BUSINESS ASSOCIATIONS-TELMAN
INTRODUCTION
 Five Type of Business Associations
 (1) Sole Proprietor
 Simplest form of business association and most numerous
 No paperwork or formalities required
 Absolute control of the business
 Absolute liability → Can be sued for more than the business is worth because there is no
separation between the owner and the business
 (2) General Partnership
 UPA (1914) § 6: Partnership Defined – A partnership is an association of two or more persons to
carry on as co-owners a business for profit
 No paperwork or formalities required
 But should consult attorney to be safe
 The default rule is that both partners are 50% liable for any debts or liabilities
 They are also joint and severally liable
 The partnership agreement can also apportion fault and this will be respected
 Advantage of pass through taxation → Only taxed once on the profits, which are personal profits
to the partners (unlike corporations)
 (3) Limited Liability Partnership
 A partnership with one or more general partners and one or more limited partners
 Paperwork and formalities required
 General partner has general liability; limited partner has limited liability
 But if the general partner is a corporation, can avoid liability issues
 Advantage of pass through taxation
 (4) Limited Liability Company
 Cross between a corporation and a partnership
 Tax advantages of partnerships
 Limited liability advantage of corporations
 Paperwork and formalities required
 Have to put third parties on notice when liability is limited
 Extremely flexible in terms of organization
 Some questions as to whether partnership or corporate law applies in some situations
 (5) Corporations
 Separation of ownership and control
 Paperwork and formalities required
 Articles or Incorporation, By-Laws, Directors, Officers, Minutes, Elections…
 Board of Directors → Elected by the shareholders and pretty much do nothing except elect the
officers
 Officers → CEO’s and other individuals selected by the board, not by the shareholders
 Corporations have their own legal identity
 Therefore people sue the corporation and not the officers (in most cases)
 Means that individuals have limited liability → Can only lose the amount of your shares, no
personal liability
 Double Taxation
 Taxed first on corporation’s earnings
 Then individuals are taxed on the dividends paid out by the corporation
 All five business associations are governed by agency rules
 Restatement of Agency (Second) § 1:
 Agency is the fiduciary relation which results from the manifestation of consent by one person to
another that the other shall act on his behalf and subject to his control, and consent by the other so
to act
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 3rd Party Agent Triangle
 (P → A) Relationship between the Principal and the Agent
 Can be an express or implied relationship
 Relationship between the Agent and the Third Party
 Concerns Agent’s dealings with Third Party
 (P → T) Relationship between the Principal and Third Party: tricky
 There is a legal relationship between the Principal and the Third Party, despite the fact that the
parties are unfamiliar with each other
 This creates a legal liability of Principal to Third Party
 Legal standard for Agency to apply:
 (1) The manifestation of consent by the Principal to the Agent, that the Agent will act
 (a) on Principal’s behalf
 (b) subject to the Principal’s control
 (2) The Agent consented to the Act
CHAPTER ONE—AGENCY
WHO IS AN AGENT?
 Gorton v. Doty
 Teacher loaned her car to a football coach to drive player to the game with the reservation that he was
the only one who could drive the car
 An accident occurred where coach died and player, Doty, was injured
 Teacher was responsible for injuries suffered by football player because she was the principal and the
coach was her agent, therefore creating the link between the player and the teacher
 Since teacher gave coach instructions about driving the car, the court saw this as the teacher
manifesting an intent that the coach would drive her car subject to her control and the coach
consented
 There is also a background assumption that when someone drives your car, they are your
agent
 Is this law fair?
 No. The teacher acted responsibly by giving the coach a few instructions, but this is what created
the legal liability
 The law always favors the victim
 Agency defined
 The relationship which results from the manifestation of consent by one person to another that the
other shall act on his behalf and subject to his control, and consent by the other so to act.
 3 forms:
 Principal and agent
 Master and servant
 Employer or proprietor and independent contractor
 Not necessary for existence of authority that there be a contract between principal and agent, nor is
it essential that they, or either, receive compensation
 Dissent:
 Agency means more than passive permission. It involves request, instruction, or command.
 Portrays the use of car as merely a loan & asking the coach drive the car was a mere precaution
upon her part
 Moreover, portrays it as a gratuitous bailment & not agent
 A. Gay Jenson Farms Co. v. Cargill, Inc.
 Cargill, a lending institution, gave money to Warren for its grain storage business. Warren
misrepresented their value and Cargill kept loaning money to it, yet taking more and more control of
Cargill’s operations to protect their investment. Warren went bankrupt and the farmers it owed money
to sued Cargill.
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Cargill became the Principal of Warren because it assumed de facto control over the day to day
operations of Warren (Rule: a creditor who assumes control of his debtor’s business may become
liable as principal for acts of the debtor in connection with the business)
 Restatement of Agency § 14 comment O enumerates the factors the court looks to when
determining if a creditor is a principal
 Distinction between creditor oversight and control of the company
 Factors in this case:
 Cargill’s constant recommendations to Warren by phone
 Cargill’s right of first refusal on grain
 Warrant’s inability to enter into mortgages, to purchase stock or to pay dividends without
Cargill’s approval
 Cargill’s right of entry onto Warren’s premises to carry on periodic checks and audits
 Cargill’s correspondence and criticism regarding Warren’s finances, officers salaries, and
inventory
 Cargill’s determination that Warren needed “strong paternal guidance”
 Provision of drafts and forms to Warren upon which Cargill’s name was imprinted
 Financing of all Warren’s purchases of grain and operating expenses
 Cargill’s power to discontinue the financing of Warren’s operations
R.2d Agency § 14K compares agent and supplier
 One who contracts to acquire property form a third person and convey it to another is the agent of
the other only if it is agreed that he is to act primarily for the benefit of the other and not for
himself.
 Factors for supplier, rather than agent:
 That he is to receive a fixed price for the property irrespective of price paid by him. This
is the most important
 That he acts in his own name and receives the title to the property which he thereafter is
to transfer
 That he has an independent business in buying and selling similar property
Is this case rightly decided?
 No. Warren was misrepresenting its value. The only way Cargill could have noticed this was
through more oversight.
 The question is who is in the best position to avoid the loss
 Cargill wants to protect its investment, but cannot get too close to Warren or it is Warren’s
principal
 This discourages lending to questionable institutions
 The farmers could easily get insurance
LIABILITY OF PRINCIPAL TO THIRD PARTIES IN CONTRACT
 Authority
 Authority is another element of agency
 (1) Is there an agency relationship?
 A manifestation of consent that the agent would act subject to the principal’s control with the
agent’s consent
 If there is no agency relationship, then there is no possibility of authority
 (2) Was the Agent acting with authority?
 Types of Authority
 (1) Actual Authority
 Focus on (P → A)
 Requires an actual manifestation from the Principal to the Agent
 Actual authority can be express, implied, or incidental
 (A) Express Actual Authority → “You are my agent, buy me booze.”
 Restatement of Agency § 26: Except for the execution of instruments under seal or
for the performance of transactions required by statute to be authorized in a
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particular way, authority to do an act can be created by written or spoken words or
other conduct of the principal which, reasonably interpreted, causes the agent to
believe that the principal desires him so to act on the principal’s account
 (B) Implied Actual Authority → “You are my agent and the manager of my store.” Store
usually buys booze.
 Implied authority is very contextual and looked at situation by situation
 Restatement of Agency § 33: An agent is authorized to do, and to do only, what it is
reasonable for him to infer that the principal desires him to do in the light of the
principal’s manifestations and the facts as he knows or should know them at the time
he acts
 Restatement of Agency § 34 (Circumstances considered in finding implied express
authority):
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 (C) Incidental Actual Authority → A person is hired to complete a construction project
and goes out and borrows a wrecking ball needed to finish the project. → incidental
 Restatement of Agency § 35 (When incidental authority is inferred): Unless
otherwise agreed, authority to conduct a transaction includes authority to do acts
which are incidental to it, usually accompany it, or are reasonably necessary to
accomplish it.
 Mill Street Church of Christ v. Hogan
 Actual Authority Case
 Bill was hired to paint the church, a two person job. The church thought he should hire Petty, but
the church told him Petty was impossible to reach so Bill hired Sam as he had done many times in
the past. Sam broke his arm. Is church (principal) liable? Yes
 Did Bill have express authority?
 No, church did not tell him to hire Sam.
 Did Bill have implied authority?
 Yes, he hired Bill on many church jobs in the past, the church told him it was a two
person job…
 Question to ask for implied actual authority
 Was it reasonable for Bill to believe he had the authority to hire Sam?
 Implied authority is actual authority circumstantially proven which the principal actually
intended the agent to possess and includes such powers as are practically necessary to carry
out the duties actually delegated
 The existence of prior similar practices is one of the most important factors
 the person alleging agency and resulting authority has the burden of proving that it exists
 Apparent authority on the other hand is not actual authority, but is the authority the agent is held
out by the principal as possessing. It is a matter of appearances on which third parties come to
rely.
 Apparent Authority
 Focus on (P → T)
 Look for a manifestation from the principal (usually through the agent) to the third party as to
make the third party believe it had authority to act
 Think McDonald’s case
 A third party can reasonably believe that an agent with the title “salesman” has the authority to
bind the principal in a sales contract
 Three-Seventy Leasing Corporation v. Ampex Corporation
 Joyce has a contract with Kays, Ampex’s salesman, for the lease of computers. Though Joyce does
not know, only people with pay grades higher than Kays can enter into binding agreements for the
company. Joyce and Kays make a deal, is it binding on Ampex?
 Yes
 Did Kays have actual authority to make the sale?
 No, he was not a big enough dog.
 Did Kays have apparent authority to make the sale?
 Yes
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Question to ask
 Were the manifestations Ampex made to Joyce that Kays had authority to make the sale?
 Yes: he was the only person contacting Joyce and he had the title salesman
 It was reasonable for Joyce to believe Kays had authority to make a binding deal
 Is this fair?
 Though the corporation did not give the person the authority they use in these cases, the
corporation should be aware that other individuals might reasonably believe a person has the
authority to bind the principal.
 The principal must make clear to the third party that the agent does not have authority to
bind the principal; write this on the contract
 Apparent authority: an agent has apparent authority sufficient to bind the principal when the
principal acts in such a manner as would lead a reasonably prudent person to suppose that the
agent had the authority he purports to exercise.
 Inherent Agency Power
 Only applicable when:
 (1) There is a general agent (as opposed to a special agent)
 (2) There is an undisclosed principal
 (3) The agent has exceeded his authority
 Restatement of Agency § 8A: Inherent agency power is a term used in the restatement of this subject to
indicate the power of an agent which is derived not from authority, apparent authority or estoppel, but
solely from the agency relation and exists for the protection of persons harmed by or dealing with a
servant or other agent
 Watteau v. Fenwick
 Humble was the manager of a bar owned by defendants. Defendants gave Humble authority to
purchase beer and wine, nothing else. Humble purchased cigars from seller, who believe Humble
was the owner of the bar (Humble’s name was above the door and seller did not know of
defendants). Are defendants liable for Humble’s contract?
 Yes
 Did Humble have actual authority?
 No, he was expressly told not to do this.
 Did Humble have apparent authority?
 No, the seller did not know of defendant principal, therefore the principal made no
manifestations to seller
 Did Humble have inherent authority?
 Yes, the principal is liable for all the acts which are usually confided to an agent of that
character
 E.g., a bar manager can usually purchase cigars
 Restatement of Agency § 194: A general agent for an undisclosed principal authorized to conduct
transactions subjects his principal to liability for acts done on his account, if usual or necessary in
such transactions, although forbidden by the principal to do them
 § 195 is the same thing but for managers of businesses
 This doctrine was created for cases such as this: It would not be fair to hold the third party
responsible for making rational decisions in regard to the agent
 Is this fair?
 Yes, it is for the protection of third parties
 The principal can easily avoid the cost of liability if he simply put third parties on notice that
there was a principal and the agent only had limited authority
 This is the price to pay for being undisclosed.
 Principal can always sue the agent
 Can’t conceal partnership to avoid liability
 Ratification
 When will ratification be applicable?
 (1) Prove an agency relationship
 (2) There is no authority (there is never authority with ratification)
 But the action is ratified after the fact
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Restatement of Agency § 82: Ratification is the affirmance by a person of a prior act which did not
bind him but which was done or professedly done on his account, whereby the act, as to some or all
persons, is given effect as if originally authorized by him
 The principal will be bound if the principal ratifies the contract → the principal accepts or derives
some benefit from the deal and is knowledgeable
 Ratification is a one way street. Principal cannot ratify after there has been a material change
of circumstances in principal’s favor
 Botticello v. Stefanovicz
 Mary and Walter owned a farm as tenants in common. Plaintiff wanted to purchase the farm, but
turned down the $100,000 offer and countered with $75,000. Mary stated she would sell for no
less than $85,000. Walter and plaintiff entered into a lease with an option to purchase agreement
without Mary. Mary saw the rent checks coming in and did not stop them. Does Mary have to sell
the farm?
 No
 Was Walter Mary’s agent?
 No. Agency has three elements that must be met.
 (1) A manifestation by the principal that the agent will act for him
 (2) acceptance of the undertaking by the agent
 (3) an understanding by the parties that the principal will be in control of the undertaking
 Marriage does not make Walter her agent. Must look at the past practices of the
couple and it shows that Mary always signed her own documents. Would be different
if she did not and had nothing to do with the property.
 Did Mary ratify the contract by accepting rent payments?
 No. Mary ratified the lease portion of the agreement but she did not know of the purchase
option, therefore she did not ratify it.
 Three requirements for ratification
 (1) A valid affirmation by the principal of a prior act
 (2) That did not bind her, although professedly done on her account
 (3) The Principal must be aware of all the relevant facts at the time of ratification (fatal in the
above case)
 Marital status cannot in and of itself prove the agency relationship. Nor does the fact that the
defendants owned the land jointly make one the agent for the other.
 A statement that one will not sell for less than a certain amount is by no means the equivalent of
an agreement to sell for that amount.
 If the original transaction was not purported to be done on account of the principal, the fact that
the principal receives its proceeds does not make him a party to it
 Estoppel
 Restatement of Agency § 8B:
 (1) a person who is not otherwise liable as a party to a transaction purported to be done on his
account, is nevertheless subject to liability to persons who have changed their positions because of
their belief that the transaction was entered into by or for him, if
 (a) he intentionally or carelessly caused such belief, or
 (b) knowing of such belief and that others might change their positions because of it, he did
not take reasonable steps to notify them of the facts.
 (2) An owner of property who represents to third persons that another is the owner of the property
or who permits the other so to represent, or who realizes that third persons believe that another is
the owner of the property, and that he could easily inform the third persons of the facts, is subject
to the loss of the property if the other disposes of it to third persons who, in ignorance of the facts,
purchase the property or otherwise change their position with reference to it (like pay money or
improve the land)
 Hoddeson v. Koos Bros.
 A woman purchased furniture from an individual in Koos Brothers furniture store. The man did
not really work there and tricked her into purchasing the furniture, which he delivered what was in
stock. Woman sues the furniture store to get the furniture.
 Was the imposter an agent of Koos Brothers?
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No. He did not work there.
Therefore, without agency there can be no authority of any kind, even though apparent
authority sounds like a good argument.
Is Koos Brothers still responsible?
 Yes, through estoppel.
Elements of Estoppel
 (1) Acts or omissions by the principal, either intentional or negligent, which create an
appearance of authority in the purported agent
 (2) The third party reasonably and in good faith acts in reliance on such appearance of
authority
 (3) The third party changed her position in reliance upon the appearance of authority
Is this outcome fair?
 Even though the man was an imposter in Koos Brothers, the court must hold one or two
innocent parties liable.
 The furniture store is in a better position to protect the public from imposters in their
store, therefore they get the blame.
Why did Koos Brothers even fight this suit?
 They did not want the court to find apparent authority (which it did not) because that
would make it too easy for them to be liable.
 Review
 (1) Is there an agency relationship?
 If yes
 (2) Did the agent act with authority?
 (a) Actual
 Express, Implied, or Incidental
 (b) Apparent
 (c) Inherent
 If there is not agency relationship
 (3) Did the individual ratify the deal?
 (4) Can the individual use estoppel for protection?
 Agent’s Liability on the Contract
 What if the principal cannot be sued?
 Can we hold the agent liable for the contract?
 Three situations:
 (1) Is there a Disclosed Principal?
 If yes, the agent is not liable on the contract
 Two exceptions
 (A) All parties agree or it is the clear intent of the parties that the agent is bound
 (B) Agent made the contract but exceeded his authority in doing so: then
 (1) Implied warranty of authority (Majority View)
 (2) Recover in tort for deficit (Minority View)
 (3) Agent is a party to the contract (Minority View)
 (2) Is there a Partially Disclosed Principal or an Undisclosed Principal?
 If yes, the agent is treated as a party to the contract
 The agent has a duty to disclose his principal
 The third party to the contract has no duty to inquire as to whom the agent is working for
 Atlantic Salmon A/S v. Curran
 Plaintiffs were doing business with Boston Seafood through the agent/defendant. The
agent/defendant was acting through his other corporation which was the agent of Boston Seafood.
Plaintiffs believed they were dealing solely with agent, not with his dissolved corporation.
Defendant dissolved parent corporation and Boston Seafood went bankrupt while owing plaintiff
$100,000.
 Is the principal disclosed?
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No. Yet plaintiffs knew they were dealing with more than just the defendant, therefore
the court held the principal was partially disclosed.
 Is the agent then liable for the contract since he did not disclose his principal?
 Yes. Even though the statute said otherwise in the case, the court found that since the
agent did not disclose his principal he was liable because he was party to the contract.
 Is this a good rule
 It encourages individuals like the plaintiff to lend money without inquiring because they
can sue the agent anyways.
 But the agent is in the best position to avoid the loss by simply disclosing the principal.
 Remember, third party has no due diligence standard.
 Easiest way around rule
 Get the principal or agent to sign a personal guarantee
If the other party to a transaction has notice that the agent is or may be acting for a
principal but has no notice of the principal’s identity, the principal for whom the agent is
acting is a partially disclosed principal. Unless otherwise agreed, a person purporting to
make a contract with another for a partially disclosed principal is a party to the contract.
It is not sufficient that plaintiffs may have had the means, through a search of the records of the
Boston city clerk, to determine the identity of the defendant’s principal. Actual knowledge is the
test
It is not, therefore, enough that the other party has the means of ascertaining the name of the
principal; the agent must either bring to him actual knowledge or, what is the same thing, that
which to a reasonable man is equivalent to knowledge or the agent will be bound. If he does not
do this, it may well be presumed that he intended to make himself personally responsible.
LIABILITY OF PRINCIPAL TO THIRD PARTIES IN TORT
 Servant Versus Independent Contractor
 Restatement of Agency § 219: When a master (employer) is liable for torts of his servants
(employees):
 (1) If employee is acting in the scope of employment
 (2) An employer is not liable for the torts of his servants acting outside the scope of their
employment, unless:
 (a) The employer intended the conduct or the consequences, or
 (b) the employer was negligent or reckless, or
 (c) the conduct violated a non-delegable duty of the employer, or
 (d) the employee purported to act or to speak on behalf of the principal and there was reliance
upon apparent authority, or he was aided in accomplishing the tort by the existence of the
agency relation
 The first question is whether someone is a servant of the employer?
 A master servant relationship exists where the servant has agreed
 (a) to work on behalf of the master, and
 (b) to be subject to the master’s control or the master has a right to control the “physical
conduct” of the servant (how the job is performed as opposed to simply asking for results)
 Servants are distinguished from independent contractors
 Restatement of Agency § 220(2) gives factors to determine when deciding if someone is a servant
or independent contractor
 Extent of control master has over details of the work
 Whether employee is employed in a distinct occupation or business
 Is the work done by a specialist without supervision or an employee
 The skill required in the profession
 Whether the employer or the workman supplies the tools
 The length of time a person is employed
 Whether the work is a part of the regular business of the employer
 Determining the difference between servant and independent contractor is an objective test
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It does not matter what the parties call themselves; it’s how they actually act
Independent contractors are of two types, agents and non-agents.
 An agent-type, independent contractor is one who has agreed to act on behalf of another, the
principal, but not subject to the principal’s control over how the result is accomplished
 A non-agent independent contractor is one who operates independently and simply enters into
arm’s length transactions with others.
The following cases only distinguish servants & independent contractors
Humble Oil & Refining Co. v. Martin
 Martin was injured when a car rolled away from Humble’s gas station and struck him. The driver
of the car did not put on brakes and Schneider was filling it with gas. Neither the driver nor
Schneider had any money, so Martin wanted to sue Humble Oil for their deep pockets.
 Was Schneider Humble Oil’s agent?
 Yes. Humble Oil exercised great control over the day to day activities of the service
station, therefore Schneider was its agent.
 Humble controlled hours of operation
 Humble paid most of the operating expenses
 Humble told Schneider what to do everyday
 The test is day to day control
 Is this case decided correctly
 We want rules that make economic sense. In reality, Humble had little control over the
day to day operations and could do nothing to stop the injury or conduct.
 It makes more sense to put the burden on the party with control because they are the most
efficient cost avoider
Hoover v. Sun Oil Company
 Plaintiff went to get his gas filled and Barone, man pumping his gas, lit his car on fire. Plaintiff
knows Barone is dumb and has no money, wants Sun Oil company who owns the station.
 Is Barone an agent of Sun Oil?
 No. The court found Barone had sufficient control of his day to day operations and other
aspects of the business. Sun Oil simply was paid rent and Barone bought their gas.
 Key facts: while Sun Oil was involved, they only made suggestions on how to run the business.
Moreover, while Peterson did offer advice to Barone on all phases of his operation, it was usually
done on request and Barone was under no obligation to follow the advice. There were no written
reports to Sun and he alone assumed the overall risk of profit or loss in his business operation.
Barone independently determined his hours of operation and the identity, pay scale, working
conditions, and posted his name as the proprietor.
 Because of these facts, the lease contract and dealer’s agreement fail to establish any relationship
other than landlord-tenant, and independent contractor
Analysis
 Important elements of business relationships include duration, control, risk of loss, and return.
Murphy v. Holiday Inns, Inc.
 Plaintiff slipped and fell at a Betsy Lynn Motor Hotel doing business as Holiday Inn. Plaintiff
wanted to sue Holiday Inn but lost.
 Was Betsy Lynn Holiday Inn’s agent?
 No. Betsy Lynn controlled day to day operations
 No control over maintenance
 No control over business, customer rates, or profit sharing
 No control over wages or hiring and firing
 Since franchise (Holiday Inn) had little day to day control, Betsy Lynn is not their agent
 Note
 Even if franchise agreement states that the parties are not principal/agent, it does not
matter if the court finds agency
 Objective test
 Court notes that the critical test is the nature and extent of the control agreed upon.
 Telman’s note:
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Court notes: “that training for licensee’s manager, housekeeper, and restaurant manager be
provided by licensor at licensee’s expense.”
 Telman argues that this gave Holiday Inn a good amount of control and could have attached
liability.
 Although they used many of the franchise names and insignias the court found no liability because
the defendant was not given power to control daily maintenance
 Analysis and Planning
 R.2d Agency § 219(1): A master is subject to liability for the torts of his servants committed
while acting in the scope of their employment. It is clear that, as a general rule, a principal is not
liable for the torts of his non-servant agents—i.e., independent contractors
 Tort Liability and Apparent Authority
 Old Rule
 Master is not liable for the torts of its servant
 Only arises in two situations
 Franchiser/Franchisee cases
 Hospital/Doctor cases
 Miller v. McDonald’s Corp.
 Miller bought a Big Mac, bit in, and chipped her tooth on a sapphire. The McDonalds she went to
was a franchise, but the court still found that the McDonalds was an agent of the corporations.
 Why?
 Apparent Agency (nothing to do with apparent authority).
 (1) If Principal represents (intentionally or negligently) that another is their agent,
and
 (2) A third party reasonably relies upon that representation to their detriment
 (3) Then the principal is liable for the torts of their apparent agent
 Same as estoppel. Principal cannot argue that the tortfeasor was not their agent.
 Distinguished from Apparent Authority
 With apparent agency, there was no agency to begin with. The apparent agency creates
the courts finding of agency.
 How can McDonalds avoid liability
 Make the sign say “Justin’s McDonalds”
 Why courts like this rule
 Allows injured plaintiffs to go after deep pockets when there is no agency relationship
 Why Telman hates this rule
 Estoppel sufficiently covers the issue
 How can you prove that plaintiff relied on manifestation?
 Plaintiffs will always say they relied in order to get money
 Operating agreement required the franchise to operate consistently with the McDonald’s system:
 Described proprietary rights in trade names, service marks, and trademarks, as well designs
and color schemes for buildings, signs, equipment, layouts, formulas, and specifications for
certain food products, methods of inventory and operation control, bookkeeping and
accounting, and manuals covering business practices and policies.
 Expressly required the restaurant to keep open during the hours prescribed, including
maintenance adequate supplies and employing adequate personnel to operate at maximum
capacity and efficiency during those hours; similar appearance.
 Agreement did not distinguish between a company-run or a franchised restaurant
 Frequently sent field consultants to the restaurant to inspect its operations. Trained
employees according to standards prescribed.
 ***Failure to comply with the agreed standards could result in loss of the franchise.
 Plaintiff went to the restaurant under the assumption that defendant owned, controlled, and
managed it. Nothing disclosed to her that any entity other than defendant was involved in its
operation
 Delaware Supreme Court:
Page 10 of 81

