment made by the directors of the co rporation.
Ordinarily, the directors’ decision protected by the business judgment
rule. No duty of loyalty issues are raised, as long as Manny, the
controlling shareholder, and director-shareholders are treated like all
other shareholders. See Sinclair v. Levien. Therefore, as long as the
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directors adequately informed themselves before deciding not to pay
dividends, Smith v. Van Gorkom, liability is unlikely. The plaintiff will
not be able to prove that this is corporate waste; the corporation is
retaining the cash, and there’s no plausible argument that keeping the
money will not benefit the corporation.
However, with only ten shareholders, Beta is a closely held
corporation. Some courts have been willing to impose stronger,
partnership-like fiduciary duties on the shareholders in closely held
corporations. See, e.g., Donahue v. Rodd Electrotype; Hollis v. Hill.
In closely held corporations, minority shareholders have no market
for their shares and therefore can earn a return only through
dividends or salaries. Recognizing that, some, but not all, courts have
applied that special fiduciary duty to give plaintiffs relief where the
controlling shareholder has refused to pay dividends. See Hollis v. Hill.
However, Delaware has rejected this special closely -held-corporation
fiduciary duty, and this is a Delaware corporation, so any such claim
will fail.
[I gave some credit to people who analyzed this type of claim. Here ’s how this
claim could be analyzed: In this case, if the minority shareholder is not
an employee, dividends are his only available return. However, if the
company has a long-term history of not paying dividends and the
decision not to pay dividends was made for a legitimate business
purpose and not in a bad faith attempt to freeze out the minority
shareholders, the minority shareholder is less likely to win on a
fiduciary duty claim. See, e.g., Zidell v. Zidell.
The cases where insufficient dividends have been held to support a
fiduciary duty violation have usually involved actions in addition to
the mere non-payment of dividends—such as firing the shareholder
and depriving him of a salary, Hollis v. Hill, or paying excessive
salaries to the controlling shareholders, Giannotti v. Hamway. A court
is less likely to grant relief where the contested action consists merely
of not paying dividends. However, the reach of the close corporation
fiduciary duty is uncertain, and there is considerable dictum in the
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cases talking about the entitlement of the minority shareholde r to a
return on his investment, so the plaintiff might recover even abs ent
other evidence of bad faith.]