“If, in practical effect, the franchise agreement goes beyond the stage of setting standards, and
allocates to the franchisor the right to exercise control over the daily operations of the
franchise, an agency relationship exists.”
 Court noted that the possible existence of a sign identifying the operator does not alter the
conclusion that there is an issue of apparent agency for the jury.
 Scope of Employment
 Manning v. Grimsley
 A pitcher for the Orioles did not like getting heckled, so he intentionally threw a ball at the heckler
in the stands and smoked him in the face. Heckler wanted to sue Manning and the Orioles and
won.
 Restatement of Agency § 228 outlines a four part test to see if an employee is acting in the
scope of employment
 (1) It is of the kind he is employed to perform
 Courts are generous with this prong, think of the Orioles case
 (2) It occurs substantially within the authorized time and space limits
 Need a frolic and detour to avoid liability
 (3) If is actuated, at least in part, by a purpose to serve the master, and
 Again, a flexible standard
 Court phrases this prong differently, “Did the injured person’s conduct presently
interfere with the employee’s performance of his duties”
 (4) If force is intentionally used by the servant against another, the use of force is not
unexpectable by the master
 Court phrases this prong differently, “Did the injured person’s conduct presently
interfere with the employee’s performance of his duties.” This is the Massachusetts
test.
 This test is close to strict liability; is this a good test?
 Though we like there to be someone with deep pockets to compensate the victim
 There is little the employer can do to avoid the incident
 Statutory Claims
 Arguello v. Conoco, Inc.
 Plaintiffs allege that they were subjected to racial discrimination while purchasing gas and other
services.
 Agency relationship between Conoco, Inc. and Conoco-branded Stores
 Plaintiffs allege:
 Conoco-branded stores are independently owned, and have entered into Petroleum
Marketing Agreements that allow them to market and sell Conoco brand gas.
 PMAs require branded stores to maintain their businesses according to the standards set
forth in the PMAs. Conoco, Inc. also controls the customer service dimension of the
Conoco stores
 Conoco has the power to debrand the stores for not complying with the contract
 Conoco also has random, bi-yearly inspections of the stores to determine compliance
 PMA states:
 Marketer is an independent business and is not, nor are its employees, employees of
Conoco. Conoco and Marketer are completely separate entities. They are not partners,
general partners…nor agents of each other in any sense whatsoever and neither has the
power to obligate or bind the other.
 Court concluded: language of PMA is clear and does not establish that Conoco has any
participation in the daily operations nor participates in making personnel decisions.
 Scope of employment
 R. § 219
 Some factors used when considering whether an employee’s acts are within the scope of
employment are:
 The time, place, and purpose of the act
 Its similarity to acts which the servant is authorized to perform
 Whether the act is commonly performed by servants
Page 11 of 81
 The extent of departure from normal methods
 Whether the master would reasonably expect such act would be performed
 Court finds the factors satisfied and notes that Smith’s position as clerk, and her authorization
from Conoco to conduct sales allowed her to interact with Arguello and Govea, and put Smith
in the position to commit the racially discriminatory acts. It was also important to note that
Conoco did not challenge whether this incident occurred. Plaintiff’s contend that the
inference that should be drawn from Smith’s actions is that Smith was authorized by Conoco
to perform the actions of a clerk and that this meant that her actions while on duty as clerk
were within the scope of her employment.
 Liability for Torts of Independent Contractors
 Majestic Realty Associates, Inc. v. Toti Contracting Co.
 Toti construction was using a demolition ball which accidently destroyed a building owned by
Majestic. Majestic sued Toti and New Jersey who hired him to do the work and won.
 General Rule:
 A Principal is not liable for torts committed by an independent contractor or employees
thereof
 Exceptions:
 (1) Principal retains control over the aspect of where the tort occurs
 (2) Principal engages an incompetent independent contractor
 This may include skill, experience, and financial responsibility. Theory is that the
contractee has the power of selection and can avoid employing a financially
irresponsible person.
 (3) Activity contracted for is a nuisance per se
 An activity that creates a peculiar risk of harm to others unless special precautions
are taken
 (4) Non-delegable duty
 One cannot delegate inherently dangerous work to 3 rd parties
 The court leaves the question of what constitutes an inherently dangerous activity to the jury
 § 416 Nuisance per se: a rule which would impose liability upon the landowner who engages an
independent contractor to do work which he should recognize as necessarily requiring the creation
during its progress of a condition involving a peculiar risk of harm to others unless special
precautions are taken, if the contractor is negligent in failing to take those precautions.
 § 52 Ultra-hazardous: one which
 Necessarily involves a serious risk of harm to the person, land, or chattels of others which
cannot be eliminated by the exercise of the utmost care, and
 Is not a matter of common usage.
 Distinction between inherently dangerous and ultra-hazardous is important because liability is
absolute where the work is ultra-hazardous
FIDUCIARY OBLIGATION OF AGENTS
 Introduction
 What fiduciary duties do agents and principals have toward each other?
 (1) Duty of Care
 (2) Duty of Loyalty
 4 Different cases in which the duty of loyalty applies
 (a) Kickbacks
 Employee is making profit on the side
 Restatement § 388: Unless otherwise agreed, an agent who makes a profit in
connection with transactions conducted by him on behalf of the principal is under a
duty to give such profit to the principal
 Singer Case
 (b) Secret Profits
 Two different situations
 Transactions with the principal (§ 389)
Page 12 of 81
 Use of position (Reading case)
Restatement § 389: Unless otherwise agreed, an agent is subject to a duty not to deal
with his principal as an adverse party in a transaction connected with his agency
without the principal’s knowledge
 (c) Usurping business opportunities from the principal
 Singer case
 (d) Grabbing and Leaving
 Town and Country case
 Note: Even absent a covenant not to compete, you can still be liable for breach of
fiduciary duty
 Duties During Agency
 Reading v. Regem
 Reading, a British soldier, used his position and uniform to help smuggle in some illicit goods to
Egypt and received a great deal of bribes for this. The British government found he was using his
military position in this manner and disgorged his profits.
 Why should the British government get the secret profits?
 § 387 Duty of Loyalty: agent is subject to a duty to his principal to act solely for the
benefit of the principal in all matters connected with his agency
 Main reason for profits: Reading position in the British Army
 An agent cannot profit from his breach of a fiduciary duty
 An agent will be disgorged of his profits to help constrain conflicts of interest
 This encourages employee loyalty, though it is a windfall for the employer
 It is a principle of law that, if a servant takes advantage of his service and violates his duty of
honesty and good faith to make a profit for himself, in the sense that the assets of which he has
control, the facilities which he enjoys, or the position which he occupies, are the real cause of his
obtaining the money as distinct from merely affording the opportunity for getting it, that is to say,
if they play the predominant part in his obtaining money, then he is accountable for it to his
master. If the servant has unjustly enriched himself by virtue of his service without his master’s
sanction, the law says that he ought not to be allowed to keep the money, but it shall be taken from
him and given to his master, because he got it solely by reason of the position which he occupied
as a servant of his master.
 There was not, in this case, a fiduciary relationship. The plaintiff was not acting in the course of
his employment. In my opinion, however, those are not essential ingredients of the cause of
action. The uniform of the Crown and the position of the plaintiff as a servant of the Crown were
the only reasons why he was able to get his money, and that is sufficient to make him liable to
hand it over to the Crown.
 General Automotive Manufacturing Co. v. Singer
 Singer, an extraordinary machinist, entered into an agreement to work for a small shop. Singer
received 3% of the gross profit, yet the agreement also stated that he could not work for anyone
else and had to work a 5 ½ day work week. The record discloses that Singer was engaged as
general manager of Automotive’s operations. Among his duties was solicitation and procurement
of machine shop work for Automotive. Because of Singer’s high reputation in the trade he was
highly successful in attracting orders. Automotive is a small concern and has a low credit rating.
Singer was invaluable in bolstering Automotive’s credit. Some people came to Singer with work
his small shop could not handle and he did the work on his time off. Small shop sued for the
profits and won.
 Why does small shop win if they could not do work themselves
 Singer had fiduciary duty to exercise the utmost good faith and loyalty and therefore he
could not serve his private interests and could not act adversely to the corporation and
serve his own interests. As a result, Singer had the duty to exercise good faith by
disclosing to Automotive all the facts regarding this matter.
 How did the small shop sue if they had no damages by the employment contract?
 Sued on a breach of fiduciary duty
 Small Shop gets a windfall

Page 13 of 81
 Though windfalls are inefficient because one side gets something for nothing, the court is
telling us that the duty of loyalty is more important
 Duties During and After Termination of Agency: Herein of “Grabbing and Leaving”
 Town & Country House & Home Service, Inc. v. Newbery
 Newbury worked for cleaning service and decided to leave and open his own business in
competition with cleaning service. Newbery took the client list of the cleaning service with him
and contacted these individuals to steal their business and cleaning service sued and won.
 Plaintiff contested that their enterprise “was unique, personal, and confidential,” and that
appellants cannot engage in business at all without breach of the confidential relationship in which
they learned its trade secrets, including the names and individual needs and tastes of its customers.
 Why is the client list a trade secret that is protected
 Trade secrets protect anything an individual has put a great deal of time and resources
into procuring
 Newbury could have avoided this result if he would have simply followed the
cleaning service van around and wrote down addresses; this would have been his
own time and effort
 Do the employees have a fiduciary duty to conceal the cleaning services information after
they are terminated?
 Yes. Restatement of Agency § 396(b) states that confidential matters are concealed even
after an employee is terminated or quits
 It would not have been illegal if all the employees did was conspire to quit in mass
and form a rival company
CHAPTER TWO—PARTNERSHIPS
WHAT IS A PARTNERSHIP? AND WHO ARE THE PARTNERS?
 Introduction
 Most states follow the Uniform Partnership Act (1914)
 There is a newer version that California follows, the (1997) version
 UPA § 6(1)
 A partnership is an association of two or more persons to carry on as co-owners a business for
profit
 UPA § 7 enumerates some factors to help identify a partnership
 Why form a partnership
 People might not be able to get a larger loan but need more money to start their business
 Bring in partners to contribute the rest of the money and cut them in on the profits
 Another reason, maybe someone has a great employee that they cannot afford to pay any more
than they currently are
 Give them some ownership interest and this will encourage them to stay
 Partnerships have tax advantages when compared with corporations
 But nothing on LLC’s, so partnerships are disappearing
 Partners Compared with Employees
 Fenwick v. Unemployment Compensation Commission
 Employee desired a higher wage during the depression, manager could not afford to pay, so they
drafted an agreement where she would receive 20% of the profits if the business was doing good
and share in none of the losses. Unemployment benefits are paid to businesses with 8 or less
employees and if employee was now a partner, the store would get benefits, so the unemployment
commission sued.
 Was employee a partner after the agreement stated she was a partner and shared the profits?
 No.
 Manager argued UPA § 7(4) which states that the sharing of profits is prima facie evidence
that he is a partner in a business
 Yet there is an exception in UPA § 7(4)(b) which states that if the profit sharing is really
just wages, then the individuals are not partners
Page 14 of 81

When determining if a relationship is a partnership, the totality of the circumstances is viewed
 She did not control the business, did not share in losses…
 Therefore, she was really only an employee
 Several elements that are considered:
 Parties intent
 Right to share in profits
 Obligation to share in losses
 Ownership and control of the partnership property and business
 Community of power in administration and the reservation in the agreement of the
exclusive control of the management of the business
 Language in the agreement and the rights of a partner
 Conduct of the parties towards third parties
 Rights of the parties on dissolution

Analysis
 § 18 of the UPA provides: The rights and duties of the partners in relation to the partnership shall
be determined, subject to any agreement between them, by the following rules: … (e) all partners
have equal rights in the management and conduct of the partnership business.
 A key finding of the court in the present case seems to have been that “Fenwick continued to have
complete control of the management of the business.”
 UPA § 31 provides, in part:
 Dissolution is caused: (1) without violation of the agreement between the partners, … (b) by
the express will of any partner when no definite term or particular undertaking is specified.
 UPA § 18 provides, in part: (a) each partner shall be repaid his contributions…and share equally
in the profits and surplus.
 Partners Compared with Lenders
 Martin v. Peyton
 Hall borrowed money from Peyton and other individuals in the sum of 2.5 million. In order to get
this loan, Peyton gained some power over Hall’s business like inspection rights, veto power,
control over employee loans… Hall goes bankrupt and his creditors go after Peyton calling him a
partner.
 Is Peyton a partner?
 No. This is a questionable outcome given the relationship.
 What were the indicia of control in this case (the more factors the more likely a partnership)
 Hall was to become managing partner
 Inspections rights
 Peyton could tell managers to retire
 Veto power over speculative transactions
 Peyton received 40% of profits
 Since Peyton has so much control, why is he not a partner?
 The things he did are things a smart creditor should do to protect their investment. The
only questionable factor is the ability to make directors resign, which the court kind of
ignores
 Primarily, this is the same as the Cargill case
 More control
 Good for investment purposes
 More likely to be viewed as a partner
 Less Control
 Make the investment more risky and less likely to be deemed a partner
 Notes
 There is an important economic principle relating to the risk that may have been at play in the
situation described in Martin v. Peyton; the principle is that you should not allow other people to
gamble with your money for their own profit.
 Partnership by Estoppel
 Young v. Jones
Page 15 of 81



Plaintiff invested in a bank, relying on a Price Water House Bahamas audit. Plaintiff believed
Price Water House was the same as Price Water House Bahamas and when the bank went under
he sued Price Water House America.
 Were the two Price Water Houses partners
 No.
 Nor did the court find a partnership by estoppel because plaintiff did not rely on any
brochures or anything but the name.
 Partnership by Estoppel, UPA § 16
 (1) Representation to a third party that partnership exists
 (2) Reliance by the third party on the partnership, regardless of whether or not the alleged
partner knows or consents to the representation
A person who represents himself, or permits another to represent him, to anyone as a partner in an
existing partnership or with other not actual partners, is liable to any such person to whom such a
representative is made who has, on the faith of the representation, given credit to the actual or
apparent partnership.
Plaintiffs never contended that they relied upon the brochure.
 Why this case sucks
 Court never addresses apparent agency or agency by estoppel
THE FIDUCIARY OBLIGATIONS OF PARTNERS
 Introduction
 Meinhard v. Salmon
 Landlord leased a building to Gerry for 20 years, and Gerry leased space to Salmon for the
construction of a store in which Gerry and Salmon would share profits. Near the end of the 20
years, landlord told Gerry he would extend the lease if Gerry would construct a new building.
Gerry agreed and never told Salmon about the opportunity. Salmon sued and won.
 Restatement of agency § 387: unless otherwise agreed, an agent is subject to a duty to his
principal to act solely for the benefit of the principal in all matters connected with his agency
 Partners are agents to the partnership
 So what is the duty these two partners owe each other?
 The punctilio: A trustee is held to something stricter than the morals of the marketplace.
Not honesty alone, but the PUNTILIO of an honor the most sensitive, is then the standard
of behavior
 Therefore, the partner should have told the other partner about the possibility of
obtaining the lease so they could compete
 This is good for the economy
 How could this have been avoided?
 UPA (1997) § 103(3): The partnership agreement may not eliminate the duty of loyalty
but the partnership agreement may identify specific types or categories of activities that
do not violate the duty of loyalty, if not manifestly unreasonable
 Planning and Policy
 § 404. General Standards of Partner’s Conduct
 (a) The only fiduciary duties a partner owes to the partnership and the other partners are the
duty of loyalty and the duty of care set forth in subsections (b) and (c)
 (b) A partner’s duty of loyalty to the partnership and the other partners is limited to the
following:
 (1) to account to the partnership and hold as trustee for it any property, profit, or benefit
derived by the partner in the conduct and winding up of the partnership property,
including the appropriation of a partnership opportunity;
 (2) to refrain from dealing with the partnership in the conduct or winding up of the
partnership business as or on behalf of a party having an interest adverse to the
partnership; and
Page 16 of 81

(3) to refrain from competing with the partnership in the conduct of the partnership
business before the dissolution of the partnership.
 (c) A partner’s duty of care to the partnership and the other partners n the conducting and
winding up of the partnership business is limited to refraining from engaging in grossly
negligent or reckless conduct, intentional misconduct, or a knowing violation of the law.
 (d) A partner shall discharge the duties to the partnership and the other partners under this
Act or under the partnership agreement and exercise any rights consistently with the
obligation of good faith and fair dealing
 (e) A partner does not violate a duty or obligation under this Act or under the partnership
agreement merely because the partner’s conduct furthers the partner’s own interest.
 (f) A partner may lend money to and transact other business with the partnership, and as to
each loan or transaction, the rights and obligations of the partners are the same as those of a
person who is not a partner, subject other applicable law.
 After Dissolution
 Bane v. Ferguson
 Bane was a retired partner is a Chicago law firm which gave a pension to former partners unless
the firm dissolved. The firm made a bad decision and merged with another firm, which resulted
with the dissolution of the firm and the end of Bane’s pension. He sued for a breach of the
fiduciary duty and lost.
 Issue: whether a retired partner in a law firm has either a common law or a statutory claim against
the firm’s managing council for acts of negligence that, by causing the firm to dissolve, terminate
the retirement benefits
 Rule
 The fiduciary relationship is between partners, not former partners
 The merger was a business judgment protected by the business judgment rule
 Therefore, without proof of illegality, Bane does not get a pension
 Grabbing and Leaving
 Meehan v. Shaughnessy (only applicable to lawyers)
 Two attorneys felt they would be better off opening their own law firm and decided to leave the
one they were at. They broke their fiduciary duty by contacting clients, asking them to leave with
them, on the former firm’s letterhead and not informing them they could stay with the former firm.
 What duty did the lawyers owe their former partners?
 A duty of the utmost good faith and loyalty
 This duty is contracted around somewhat by the contract
 Punctilio is a default rule, can be contracted around
 As a fiduciary, a partner must consider his or her partners’ welfare and refrain from acitng for
purely private gain.
 A partner has an obligation to render on demand true and full information of all things affecting
the partnership to any partner.
 What can a lawyer who is leaving his firm do without violating this duty?
 Locate office space
 Contract clients before they announce their departure
 Negotiate merger with another firm
 Keeps plans to leave confidential
 Negotiate with former partners
 Take desk files
 What can a lawyer not do
 Deny they are leaving when asked
 Not tell clients they have the right to be represented by any firm they wish
 What is questionable regarding a breach of fiduciary duty/
 Negotiating with associates
 Taking client files
 Contacting clients before leaving
 Why is this a different outcome then Town and Country where the client list was protected
Page 17 of 81

Lawyers expend effort to build relationships with their clients and to find clients
 Further, the Sixth Amendment guards a person’s right to have whatever counsel they
wish
 Expulsion
 Lawlis v. Kightlinger & Gray
 Lawlis was a partner at a law firm whose partnership agreement provided that a partner could be
dispelled from the partnership by a 2/3 vote. Lawlis developed a drinking problem and was voted
out.
 How can partners expel their fellow partner?
 In this case, the partnership agreement contracts around the Punctilio with the 2/3 vote
clause (Guillotine clause)
 Shows that contract provisions are predominant over the default partnership rules
 Without the contract, how can partners expel another partner without violating their fiduciary
duty?
 There is a good faith standard
PARTNERSHIP PROPERTY
 Putnam v. Shoaf
 Putnam sold her share of partnership to Shoaf on the condition that Shoaf assumed her $90,000 debt.
Shoaf quickly found the problem was that the bookkeeper was embezzling and was awarded a large
sum of money. Putnam sued to get in on the judgment, but lost.
 The court treats the partnership as an entity. Putnam only had an interest in the entity which she
sold; she has no interest in any of the property because it is owned by the partnership. UPA § 2426
 UPA (1997) § 201(a): A partnership is an entity distinct from its partners
 UPA (1997) § 203: Property acquired by a partnership is property of the partnership and not
of the partners individually
 Therefore, a partner cannot convey any interest in the property of the partnership, they
can only convey an undivided interest in the partnership itself
 Partnership profits
 Profits of a partnership are equally divided, absent an agreement to the contrary (default rule)
 UPA (1914) § 18(a)
 UPA (1997) § 401(b)
 Losses follow the same distribution as profits, absent an agreement to the contrary (default
rule)
 UPA (1914) § 18(a)
 UPA (1997) § 401(b)
 Remember, partners can contract to any distribution of profits and losses they like, the above
rules are just default.
 This situation is no different from a hypothetical oil discovery on the partnership real property after
transfer of a partnership interest with neither party believing oil to be present at the time of the
conveyance. We wonder what would be the position of Mrs. Putnam, or the estate, had the Frog Jump
Gin failed, leaving a sizeable deficit, even after the influx of the bank’s refund. Would she accept a
partner’s share of the Frog Jump Gin’s liabilities for a share of the bank’s refund?
THE RIGHTS OF PARTNERS IN MANAGEMENT
 In most small partnerships, each of the partners expects to play a role in conducting the business of the
partnership. The right of each partner to participate in the operation of the business in some way will be an
implicit term of the partnership agreement
 § 18(e) of the UPA provides that in the absence of an agreement to the contrary, all partner have equal
rights in the management and conduct of the partnership business.” And § 18(h) provides that ‘any
difference arising as to ordinary matters connected with the partnership business may be decided by a
majority of the partners.’
Page 18 of 81
 The majority can deprive the minority partner of the authority to buy bread from that supplier.
 If, however, there are only two partners, there can be no majority vote that will be effective to deprive
either partner of authority to act for the partnership. Similar stalemates can arise in any partnership with
even numbers.
 National Biscuit Company v. Stroud
 C.N Stroud and Earl Freeman entered into a general partnership to sell groceries under the name of
Stroud’s Food Center; Stroud advised Freeman that he would not be responsible for any additional
bread sold to Stroud’s Food Center. The other partner continued to buy bread from them. Stroud
attempts to escape liability for the bread, but losses.
 Rule: if one partner goes to a third person to buy an article on time for the partnership, the other
partner cannot prevent it by writing to the third person not to sell to him on time; or, if one party
attempt to buy for cash, the other has no right to require that it shall be on time; what either partner
does with a third person is binding on the partnership
 A: UPA – General Assembly of N.C. “every partner is an agent of the partnership for the purpose of
its business, and the act of every partner, including the execution in the partnership name of any
instrument, for apparently carrying on in the usual way the business of the partnership of which he is a
member binds the partnership, unless the partner so acting has in fact no authority to act for the
partnership in the particular manner and the person with whom he is dealing has knowledge of the fact
that he has no such authority.
 H: Freeman is a general partner – no restrictions are placed on his to act within the scope of the
partnership – purchasing bread is an ordinary matter connected with the partnership business – Stroud
cannot restrict his partner from buying bread; Freeman’s purchases bind the partnership
 In this two person business, Stroud told National Biscuit he would not be liable for bread bought
by a certain producer, and Stroud informed the producer.
 UPA (1914) § 9(1): in short states that the partners are agents of the business and are jointly and
severally liable for any debt that occurs from its doing business unless the person made a deal without
authority.
 Does partner have authority to buy bread when the other partner told him not to?
 Yes. Buying bread was in the scope of their business, therefore partner can buy any bread he likes
until a majority of the partners vote otherwise.
 A majority of the partners in this case is both of them
 Rule from case:
 Each partner is an agent of the partnership, unless
 (1) The individual does not have actual authority to make a deal; and
 (2) Third party knows the individual does not have actual authority
 Summers v. Dooley
 Two individuals started a garbage collection agency. Dooley became ill and stopped working, but paid
a replacement out of his own pocket. Summers believed the partnership needed additional employees
and hired one out of his own pocket. Dooley accepted the increased profits, but would not pay Summer
for the additional help. Summers sues and loses. Summers continually voiced his objection of hiring a
third man  UPA (1914) § 18(h): Any difference arising as to ordinary matters connected with the partnership
business may be decided by a majority of the partners; but no act in contravention of any
agreement between the partners may be done rightfully without the consent of all the partners
 Summers could not make the decision to hire additional work alone, because he did not
control a majority vote
 Dooley probably ratified, but the court does not address this matter
 This case comes out differently from National Biscuit because
 This is a suit between partners
 It is about partners equality
 Biscuit was a suit brought by a third party
 It was about partners being agents of the partnership
 H: it is manifestly unjust to permit recovery of an expense which was incurred individually and not for
the benefit of the partnership but rather for the benefit of one partner.
Page 19 of 81
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Rule: “any difference arising as to ordinary matters connected with the partnership business may be
decided by a majority of the partners.” – central them of the UPA is the concept of equality between
partners with respect to management of business affairs – so business differences must be settled by a
majority provided that no other agreement between the partners speaks to the issues
PARTNERSHIP DISSOLUTION

The Right to Dissolution
 Owen v. Cohen
 Two individuals entered into an oral agreement to enter into a partnership for a bowling alley.
Owen put down all the start up money and Cohen completely killed the deal by not working. The
partnership fell apart and Owen sued for dissolution and his money back; Owen won.
 Q: whether or not the evidence warrants a decree of dissolution of the partnership?
 A: the breach between the partners was in due large measure to Cohen’s persistent endeavors
to become the dominating partner of the enterprise – to humiliate plaintiff before the
employees and customers of the bowling alley. Cohen told Owen that he had not worked in
47 years and did not intend to start now …he also told a mutual acquaintance that Owen
would not be here very long. Another dispute – happened when Cohen wanted to open a
gambling room on the second floor – Owen did not approve. Cohen was also taking money
from the partnership funds – without consent or knowledge of Owen.
 If this was a partnership at will, Owen could quit at any time. UPA (1914) § 31(b), and he would
have been able to take what he had put into the partnership
 But it was not
 Possible Owen wanted damages for wrongful dissolution of the partnership. UPA (1914)
§ 38(2)
 The court orders dissolution; rule:
 Courts of equity may order the dissolution of a partnership where there are quarrels and
disagreements of such a nature and to such extent that all confidence and cooperation between
the parties has been destroyed or where one of the parties by his misbehavior materially
hinders a proper conduct of the partnership business
 What options does the court have after dissolution:
 (1) Owen can buy out Cohen and continue business
 (2) Cohen can buy out Owen and continue the business
 (3) Liquidation
 (4) Sell business to third party
 In event of any sale of the business or its assets, the funds are distributed according to
UPA (1914) § 40
 Creditors go first, then the partners get their share
 801(b)(5)
 Economic purpose is likely frustrated
 One partner has engaged in activity that it is not reasonably practicable to carry on the
partnership
 No longer to carry on the partnership in conformity with the partnership agreement
 Rule: normally trifling and minor differences – that involve no permanent mischief – will not
authorize a court to decree a dissolution of a partnership, however, courts of equity may order the
dissolution where there are quarrels and disagreements of such a nature – to the extent that all
confidence and cooperation between the parties has been destroyed – or where one of the parties
by his misbehavior materially hinders a proper conduct of the partnership business.
 H: Cohen’s whose persistence in the commission of acts provocative of dissension and
disagreement between the partners made it impossible for them to carry on their partnership
business, and is no position now to insist on its continued operation. To be in the court of equity,
you cannot come with unclean hands.
 Page v. Page
Page 20 of 81
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
Two brothers started a linen business which operated at a loss for 8 years. When the business
started making money, brother 1 wanted to dissolve the partnership and reap the profits that which
were expected to increase because the Vandenberg Air Force Base was coming into the vicinity.
 Does brother 1 have power to dissolve partnership?
 Yes. Even though the brothers former partnership were always for a definite term, this
partnership agreement was silent as to the term. If the partnership agreement is silent, the
partnership is at will.
 Therefore either partner can dissolve at any time subject to their fiduciary duties.
 Solution to this problem?
 Contract carefully. Even though this is unfair, this is what the default rules imply.
 A: the defendant admitted that the former partnership in which earnings were to be retained until
the obligations were repaid; the previous partnerships they were in – had definite term of 5 years
and a partnership at will after that – the partners never figured out how they would deal with losses
– it proved that the partners expected to meet current expenses from the income they were
bringing in – and recoup their investment;
 H: Defendant failed to prove any facts from which an agreement to continue the partnership for a
term may be implied.
 -All they had was common hope that a partnership earnings would pay for the necessary
expenses.
 -Such a hope does not establish even by implication a “definite term or particular
undertaking” as required by section 15031 of the Corporations Code.
 Rule: when a partner advances a sum of money to a partnership with the understanding that the
amount contributed was to be a loan to the partnership and was to be repaid as soon as feasible
from the prospective profits of the business, the partnership is for the term reasonably required to
repay the loan. Owen v. Cohen
 Rule: a partner at will is not bound to remain in a partnership, regardless of whether the business
is profitable or unprofitable. A partner may not however, by use of adverse pressure “freeze out”
a co-partner and appropriate the business to his own use. A partner may not dissolve a
partnership to gain the benefits of the business for himself, unless he fully compensates his copartner for his share of the prospective business opportunity…
The Consequences of Dissolution
 Under the UPA (1914) → Dissolution
 Dissolution is not the same thing as going out of business
 A dissolution is simply the change in relationship of the partners caused by any partner ceasing to
be associated in the carrying on of the firm’s business UPA (1914) § 30
 After Dissolution, two options under the UPA (1914)
 (1) Winding up
 Business will continue to operate, as a partnership, until it can be shut down
 (2) Continue to operate the business as per the partnership agreement, as among the surviving
partners
 Under the UPA (1997) → Dissociation and dissolution
 Dissociation: UPA (1997) § 601
 Business is continued per Article 7
 Purchase of dissociated partner’s interest (§ 701)
 Dissociated partner not automatically released from liability (§ 703)
 Dissolve per Article 8
 Events of dissolution (§ 801)
 Business must be wound up
 Prentiss v. Sheffel
 After freezing Prentiss out of management, he was always the minority vote, Sheffel and Iger filed
for dissolution. They purchased the partnership assets at a judicially supervised sale
 This is a partnership at will governed by UPA (1914) § 31(1)(b)
 Means that as long as the remaining partnership does not act in bad faith, this is an
acceptable dissolution and purchase
Page 21 of 81
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

Prentiss wants to continue the business because he has less equity in the partnership and it
will cost him much more to purchase the business if it is sold than it will Sheffel and Iger
(paper dollars argument)
 Yet, Sheffel and Iger can buy the business all they want if the dissolution is lawful
 Q: whether two majority partners in a three-man partnership-at-will, who have excluded the third
partner from partnership management and affairs, should be allowed to purchase the partnership
assets at a judicially supervised dissolution sale?
 A: Such a purpose is proper –
 Principal contention by defendant is that he was wrongfully excluded from the
management of the partnership - and plaintiffs should not be able to purchase the
partnership assets at a judicial sale.
 There was no evidence of bad faith – by the partners – it was simply for the purpose of the
inability of partners to harmoniously work together in a partnership relationship.
 Defendant failed to show how he was injured as a result of the judicial sale – in fact he was
given more money since the plaintiffs were the highest bidders – drove the price up more –
and therefore defendant since he received 15% of the interest – received more due to the
higher bidding price.
 H: plaintiffs had the power and permission to buy the partnership assets at a judicial sale – the
defendant had the same right to purchase the partnership assets as the plaintiffs- if he would have
submitted the highest bid.
Pav-Saver Corporation v. Vasso Corporation
 Dale creates an amazing paving device and patents it. Vasso brings the money and the operation
gets rolling. Dale gets dissatisfied and wants to leave with his patents, but the partnership term is
not up (not a partnership at will). The partnership agreement stated that Dale got his patents back,
yet this would mean that Vasso Corp. could no longer operate.
 This was a wrongful dissolution by Dale
 He violated the partnership agreement
 Why does the court find it necessary to give the patents to Vasso and make Dale pay
damages?
 The contract was drafted stating what would happen if a partner terminated the
partnership
 No partner can terminate the partnership
 Wrongful dissolution entitles the innocent partner to breach of contract damages and the
option to continue to run the business
 UPA (1914) § 38(2)(b)
 Similar under the UPA (1997), yet called dissociation
 Partner whose conduct is wrongful is entitled to his share of the partnership, minus good will
 UPA (1914) § 38(2)(c)(ii)
 UPA (1997) does not deprive the partner who wrongfully terminates of good will
 The partners who have not wrongfully cause a dissolution shall have the right to continue the
business in the same name and to receive damages for breach of the agreement
 Rule: when dissolution is caused by contravention of the partnership agreement the rights of
the partners shall be as follows:
 each partner who has not caused dissolution wrongfully shall have
 II. the right, as against each partner who has caused the dissolution
wrongfully, to damage for breach of the agreement
 the partners who have not caused the dissolution wrongfully, if they desire may
continue the business in the same name, either by themselves or jointly with others,
may do so, during the agreed term for the partnership and for that purpose may
possess the partnership property
 a partner who has caused the dissolution wrongfully shall have:
 II. the right against his co-partners and all claiming through them in respect
of their interests in the partnership, to have the value of his interest in his
partnership, less any damages caused to his co-partners by dissolution
Note
Page 22 of 81
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
Under UPA § 701 (1997), if a partner withdraws from a partnership in contravention of the
partnership agreement, the partnership does not necessarily dissolve. If it does not, the partnership
must buy out the withdrawing (dissociated) partner for an amount equal to his or her share of the
value of the assets of the partnership if ‘sold at a price equal to the greater of the liquidation value
or the value based on a sale of the entire business as a going concern without the dissociated
partner.’ This amount is reduced by any damages for wrongful withdrawal.
The Sharing of Losses
 Kovacik v. Reed
 Kovacik fronted all the capital for a business and brought on a partner who contributed no capital,
Reed. Reed was only in charge of labor. Neither partner received a salary, yet both equally shared
in profits. When the partnership started losing money, Kovacik wanted to dissolve the partnership
and have Reed split the losses with him. The court did not agree.
 Profits – general rule
 Profits of a partnership are equally divided, absent an agreement to the contrary
 UPA (1914) § 18(a)
 UPA (1997) § 401(b)
 Losses follow the same distribution as profits, absent an agreement to the contrary
 UPA (1914) § 18(a)
 UPA (1997) § 401(b)
 Why did the court not find that profits followed losses in this case?
 Both partners share the profits equally, but the court found this case to be an exception to
the general rule
 Kovacik rule
 When one partner contributes all the capital and another partner contributes no capital,
but only labor
 → The capital partner bears the entire loss
 Theory
 The capital partner loses his money while the working partner losses the
value of his labor; the court finds these are equal and therefore the losses are
equally split
 The Kovacik rule does not apply when:
 (1) The labor party is compensated for his work (salary)
 (2) The labor party made a capital contribution, even if the contribution was nominal
 Rule
 In a joint venture in which one party contributes funds and the other labor, neither party
is liable to the other for contribution for any loss sustained
 Is this a good rule?
 No, in the sense that the labor partner is “playing” with other people’s money and is more
likely to take risks with your money
 To avoid: make labor partner contribute a nominal amount of capital and the Kovacik
rule does not apply, but the UPA will apply
 Rule: in the absence of an agreement the law presumes that partners and joint adventurers
intended to participate equally in the profits and losses of the common enterprise, irrespective of
any inequality in the amounts each contributed to the capital employed in the venture with the
losses being shared by them in the same proportions as they share profits.
 the parties had contributed capital either money or land or services – and each was to receive
compensation for services rendered to the common undertaking which was to be paid before
computation of the profits or losses.
 HOWEVER HERE Where one partner or joint adventurer contributes the money capital as
against the other’s skill and labor, neither party is liable to other for contribution for any loss
sustained.
 Notes and Questions
 UPA § 18(a) provides:
 The rights and duties of the partners in relation to the partnership shall be determined, subject
to any agreement between them, by the following rules:
Page 23 of 81
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(a) each partner shall be repaid his contributions, whether by way of capital or advances
to the partnership property and share equally in the profits and surplus remaining after all
liabilities, including those to partners, are satisfied; and must contribute towards the
losses, whether of capital or otherwise sustained by the partnership according to his share
in the profits.
 UPA § 40 provides that:
 Subject to any contrary agreement, upon dissolution, liabilities of the partnership shall be paid
in the following order:
 Those owing to creditors other than partners,
 Those owing to partners other than for capital and profits,
 Those owing to partners in respect of capital,
 Those owing to partners in respect of profits.
Law Partnership Dissolutions
 With attorneys, how do we allocate fees from active cases absent a partnership agreement?
 UPA rule
 Fees split according to the partnership interest
 Jewel v. Boxer
 Four lawyers were operating a partnership without a partnership agreement. Two of the partners
wanted to leave, therefore the question of how to split the fees for the current cases became an
issue
 How do we split the fees from current cases
 Divide up the profits and distribute according to the partnership interest each individual
has prior to their breakup
 Advantages of split profits on partnership interest lines
 Prevents competition among partners to poach the “good” cases
 The departing partners are no worse off than they would have been if they had stayed
with the firm
 Fiduciary duties prevents unjust enrichment
 Disadvantage to splitting profits according to partnership interest
 Encourages competition among partners regarding shitty cases (dump bad cases)
 Enforcing partners fiduciary duties is highly difficult
 Locks in partnership shares as of the time of dissolution and ignores inequities that may
have led to the dissolution in the first place
 How to avoid these questions
 Draft a partnership agreement that answer questions of what happens when partners leave
(like Meehan)
 Trial court’s alternative approach – Quantum Meriut (not a majority rule)
 Divide assets by looking at:
 Origin of case (what lawyer got the case)
 Time spent on the case
 If the case is contingency based
 Too difficult to work with; test requires a case by case analysis
LIMITED PARTNERSHIPS
 Limited Partnership
 A partnership formed by two or more persons and having one or more general partners and one or
more limited partners
 The most limited partners can lose is their investment in the partnership
 The general partners are personally liable for the debts and obligations of the partnership
 Limited Partnerships are creatures of State law
 A limited partnership is created by filing the requisite documents with the state, usually the Secretary
of the State
 Holzman v. De Escamilla
Page 24 of 81
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Hacienda Farms was formed as a limited partnership with Russell and Andrews acting as limited
partners and Escamillia acting as general partner. When the business suffered losses, Russell and
Andrews believed they were not personally responsible for the loss, the court disagreed.
 Typically, a limited partner shall not become liable as a general partner, unless, in addition to the
exercise of his rights and powers as a limited partner, he takes part in the control of the business
 Russells and Andrews took control of the business
 (1) Crop planning veto power
 (2) Absolute power to withdrawal from bank account without the general partner’s
knowledge
 (3) General partner could not write a check without one of their signatures
 (4) Required general partner to resign
 How do we know if limited partners took business control?
 The test is substantive rather than formal (totality of circumstances)
 It does not matter what they called themselves or even that they filed the paperwork
calling themselves a limited partnership, they acted like a general partnership and that is
what they were
CHAPTER THREE—THE NATURE OF THE CORPORATION
PROMOTERS AND THE CORPORATE ENTITY
 In the corporate context, the word promoter is a term of art referring to a person who identifies a business
opportunity and puts together a deal, forming a corporation as the vehicle for investment by other people
 The promoters acts as agent for the business before it is incorporated
 §338 R. 2d Agency – “unless otherwise agreed, an agent who makes a profit in connection with
transactions conducted by him on behalf of the principal is under a duty to give such a profit to the
principal”
 Legal Issues
 Once the articles of incorporation are filed, does the corporation become a party to the contract?
 Yes, but not automatically. The corporation must adopt the contracts (like ratification)
 Once the articles of incorporation are filed, is the promoter liable if the corporation breaches the
contract?
 Yes. MBCA § 2.04: All persons purporting to act as or on behalf of a corporation, knowing there
was no incorporation under this Act, are jointly and severally liable for all liabilities created while
so acting
 Yet, a promoter may be released from liability by the third party once the contract is adopted
 If the articles are not filed, is the promoter liable on the contract?
 Yes. MBCA § 2.04
 Absent an agreement to the contrary, the promoter remains liable on the contract if the corporation
never comes into existence
 If the articles are not filed or are defective, can the defectively formed entity enforce the contract?
 Look to Southern-Gulf
 Southern-Gulf Marine Co. No. 9, Inc. v. Camcraft, Inc.
 Southern Gulf – a company yet to be formed – was to purchase 156 foot vessel from Camcraft Inc. for
$1,350,000.00; a letter of agreement - had an anticipated delivery date, authority for Camcraft to begin
purchasing components – and a specific set of specifications and a Vessel Construction Contract –
letter was signed by both President of Camcraft and President of Southern Gulf; the Contract was later
executed – the contract stated that Southern Gulf was a Texas corp. – among one of the promises in the
contract was that of the Shipping Act of 1916- where the owners warranted they were citizens of the
United States – however President of Southern –Gulf wrote to President of Camcraft informing him
that his corp. was incorporated in the Cayman Islands – this was done to make the vessel’s use in
foreign commerce more economical – this hiccup was understood and agreed upon everyone involved
– signed etc.; Camcraft however defaulted on its obligation – and thus attempted to rid liability stating
that there was no contract because of the legal status regarding Southern-Gulf.
Page 25 of 81

Issue one: should Camcraft be estopped from asserting the lack of corporate capacity by SouthernGulf at the time the Vessel Construction Contract was executed – after dealing with Southern-Gulf as a
corporation?
 NO! Camcraft should not be afforded the opportunity to escape performance by raising an issue as
to the character of the organization to which it was obligated; both parties relied upon this contract
–
 Rule: one who contracts with what he acknowledges to be and treats as a corporation,
incurring obligations in its favor, is estopped from denying its corporate existence,
particularly when the obligations are sought to be enforced.
 Rule: where a party has contracted with a corporation, and is sued upon the contract, neither is
permitted to deny the existence, or the legal validity of such corporation.
 Issue two: Should Camcraft be able to inject into the case the fact that Southern-Gulf subsequently
did incorporate into the Cayman Islands rather than in Texas as originally represented?
 The agreement did not stated that Southern Gulf needed to be a US corporation. It is
immaterial where they incorporated at.
 the evidence indicates that the plaintiff’s legal status is not germane to any cause for the
contract and as such should not be grounds for avoidance of the contract.
 The court enforces the contract to avoid a windfall in favor of Camcraft
 Rule: Corporation by Estoppel
 A third party who dealt with the firm as though it were a corporation and relied on the firm,
not the individual defendant, for performance is estopped from denying the existence of the
corporation
 Distinguish estoppel from a De Facto Corporation
 We treat the firm as a corporation if the promoters:
 (1) In good faith, tried to incorporate, and
 (2) Had a legal right to incorporate, and
 (3) Acted as a corporation
 Holding
 Where a party has contracted with what he acknowledges to be a corporation, he is estopped
from denying the existence of the legal validity of such a corporation
THE CORPORATE ENTITY AND LIMITED LIABILITY
 Walkovszky v. Carlton
 Carlton created a taxi cab company in which he formed ten different corporations which owned only
one or two cabs apiece; he did this to keep little money in each corporation and make them judgment
proof. One of Carlton’s cabs hit the plaintiff, and plaintiff wants to sue Carlton individually, which he
is not allowed to do here.
 There are two different legal theories that will allow an individual to reach beyond the corporate
structure for recovery
 (1) Enterprise liability
 Only a larger corporation could sufficiently compensate the plaintiff, therefore, plaintiff
claims all of the smaller corporations are in reality one large corporation which he should be
able to sue all of them
 Plaintiff would have to show that the smaller cab companies were “fictions” and the
structure was really that of one company
 This would allow the plaintiff to reach the other undercapitalized corporations (would do
him no good)
 The court ultimately concludes that setting up a corporation this way is not wrong
 What facts would help support this conclusion
 Intermingling of the funds of all the cab companies, showing that drivers were exchanged
between all the companies, supplies were ordered for all the companies at once…
 This was not the case though, Carlton was smart. Primarily, as long as corporate
formalities are adhered to, the corporate veil will not be pierced.
 (2) Veil piercing
Page 26 of 81

This theory would allow the plaintiff to sue Carlton directly rather than all the different
corporations
 When is this allowed?
 When it is necessary to prevent fraud or to achieve equality
 Under agency theory, when a person uses control of a corporation to further his own
rather than the corporation’s business
 Veil piercing is an extreme remedy because the entire purpose of a corporation is to limit
liability
 DISSENT:
 -Carlton was a principal shareholder and organizer of the taxicab corp. Under the circumstances
of this case – shareholders should all be held individually liable to the plaintiff for the injuries he
suffered…
 -Doesn’t agree with the fact that because the minimum amount of insurance required by the statute
was met – the corporate veil cannot be pierced
 Dissent wants to use this case to move the policy –
 The dissent – says you and I need $10,000 minimum for insurance - it wasn’t saying Carlton
go out and purposely undercapitalize your companies so that you liable for the minimum
amount –
 H: a participating shareholder of a corporation vested with a public interest, organized with capital
insufficient to meet liabilities which are certain to arise in the ordinary course of the corporation’s
business, may be held personally responsible for such liabilities.
 Analysis
 There are three separate legal doctrines that the plaintiff might invoke in a case like Walkovszky v.
Carlton:
 Enterprise liability
 Respondeat superior
 Disregard of the corporate entity (“piercing the corporate veil)
 Sea-Land Services, Inc. v. Pepper Source
 Marchese owned ten different, very undercapitalized, corporations in which he was the sole
shareholder. Only one of these corporations has any assets. Marchese enters into a contract with SeaLand with one of his corporations and dissolves before Sea-Land can collect for its services. Sea-Land
wants to pierce the corporate veil, and is able to.
 The test for piercing the corporate veil; two steps
 (1) Establish control: unity of interest and ownership, such that the separate personalities of
the corporation and individual do not exist
 Factor that evidence the control prong:
 Commingling of funds
 Undercapitalization
 Disregard of corporate records or formalities
 Failure to hold shareholder meetings
 Failure to hold board meetings
 Failure to keep books
 Totality of the circumstances test.
 One corporation treating the assets of another corporation as its own
 (2) Honoring the corporate form would sanction a fraud or promote injustice
 It is not enough that the plaintiff will not be able to collect money owed to it to allow veil
piercing, there must be something more like fraud or unjust enrichment
 This is easier to show with a tort than with a contract claim
 With contract, both parties are experience business men and should know how
to avoid problems
 Intent is not required for this prong, just look at situation & ramifications
 Once the veil is pierced, treat the corporate stockholders like general partners
 Thing to know: As long as corporate formalities are followed, the shareholders will not be liable;
even if they have ten corporations
Page 27 of 81
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A: for physical facilities – Marchese runs all of these corporations out of the same single office with
the same phone line – same expense accounts; Marchese borrows money from these corporations
when he feels like it – and corporations borrow money from each other when need be; Marchese has
used these accounts to pay personal things – like child support, education expenses for his children,
maintenance of automobiles, health care of his pet, Marchese did not even have a personal bank
account – he simply used the corporations;
 Here: the “shared control/unity of interest and ownership part of the Van Dorn test was met in this
case – corporate records and formalities have not been maintained – funds and assets have been
commingled;
 Roman Catholic Archbishop of San Francisco v. Sheffield
 Individual entered into agreement to purchase St. Bernard. Paid a total of $60 but never received the
dog and was not refunded the money. Complaint alleged that defendants were controlled and
dominated by defendants , that there exists a ‘unity of interest and ownership between all and each of
the defendants,’ that the defendants were merely a shell and naked framework which defendants have
used and do use as a mere conduit for the conduit of their ideas, business, property, and affairs, and
that all defendants are alter egos of each other.
 The requirements for applying the alter ego principle are thus stated: it must be made to appear that
the corporation is not only influenced and governed by that person or other entity, but that there is such
a unity of interest and ownership that the individuality, or separateness, of such person and corporation
has ceased, and the facts are such that an adherence to the fiction of the separate existence of the
corporation would , under the particular circumstances, sanction a fraud or promote injustice.
 Plaintiff relies on theory that the church is a single entity controlled, spiritually and temporally by the
pope in Rome.
 Introductory Note
 The tax advantage of the use of the limited partnership form of organization was that the investors
were able to claim their pro rata share of the (economically artificial) losses of the partnership on their
individual tax returns, which is not possible for tax-shelter-type investments if the corporate form is
used.
 Beginning in the late 1960s, lawyers for the promoters of tax shelter investments developed a variation
on the basic limited partnership: a limited partnership with a corporation as the sole general partner.
 With this, no individual was liable for the debts of the partnership.
 Frigidaire Sales Corporation v. Union Properties, Inc.
 Union properties was a limited partnership, with a corporation as its general partner. The general
partner corporation was wholly owned and operated by the limited partners. Union entered into and
breached a contract with Frigidaire, and Frigidaire wanted to hold the limited partners personally
liable. Frigidaire was unable to pierce the limited liability veil.
 Law
 It is permissible to establish a limited partnership with a corporation as the general partner
 Frigidaire would have to pierce the corporate veil in order to hold the limited partners,
who owned the corporation which was the general partner, personally liable
 Great business plan
 How could Frigidaire avoid this
 Get a personal guarantee
THE ROLE AND PURPOSES OF CORPORATIONS
 A.P. Smith Mfg. Co. v. Barlow
 A.P. Smith incorporated in 1896 – engaged in manufacture and sale of valves, fire hydrants, and
special equipment – the board of directors in 1951 adopted a resolution that said it was in the
company’s best interest to join with others in the Annual Giving to Princeton University a sum of
$1,500 – this action was questioned by stockholders; the President of the company Hubert F. O’Brien
testified that he felt this was a sound investment for the company – the public expects corporations to
aid philanthropic events, they obtain good will with the community- charitable donations create
favorable environment for business operations. The shareholders sued, stating that this was a waste of
the corporation’s funds. Shareholders lose.
 Plaintiffs position –
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
plaintiff’s certificate of incorporation does not expressly authorize the contribution and under
common-law principles that company does not possess any implied or incidental power to make it,
(2) the NJ statutes which expressly authorize the contribution may not constitutionally be applied
to the plaintiff, a corporation created long before their enactment
 Can corporations give money to charitable organizations?
 Yes, under the business judgment rule
 Though this was an early case applying the business judgment rule: “It cannot be
unreasonable and must be made for the right reasons”
 Policy arguments for allowing corporations to give to charitable purposes
 If the corporation does so, it will foster good will and may lead to an increase in the
corporation’s reputation
 Further, investing in Princeton may lead to investing in their future employees which is a
direct benefit to the corporation
 Policy arguments against this
 Corporations are around to make their shareholders money, nothing else
 Further, it is difficult to monitor how corporations are spending all of their money
 1930 NJ Statute: any corporation can cooperate with other corporations in the creation and
maintenance of community funds and charitable – philanthropic events conducive to public welfare,
and could for such purposes expend corporate funds as the directors “deem expedient and as in their
judgment will contribute to the protection of the corporate interests.”
 H: no hesitancy in sustaining the validity of the donation by the plaintiff. – it was made to an
institution of higher learning, in a modest amount and well within the limitations imposed by statutory
requirements, and was voluntarily made in the reasonable belief that it would aid the public welfare
and advance the interests of the plaintiff as a private corporation and as part of the community in which
it operates.
 Note
 Delaware General Corporation Law § 122 provides: every corporation created under this chapter shall
have the power to…(9) make donation for the public welfare or for charitable, scientific or educational
purposes, and in time of war or other national emergency in aid thereof. Courts have been extremely
tolerant in accepting the business judgment of the officers and directors of corporations, including their
business judgment about whether a charitable donation will be good for the corporation in the long run.
 Dodge v. Ford Motor Co.
 The Ford company started production and quickly realized a tremendous profit. The company was
paying huge special dividends. The Dodge brothers, large owners of Ford stock, wanted to start
competing with Ford, and were financing their business off of their Ford investment. Ford decided to
stop paying large special dividends because it wants to build its own smelting plant and the Dodge
brothers sued to get their special dividends back. Dodge brothers win because of Ford’s testimony.
 What is the purpose of a corporation?
 Shareholder Primacy → This court finds that the purpose of a corporation is to make profits
for its shareholders
 Not for charity (Ford wanted to lower the costs of his vehicles to help the public)
 Why is the court allowed to intervene in Ford’s decision?
 The business judgment rule
 Judges are not business experts
 Courts will intervene if conduct amounts to such an abuse of discretion as would
constitute a fraud, or breach of good faith
 The court found it was bad faith for Ford to make less profit than it could because the
corporation’s purpose was to make shareholders money
 How is this compatible with Barlow
 Ford: Thinks shareholder made enough money and wants to help the public
 Barlow: Wants to invest in education which might directly benefit their corporation
 Side note: Why did the other Ford shareholders not sue the Dodge brothers for competing with
Ford?
 There is no fiduciary duty between stockholders (unless we are talking about a close
corporation)
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
Finally, this is a rare case where the court interferes with the business judgment of the directors
without a showing of fraud, self dealing or illegality
 Rule: directors of a corporation, and they alone, have the power to declare a dividend of the earnings of
the corporation, and to determine its amount. Courts of equity will not interfere in the management of
the directors unless it is clearly made to appear that they are guilty of fraud or misappropriation of the
corporate funds, or refuse to declare a dividend when the corporation has a surplus of net profits which
it can, without detriment to its business, divide among its stockholders, and when a refusal to do so
would amount to such an abuse of discretion as would constitute fraud, or breach of that good faith
which they are bound to exercise towards the stockholders.
 Mr. Ford said that this company has made too much money – and by reducing prices of the car –
sharing the profits with the public ought to happen – the court agrees that Mr. Fords plan has been
fueled by philanthropic and sentiment – policy based to improve the public welfare –
 a business corporation is organized and carried on primarily for the profit of the stockholders
 powers of the directors are to be employed for that reason
 discretion of the directors is to be exercised in the choice of means to attain that end.
 H: we are not persuaded that we should interfere with the proposed expansion of the business of the
Ford Motor Company. Judges are not business experts.
 Shlensky v. Wrigley
 Majority shareholder of Wrigley field did not want to install lights, so there were no night games.
Shareholder sued because he believed that night games would increase profits. Shlensky contends that
Wrigley refuses to install lights not because of the interest of the welfare of the corporation – but
because of his public belief “that baseball is a daytime sport” – and that installation of lights will have
a deteriorating effect on the surrounding neighborhood. Shareholders lose.
 Rules:
 its not courts’ function to resolve corporation questions of policy and business management directors are chosen to pass upon such questions and their judgments unless shown to be tainted
with fraud is accepted as final
 given the benefit of the doubt that directors were chosen in good faith and designed to promote the
best interests of the corporation they serve
 in a purely business corporation … the authority of the directors in the conduct of the business of
the corporation must be regarded as absolute when they act within the law, and the court is
without authority to substitute its judgment for that of the directors.
 Business Judgment Rule:
 The authority of the directors in the conduct of the business of the corporation must be regarded as
absolute when they act within the law, and the court is without authority to substitute its judgment
for that of the directors
 There must be a showing of fraud, self dealing, or illegality to overturn a business
decision
 Further, the corporation does not need to prove the business benefits of its decisions
 The judgment of the directors of corporations enjoys the benefit of a presumption that it was
formed in good faith and designed to promote the best interests of the corporations they serve
 The burden is on the plaintiff to show fraud, self dealing, or illegality or they will lose
 H: Even though Wrigley and directors may be acting fueled by other motives they are not contrary to
the best interests of the corporation and the stockholders –
 Surrounding neighborhood might need to be considered by a director who is considering putting
lights
 Long run interest of the corporation – is beyond our jurisdiction and our ability –
 Decision is one properly before directors – and since the alleged motives showed no fraud,
illegality or conflict of interest in making that decision – its ok
 No evidence was given to show that other teams have substantially (profit wise) benefited from
having night games – opposed to day games
 Directors are elected for their business capabilities and judgments and the courts cannot
requires them to forego their judgment because of the decisions of directors of other companies –
we can’t force the Cubs directors to follow the same practice as other major league baseball
directors.
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CHAPTER FIVE—THE DUTIES OF OFFICERS, DIRECTORS, AND OTHER INSIDERS
THE OBLIGATIONS OF CONTROL: DUTY OF CARE
 Kamin v. American Express Company
 American Express invested 28 million into stock that depreciated in value to 8 million. American
Express could have (1) sold the stock and gained the tax benefits of the loss, or (2) give the stock out
as a dividend and not get the tax benefit. AMEX gave the stock to its shareholders because it believed
declaring that large of a loss would hurt its stock price. A shareholder derivative suit was filed and the
shareholders lost.
 Why do the shareholders lose? Business Judgment Rule.
 Court does not intervene because absent fraud, self dealing, waste, or illegality, the business
judgment rule will apply and the court will defer to the Board
 Rule
 Whether or not a dividend is to be declared or a distribution made is exclusively a matter or
business judgment for the board of directors, and the courts will not, therefore, interfere as
long as the decision is made in good faith
 Why would it not matter how much of a loss AMEX declared
 Efficient Capital Markets Hypothesis
 Theory believes that a corporation’s stock price clearly reflects the value of the stock at
any given time (therefore AMEX stock price already reflected the loss)
 Assumptions of the hypothesis
 Rational Actors – people buy stock to make money, not for other sentimental reasons
 Perfect Information – all the information is available and instantaneously transmitted
 Zero transaction costs
 Actually a pretty good gauge of a stock’s price
 A: How do AmEx directors defend their decision?
 Such a reduction of net income would have a serious effect on the market value of the publicly
traded AmEx stock”
 We are announcing to the world we took a bath to the tune of $26 million.
 Economists pretty much universally reject this theory, arguing that writing off the DLJ stock
would have had no effect on AmEx’s stock price.
 If AmEx declared the loss on their taxes – it would have zero effect on the stock price – because
analysts know that they would have already taken that loss
 H: Directors and officers are often compensated for making achievement goals – which is probably
why they didn’t report this – plaintiffs didn’t make this argument – court didn’t acknowledge
 We are left with a waste claim – the court doesn’t buy it – AmEx comes up with a justification – even
though its crappy – the court buys it and defers the board to the business judgment
 Smith v. Van Gorkom
 Trans Union wanted to sell its company because they had tax credits they could not use that made their
company artificially more valuable, up until the tax credits expired. Trans Union entered into secret
negotiations with Van Gorkom and they worked out that he would purchase Trans Union. The Board
of Directors are given only two hours to decide whether or not to accept this offer, which they
reluctantly do only after demanding a market test of the price. Van Gorkom interferes with the markets
test and it is unreliable. The shareholders approved by a high margin. Some shareholders sued and won
 Business judgment rule
 A presumption that directors act on an informed basis, in good faith, and the honest belief that
decisions are in the best interest of the company
 How do the shareholders get around this?
 The business judgment rules does not protect
 Fraud, illegal conduct, or self dealing
 In this case, egregious misconduct
 No protection for uninformed decisions
 Moreover, no protection for directors who made an unintelligent or unadvised judgment
 Directors have three fiduciary duties:
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
(1) Duty of Care
 This is the only fiduciary duty the Business Judgment Rule comes into play with
 (2) Duty of Loyalty
 (3) Duty of Good Faith
 Primarily, the business judgment rule can be beaten if the attacking party can prove:
 Gross negligence of the directors by failing to inform themselves of all the material
information reasonably available to them
 $55 dollars was above the market price, why is this even a question as to a grossly negligent
business decision
 Stock consists of two rights:
 Economic: right to dividends
 Voting
 If a party is acquiring a controlling share, they might be able to change the board of
directors and make the company much more profitable
 Trans Union did not test the market to see what a good price might be
 If this would have occurred, liability might have been avoided, but Van Gorkom stopped
a meaningful market test from taking place
 The shareholders ratified the decision, again, why is this is court
 The stockholder where given incomplete information and therefore could not make an
informed decision
 Rule from the case
 How do we show a breach of the duty of care which will bypass the business judgment rule
 (1) Did the board inform itself of all material information reasonably available to it
 (2) Did the board disclose material information that a reasonable stockholder would
consider important
 This is evaluated in a gross negligence standard
 One exception to the investigating relevant information standard
 DE § 141(e): Can rely on expert information without a follow up
 If market test was done properly, directors win
 What did the legislature do after this case?
 DEGL § 102(b)(7): no liability for directors for the breach of the duty of care unless actions were
not in good faith
 No personal liability for directors for breach of the duty of care, only remedy is an injunction
 Now plaintiffs must argue that a breach of the duty of care amounts to a breach of the duty of
loyalty
 Q: Did the directors reach an informed business judgment on Sept. 20, 1980? And whether the
directors’ actions taken subsequent to September 20 were adequate to cure an infirmity in their action
taken on Sept. 20?
 The directors failed to inform themselves of all information reasonably available to them and
relevant to their decision to recommend the Pritzker merger; failed to disclose all material
information such as a reasonable stockholder would consider important in deciding whether to
approve the Pritzker offer
 The Agreement between Pritzker and Van Gorkom – concedes that the Agreement barred
Trans Union from actively soliciting such offers and from furnishing to interested parties any
information about the Company other than that already in the public domain
 Holding: Board of Directors did not reach an informed business judgment on Sept. 20, 1980 – they
breached their fiduciary duty to their stockholders
 we hold that the directors of Trans Union breached their fiduciary duty to their stockholders (1) by
their failure to inform themselves of all information reasonably available to them and relevant to
their decision to recommend the Pritzker merger; and (2) by their failure to disclose all material
information such as a reasonable stockholder would consider important in deciding whether to
approve the Pritzker offer.
 Note on Cinerama, Inc. v. Technicolor, Inc.
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Similar to van gorkom; CEO in effect made the deal with Perelman and then presented it to the board,
which approved it quickly, without adequate information and adequate deliberation and without
conducting a market check
 Delaware Supreme Court reversed by distinguishing the two cases
 Court noted various factors that must be considered in an analysis fo the entire fairness of the
transaction:
 The timing
 Initiation
 Negotiation
 Structure of the transaction
 The disclosure to and approval by the directors, and
 Disclosure to and approval by the shareholders.
Analysis
 One way directors faced with the opportunity to sell the company can protect themselves is to hire an
investment banking firm to issue an opinion as to the fairness of the price that has been offered.
Note on Legislative Response
 After Van Gorkom, many states created statutes which allowed corporations to place in their articles of
incorporation statement eliminating the personal liability of a director to the corporation or its
stockholders.
Brehm v. Eisner
 Disney hired a new President, Ovitz, who was going to be handsomely compensated. The board relied
on the advice of an expert opinion when determining his salary and severance package. It turns out,
though the expert did not inform them of this fact, that Ovitz would make more money if he was fired
non-fault. Nobody would work with Ovitz, and after consulting their attorneys, Disney fired him nonfault and a few stockholders sued. Disney wins.
 Business judgment rule governs compensation questions
 When analyzing questions of due care, the court will only look to the process of the decision
made by the board, not the substance or results of that decision
 The court will only become involved if the board acted irrationally, or in other words, a
gross negligence standard
 Absent irrationality, compensation is a matter of business judgment and the court will not review
the Board’s decision
 Did the board violate its duty of care and commit waste when it set Ovitz’s compensation and
severance?
 Yes, but they avoid liability because of exception
 DE § 141(e): Board can rely on advice from experts.
 Did the board violate its duty of care and commit waste when it fired Ovitz non-fault?
 No. Disney consulted its attorney and could not think of a reason to fire Ovitz, therefore
it was non-fault
 The board members made a rational decision relying on their attorney
Analysis
 Two conception of the business judgment rule compete in the case law:
 One treats the rule as having substantive content. Put another way, the business judgment rule
comes into play as a standard of liability only after one has determined that the directors satisfied
some standard of conduct. In effect, if not in doctrine, the rule simply raises the liability bar from
mere negligence to gross negligence or recklessness.
 Alternatively, the business judgment rule can be seen as an abstention doctrine. If so, the rule’s
presumption of good faith is also a presumption against judicial review of duty of care claims.
The court will abstain from reviewing the substantive merits of the directors’ conduct unless the
plaintiff can rebut the business judgment rule’s presumption of good faith.
Francis v. United Jersey Bank
 Pritchard ignored her duties as a director, allowing her sons to withdraw over $12 million from client
trust accounts. The business went bankrupt and plaintiff’s alleged a breach of duty of care by Pritchard.
 Q: Did Mrs. Pritchard breach her duty of care?
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
Yes – she was inattentive- facts that she was old, depressed, drunk and ignorant of the
business were not defense worthy in this case
 A: Mrs. Pritchard was not active in the business; - she knew nothing virtually about the
corporate affairs – She was warned by her husband that Charles Jr. would “take the shirt off
my back” - Mrs. Pritchard wasn’t taken any precaution or look over the business – she was
too busy getting drunk  Does the business judgment rule protect Pritchard?
 No. The business judgment rule applies to business decisions; Pritchard never made a
decision, she just failed to exercise any oversight of her business.
 Does this mean she is automatically liable because she is not protected by the business judgment
rule.
 No. The Plaintiffs still must show that she breached her fiduciary duty of care.
 Did plaintiffs prove this?
 Yes. The duty of care encompasses a duty to be informed.
 Pritchard had an obligation of basic knowledge and supervision
 To read and understand financial reports
 And object to misconduct and ultimately resign if she was ineffective or incompetent
 Rule: directors are under a continuing obligation to keep informed about the activities of the
corporation…
 Directors may not shut their eyes to corporate misconduct and then claim that because they did not
see the misconduct, they did not have a duty to look.
 Directorial management – does not require a day-to-day inspection of activities; rather a general
monitoring of corporate affairs and policies.
 Holding: Mrs. Pritchard’s estate is liable – her neglect of duty contributed to the climate of
corruption; her failure to act contributed to the continuation of that corruption.
 In Re Caremark International Inc. v. Derivative Litigation
 Shareholders sue Caremark derivatively when the corporation losses a lawsuit which results in a $250
million settlement. This resulted from, what the shareholders believe, a failure to monitor for illegal
conduct within the corporation.
 There are two types of duty of care cases:
 (1) Van Gorkom (decision made)
 When an improper decision is made the business judgment rule is applied
 Use a gross negligence standard
 (2) Graham (no decision made)
 Absent cause for suspicion there is no duty upon the directors to install and operate a
corporate system of espionage
 This court acknowledges this duty of care case falls under a no decision made analysis, but apply a
different rule than Graham
 “Board must attempt in good faith to assure a corporate information and reporting system
 This is an affirmative duty on the corporation to monitor for questionable behavior
 The court justifies this by following DE § 141 stating the board has supervisory and
monitoring roles
 Unfortunately, it is unclear which standard applies to the non-action cases, therefore
 Use both the Graham and Caremark standards on the test
 Allen says the Graham standard is no longer reliable – 3 Reasons
 things have changed since 1963 – suggests that the S.C. not takes much more seriously the boards
duty to monitor
 section 141 – the board has a supervisory and monitoring rule
 revision to the federal sentencing guidelines – imposes new penalties on corporations for
violations and thus imposes new duties on boards – take reasonable and good faith – to see that
your board does not get fined $250 million
 In order to show that the Caremark directors breached their duty of care by failing adequately to
control Caremark’s employees, plaintiffs would have to show either (1) that the directors knew or (2)
should have known that violations of law were occurring and, in either event, (3) that the directors took
Page 34 of 81
no steps in a good faith effort to prevent or remedy that situation, and (4) that such failure proximately
resulted in the losses complained of
DUTY OF LOYALTY
 Directors and Managers
 Bayer v. Beran
 President of the corporation decided they needed advertising to promote their product and started a
radio show in which his wife was the main singer. Shareholders sued believing this was a waste of
corporate resources.
 Q: whether the action of the directors was intended or calculated to “subserve some outside
purpose, regardless of the consequences to the company, and in a manner inconsistent with its
interests”?
 A: the expenditure was not reckless – or unconscionable: it is not improper to appoint
relatives of officers or directors to responsible positions in a company but where a close
relative of the CEO of a corporation, and one of its dominant directors, takes a position
closely associated with a new and expensive field of activity – motives of the directors are
likely to be questioned – the board would be placed in a position where selfish, personal
interests might be in conflict with the duty it owed to the corporation – therefore this must be
challenged under rigorous scrutiny  Standard of Review
 Business Judgment Rule
 Other claim: Breach of the Duty of loyalty
 The business judgment rule yields to the rule of undivided loyalty. This great rule is designed
to avoid the possibility of fraud and to avoid the temptation of self-interest
 Standard
 The entire transaction must be subjected to the most rigorous scrutiny to determine if the
action was intended to serve some outside purpose
 Did the corporation violate its duty
 No. The President’s wife received a reasonable salary, the show did not promote her career
but the corporation’s product, outsiders agreed that the President should hire his wife…
 Although the president knew his wife might be paid, other directors did not know this until
they had approved the campaign
 What about the fact that the entire board did not vote on the issue
 They ratified it after the fact and further this board had a closer working relationship than
most boards and therefore ratification was plausible
 In total
 Policies of business management are left solely to the discretion of the Board and may not be
questioned absent a showing of fraud, improper motive, or self interest
 H: evidence fails to show the program was designed to foster or subsidize “the career of Miss
Tennyson as an artist” or to “furnish a vehicle for her talents.” Her compensation was in
conformity with that paid for comparable work – she received less then the other artists  Rule: directors acting separately and not collectively as a board cannot bind the corporation –
 collective procedure is necessary in order that action may be deliberately taken after an
opportunity for discussion and an interchange of views;
 directors are the agents of the stockholders and are given by law no power to act except as a
board
 failure to observe the formal requirements is by no means fatal – its members are in daily
association with one another and their full time is devoted to the business of the company with
which they have been connected for many years
 Lewis v. S.L. & E., Inc.
 Two parties had entered into a lease agreement over the years, but when the lease expired, one
party continued paying at the old rate and no new lease was entered into.
 The sole claim raised in the complaint was that the defendant directors had wasted the assets of
SLE by ‘grossly undercharging’ LGT for the latter’s occupancy and use of the Property.
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
First question was the burden of proof. Court concluded that the lower court erred in placing upon
plaintiff the burden of proving waste. Because the directors of SLE were also officers, directors
and/or shareholders of LGT, the burden was on the defendant directors to demonstrate that the
transactions between SLE and LGT were fair and reasonable.
 Court rejects the business judgment rule b/c it presupposes that the directors have no conflict
of interest. When a shareholder attacks a transaction in which the directors have an interest
other than as directors of the corporation, the directors may not escape review of the merits of
the transaction.
 When the transaction is challenged in a derivative action against the interested directors, they
have the burden of proving that the transaction was fair and reasonable to the corporation
 Court is convinced that the defendants failed to carry the burden
 Corporate Opportunities
 Broz v. Cellular Information Systems, Inc.
 Broz was approached in his individual capacity to purchase a cellular license. Broz was on the
board of two different cellular companies. The cellular contract was offered to Broz’s wholly
owned company, because the other corporation he was part of was considered financially unable
to do so. Broz nonetheless approached every member of the other corporation’s board and asked
them if they would be interested in the deal, which they stated no. The financially unstable
corporation merged with another corporation and the new CEO sued Broz for violating his duty of
loyalty by usurping a corporate opportunity.
 DOCTRINE OF CORPORATE OPPORTUNITY –
 If there is presented to a corporate officer or director a business opportunity which the
corporation is financially able to undertake, is, from its nature, in the line of the
corporation’s business and is of practical advantage to it, is one in which the corporation has
an interest or a reasonable expectancy, and, by embracing the opportunity, the self-interest of
the officer or director will be brought into conflict with that of the corporation, the law will
not permit him to seize the opportunity for himself.
 A corporate opportunity exists where:
 (1) Corporation is financially able to take the opportunity
 (2) Opportunity is in the corporation’s line of business
 (3) Corporation has an interest or expectancy in the opportunity
 Interest – something to which the firm has a better right
 Expectancy – something, which in the ordinary course of things, would come to the
corporation
 (4) Embracing the opportunity would create a conflict between director’s self interest and
that of the corporation
 This test is a weighing test, therefore the absence of any one factor is not dispositive
 Does Broz need board approval to be safe?
 Board approval is not required by law
 But it creates a safe harbor for the individual
 Another factor
 Broz was approached in his individual capacity, not his corporate capacity
 Why does Broz win
 The other corporation was financially incapable of handling the deal and Broz cannot
know what the corporation will want after the merger
 The corporate opportunity doctrine – only comes in to play with cases when the
fiduciary’s seizure of an opportunity results in a conflict between the fiduciary’s duties
to the corporation and the self-interest of the director as actualized by the exploitation of
the opportunity.
 H: Broz was under no duty to consider….the contingent and uncertain plans of PriCellular in
reaching his determination of how to proceed. Broz did not breach his fiduciary duties  In Re eBay, Inc. Shareholders Litigation
 eBay executives are offered IPO shares which they spin into millions of dollars of personal profits,
in return they acquire PayPal and the corporation that gave them the IPO shares gets an 8 million
dollar commission. Shareholders sue claiming waste and usurpation of a corporate opportunity.
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
Did the eBay executives steal a corporate opportunity?
 (1) Corporation is financially able to take the opportunity
 In this case, eBay is able to take this opportunity, no one disputes eBay financially
was able to explain the opportunities in question
 (2) Opportunity is in the corporation’s line of business
 Investing was a line of business of eBay
 Don’t all corporations invest
 (3) Corporation has an interest or expectancy in the opportunity
 Court does not really address this prong
 Rather, court points out that eBay execs got these perks because of their positions
and not because they were wealthy investors
 Clear conflict here because eBay should have gotten the profits
 Alternative theory- agent must account for profits
 (4) Embracing the opportunity would create a conflict between director’s self interest and
that of the corporation
 The court finds there was no violation of the duty of loyalty
 The outside directors ratified the decision and this is not a violation of the duty of loyalty
because they can state they were simply rewarded the directors for their hard work
 The court finds no breach of the duty of care
 The business judgment rule has never overturned a corporate decision because of waste
 Holding
 Executives usurped a corporate opportunity
 Are disgorged of their profits
 RULES: an agent is under a duty to account for profits obtained personally in connection with
transactions related to his or her company.
 H: eBay has to return the money – illegal
 Analysis
 As an alternative theory of liability, the court invokes the common law restated by R.2d Agency §
388, which provides:
 Unless otherwise agreed an agent who makes a profit in connection with transactions
conducted by him on behalf of the principal is under a duty to give such profit to the principal.
 Commentary following notes:
 Thus, an agent who, without the knowledge of the principal, receives something in
connection with, or because of, a transaction conducted for the principal, has a duty to
pay this to the principal even though otherwise he has acted with perfect fairness to the
principal and violates no duty of loyalty in receiving the amount.
 Dominant Shareholders
 Sinclair Oil Corp. v. Levien
 Sinclair Corp. owned 90% of Sinven. Sinclair, since it dominated the board of Sinven, caused it to
pay out huge dividends, larger than its profits. The minority shareholders sued because of the
forced large dividends and a breach of contract.
 Typically, shareholders do not owe each other a fiduciary duty
 However, a dominant shareholders owes a fiduciary duty to minority shareholders
 A dominant shareholder is one that controls the board
 Which burden of proof applies in this case
 (1) Business judgment rule
 Burden of Proof on Plaintiff
 (2) Intrinsic Fairness test
 Burden on the Defendant
 How does the court know which burden to apply
 Intrinsic fairness is only used when parent has received a benefit to the exclusion of
the minority shareholders of the subsidiary and at the expense of the minority
shareholders of the subsidiary (aka self-dealing)
 First, which burden applies to the dividend payments?
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

Business judgment rule
 Everyone received the dividends, therefore this is business judgment
 Issuing dividends is always business judgments
 The only time dividends might be problematic is if the dividends resulted from
an improper motive and waste.
Second, which rule applies to the breach of contract claim
 Intrinsic Fairness because Sinven stockholders were not receiving the same benefit as
Sinclair stockholders

Analysis
 Supreme court has noted;
 A director is a fiduciary…so is a dominant or controlling stockholder or group of
stockholders…their powers are in trust…their dealings with the corporation are subjected to
rigorous scrutiny and where any of their contracts or engagements with the corporation is
challenged the burden is on the director or shareholder not only to prove the good faith of the
transaction but also to show its inherent fairness from the viewpoint of the corporation and
those interested therein.
 Zahn v. Transamerica Corporation
 Trans controlled the board and had the option in the stock agreement to recall Class A stock at $60
per share. After learning of an upcoming increase in the price of tobacco, Trans recalled the Class
A stock without telling the stockholders of the upcoming price increase they were aware of. Class
A sues and wins, in some fashion.
 The court applies the intrinsic fairness test
 The dominant stockholder did not disclose material information for the purpose of
profiting at the minorities expense
 Majority stockholders owe a duty to minority stockholders that is similar to the duty owned
by a director, and when a controlling stockholder is voting, he violates his duty if he votes for
his own personal benefit at the expense of the stockholders
 3 options:
 redeem without disclosing intent to liquidate -----what they actually did
 liquidation without redemption ----- what plaintiff wanted to happen
 redeem after giving notice of the material facts and their intent to liquidate
 A: you have to redeem but after giving notice – you have to give them the opportunity – that all
A’s would make under the circumstances – which is to trade in their B shares for A’s shares and
share in the liquidation.
 Ratification
 Fliegler v. Lawrence (see nate)
 Issue: whether the individual defendants, in their capacity as directors and officers of both
corporations, wrongfully usurped a corporate opportunity belonging to Agau, and whether all
defendants wrongfully profited by causing Agau to exercise an option to purchase that
opportunity…
 Defendants argue that they have been relieved of the burden of proving fairness by reason of the
shareholder ratification of the board’s decision to exercise the option
 Defendants rely upon Gottlieb which stated that shareholder ratification of an interested
transaction, although less than unanimous, shifts the burden of proof to an objecting shareholder to
demonstrate that the terms are so unequal as to amount to a gift or waste of corporate assets…
 Court rejects this argument
 Court also noted its belief that the legislature did not intend such a consequence b/c Delaware
statute provides: no contract or transaction shall be void or voidable if: the material facts as to the
relationship or interest and as to the contract or transaction are disclosed or are known to the board
of directors or the committee, and the board or committee in good faith authorizes the contract or
transaction by the affirmative votes of a majority of the disinterested directors…
 In Re Wheelabrator Technologies , Inc. Shareholders Litigation
 Shareholders of Wheelabrator filed a class action suit alleging that WTI and its directors breached
their fiduciary obligation to disclose material information concerning a corporate merger. The 2
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merging companies are merging and the minority shareholders are dissatisfied. The company
argues the minority shareholders ratified the deal when they agreed to the merger.
 Issues:
 (1) Disclosure
 Even though lacking, the court finds it sufficient in this case
 (2) Duty of care
 If minority shareholders ratify deal, then there can never be a duty of care claim
 (3) Duty of loyalty
 Depends
 There are two types of ratification claims with the duty of loyalty
 (1) Interested transactions (not majority shareholder)
 Will not be voidable if it is approved in good faith by a majority of disinterested
shareholders
 If claim is ratified by disinterested shareholders, burden shifts to the plaintiff to
prove the business judgment rule is not satisfied
 (2) Controlling shareholder transactions
 If ratified by the minority shareholders, burden shifts to the plaintiff to show by the
entire fairness test is not satisfied
 Here, the defendant was not a controlling shareholder, therefore business judgment rule
applies
 Ratification by disinterested shareholders has different effects depending on the claim
 If disinterested shareholders with full disclosure ratify the claim
 No duty of care claim is permissible
 Duty of loyalty can be challenged, depending on the type of ratification
CHAPTER THREE—THE NATURE OF THE CORPORATION (CONTINUED)
SHAREHOLDER DERIVATIVE ACTIONS
 Introduction
 Derivative Actions are suits brought on the companies behalf (more about this under the Demand
Section)
 The real winners in derivative actions are the plaintiff’s attorney. He is the only person who gets
directly paid (by the corporation) while the judgment goes to the shareholders in general
 Cohen v. Beneficial Industrial Loan Corp.
 Cohen, a shareholder filing a derivative action, challenged the constitutionality of a New Jersey
statute requiring a plaintiff to front a large sum of money and reimburse the corporation if the
plaintiff’s suit is unsuccessful.
 New Jersey has a security for expense statute
 It forces a plaintiff to put up large amounts of money up front to deter plaintiffs from
filing baseless claims
 Delaware and FRCP do not require this, but Jersey does
 Why should we allow the shareholders to question the board anyways?
 The board has control over the officers and the company, yet no one has oversight over
the board
 The shareholders are in the best position to monitor the board because the board is
playing with their money
 Because the board is usually the defendants, the corporation will not likely sue itself
 Derivative suits are in equity, this allows shareholders to hold board members
accountable
 Further, derivative actions are somewhat encouraged because the corporation must
compensate the plaintiff for his legal fees if there is a substantial non-monetary benefit to
the corporation
 The court will almost always find this
Page 39 of 81


Why should Jersey have a security for expense statute then
 Because plaintiff’s attorneys are the real winners in derivative actions. He is the only one
who personally benefits, monetarily, from these suits and therefore requiring large
upfront payments will deter individuals from baseless claims simply for hopes of
settlement.
 Weird fact about this case
 Since the court views a securities for expense statute as substantive, the court applies
Jersey law (where the corporation is located) and not Delaware law (where the
corporation is incorporated)
 Two types of shareholder suits
 Direct
 Brought by the shareholder in his own name
 Cause of action belongs to the shareholder in his or her individual capacity
 Arises from an injury directly to the shareholder
 Derivative
 Brought by a shareholder on corporation’s behalf
 Cause of action belongs to the corporation as an entity
 Arises out of an injury done to the corporation as an entity
 Hypos
 (1) ABC Corp. entered into a contract with Jane Jones
 Jones breached the contract, but ABC Corp. has not sued her for that breach
 May shareholder of ABC Corp. sue Jones directly
 No. Jones owned no duty to the shareholder as such
 Jones breach did not injure the shareholder directly
 Hence, a shareholder suit against Jones must be brought as a derivative suit
 (2) ABC Corp’s treasurer embezzles all its money and absconds
 Shareholder’s stock is now worthless
 May a shareholder of ABC Corp. sue treasurer directly
 No
 Not enough for a shareholder to allege that challenged conduct resulted in a drop in
corporation’s stock market price
 Because your loss is derivative of the corporation’s loss, only the corporation can sue
Eisenberg v. Flying Tiger Line, Inc.
 Eisenberg owned shares in Flying Tiger Line which reorganized into Flying Tiger which
Eisenberg had no power in because the reorganization diluted his voting rights.
 Is this a derivative or direct suit? Eisenberg cares because he does not have to put up the large
security if the suit is direct
 Court applies the Eisenberg standard:
 A suit is only derivative if it is brought in the right of a corporation to procure a
judgment in the corporation’s favor
 The real question is who can get a judgment on their behalf, the individual or the
corporation
 This was a direct suit in this case
 The shareholder suffered a dilution of his voting rights in stock, not his economic rights
 This is not a piece of the corporate pot
 Delaware formulation of figuring out the question
 (1) Who suffered the alleged harm
 (2) Who would receive the benefit of any recovery or other remedy
 In tough cases, the court should defer to what the plaintiff calls the case.
 Standing to bring a derivative suit
 MCBA § 7.41 limits standing to shareholders who
 (1) Were shareholders of the corporation at the time of the alleged wrong
 (2) Must fairly and adequately represent the interests of the corporation in enforcing
the right of the corporation
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
MCBA § 7.42 further explains that plaintiff must be a shareholder when the suit is
commenced
 Boards usually block derivative suits through the requirement of Demand
 TEST: whether the object of the lawsuit is to recover upon a chose in action belonging directly
to the stockholders, or whether it is to compel the performance of corporate acts which good
faith requires the directors to take in order to perform a duty which they owe to the
corporation, and through it, to its stockholders.
 if Flying Tiger’s directors had a duty not to merge the corporation – the duty was owed to
the corporation and only derivatively to its stockholders
 Rule: security for costs could not be required where a plaintiff – “does not challenge acts of the
management on behalf of the corporation. He challenges the right of the present management
to exclude him and other stockholders from proper participation in the affairs of the
corporation. He claims that the defendants are interfering with the plaintiff’s rights and
privileges as stockholders.”
 Analysis
 In Delaware, many courts use the ‘special injury’ test to determine whether a suit was direct or
derivative. A special injury was defined as a wrong that ‘is separate and distinct from that
suffered by other shareholders…or a wrong involving a contractual right of a shareholder, such as
a right to vote, or to assert majority control, which exists independently of any right of the
corporation.
 Twenty years later, the Delaware supreme court rejected the special injury test, in favor of a twoprong test;
 Who suffered the alleged harm, the corporation or the suing stockholders, individually;
 Who would receive the benefit of any recovery or other remedy, the corporation or the
stockholders, individually.
 The Requirement of Demand on the Directors
 Grimes v. Donald
 DCS Corp. hired Grimes with and offered him an extraordinary separation package. Shareholder
believed that this was abdictating the board’s power because they would never question Grimes
decisions, due to the fact that firing him would be too costly. Shareholder also argued that Grimes
compensation was ridiculous. Shareholder made demand which was refused.
 First, court mistakenly characterizes shareholders claim as direct because he does not want
money, he wants an injunction as to the separation agreement.
 Though this is wrong, it shows an important point; demand is not required in direct suits
 Court should have used the Eisenberg test to determine whether this was a derivative
suit or direct
 With the excessive compensation claim:
 The court found it was a derivative suit
 Since Shareholder made demand, he loses
 Why should Grimes not have made demand?
 By making demand, he waived his right to contest the independence of the board
 Should come to court, without making demand, and explain that demand was futile
 If the shareholder makes demand and the board rejects his proposal
 The board rejecting the demand is entitled to the presumption that the rejection was made
in good faith unless the stockholder can allege sufficient facts to overcome the
presumption
 When someone makes demand, they concede the point that demand is required and
may not argue demand futility
 The only argument is that demand was improperly denied
 Then the business judgment rule applies
 Strategies for the plaintiff
 Make demand
 But demand is always denied (the corporation is not going to sue itself)
 Once demand is refused, the refusal is reviewed under the business judgment rule
Page 41 of 81
 Plaintiff pretty much loses
Argue that making demand is futile
 The business judgment rule is still in effect
 But only as one of three distinctive prongs
 Argue that the majority of the board has a material financial or familial interest
 Argue that the majority of the board lacks independence (domination and control by
wrongdoers)
 Argue that the transaction is not a product of the valid exercise of business judgment
 Why do we even have demand?
 It is a screening mechanism to eliminate strike suits
 Provides opportunity for Board action
 Board can see if the claims have merits
 Board can implement remedial measures and correct the problem itself
 A: if an independent and informed board, acting in good faith, determines that the services of a
particular individual warrant large amounts of money, whether in the form of current salary or
severance provisions, the board has made a business judgment.
 This judgment will receive protection of the business judgment rule unless the facts show that
such amounts compared to the services to be received in exchange, constitute waste or could
not otherwise be the product of a valid exercise of business judgment
 Demand Requirement purposes –
 requiring intracorporate remedies – invokes a species of alternative dispute resolution – avoid
litigation altogether
 if litigation is beneficial – corporation can control the proceedings
 if demand is excused or wrongfully excused the stockholder will normally control the
proceedings
 a stockholder who makes a demand is entitled to know promptly what action the board has
taken in response to the demand
 a stockholder who makes a serious demand and receives only a peremptory refusal has the
right to use the “tools at hand” to obtain the relevant corporate records, such as reports or
minutes, reflecting the corporate action and related information in order to determine
whether or not there is a basis to assert that demand was wrongfully refused
 The stockholder by making demand, waive the right to claim that demand has been
wrongfully refused.
 Rule: if a demand is made and rejected, the board rejecting the demand is entitled to the
presumption of the business judgment rule unless the stockholder can allege facts with
particularity creating a reasonable doubt that the board is entitled to the benefit of the presumption.
 If there is reason to doubt that the board acted independently of with due care = stockholder
may have the basis ex post to claim wrongful refusal
 A: Here the Board of DSC considered and rejected the demand – they invested time and resources
to consider and decide whether or not to take action
Marx v. Akers
 Marx, shareholder of IBM, brought a derivative action against the corporation alleging that the
directors violated their fiduciary duties by voting for unreasonably high compensation for
executives
 Marx asserts two breach of fiduciary duty claims
 Excessive director compensation
 Excessive executive compensation
 Marx failed to make demand
 When suing an entire or a majority of the board, there is a stronger case that demand
would be futile
 3 Approaches to demand futility argument
 MBCA: Universal demand requirement
 No futility exception
 Demand must always be made


Page 42 of 81

Board must act within 90 days, failure to do so permits the shareholder to bring the
claim
 The only exception to demand is “irreparable harm,” (whatever that is)
 Delaware standard
 Reasonable doubt as to:
 (1) Majority of the board has a material interest; or
 (2) Majority of the board lacks independence; or
 (3) Challenged transaction is not a product of valid exercise of business
judgment
 New York Standard
 (1) Demand is excused because of futility when a complaint alleges with
particularity that a majority of the board of directors is interested in the challenged
transgression;
 (2) Demand is excused because of futility when a complaint alleges with
particularity that the board of directors did not fully inform themselves about the
challenged transaction to the extent reasonably appropriate under the circumstances;
or
 (3) Demand is excused because of futility when a complaint alleges with
particularity that the challenged transaction was so egregious on its face that it could
not have been the product of sound business judgment of the directors
 Only need to show one factor
 Both the Delaware and New York standards are very similar
 Minus the reasonable doubt language of Delaware
 Remember, for the interest prong
 (1) Self interest – board member personally benefits
 (2) Loss of independence – you are indebted to another who will benefit from the
transaction
 **need to have a balance between discretion of directors to manage a corporation with
undue interference – and permit shareholders to bring claims on behalf of the corporation
when directors wrongfully refuse to bring the claims
 A: Since only three directors are alleged to have received the benefit of the executive
compensation scheme, plaintiff has failed to allege that a majority of the board was interested in
setting executive compensation….the complaint does not allege particular facts in contending that
the board failed to deliberate or exercise its business judgment in setting those levels
 Rule: Directors are self-interested in a challenged transaction when they will receive a direct
financial benefit from the transaction which is different from the benefit to shareholders
generally..
 A director who votes for a raise in directors’ compensation is always “interested” because that
person will receive a personal financial benefit from the transaction not shared in by
stockholders
 H: plaintiff has not stated a cause of action regarding director compensation – and the complaint it
dismissed entirely –
 Rule: a complaint challenging the excessiveness of director compensation must - to survive a
dismissal motion – allege compensation rates excessive on their face or other facts which call into
question whether the compensation was fair to the corporation when approved, the good faith
of the directors setting those rates, or that the decision to set the compensation could not have
been a product of valid business judgment.
 The Role of Special Committees
 Auerbach v. Bennett
 Shareholders made demand for corporation to sue itself due to some of its directors making illegal
bribes overseas. The corporation set up an independent investigation committee which decided not
to sue the board. Shareholders did not like that the corporation decided who made the decision to
sue them, but the corporation wins.
 The business judgment rule applies to SLC recommendations
 Yet judicial inquiry is permitted, there is a two tiered inquiry
Page 43 of 81


(1) How independent is the SLC
 This determines good faith
 There is a concern with structural bias
 (2) Adequacy of SLC’s investigation
 Need good faith procedures
 The burden of proof is on the defendant
 Primarily, a court will only look to the independence and adequacy of a special litigation
committee’s investigation
 If these are satisfactory, then the corporation usually wins because the business judgment
rule is applied to the ultimate decision of the SLC
 Rule: the business judgment rule does not foreclose inquiry by the courts into the disinterested
independence of those members of the board chosen by it to make the corporate decision on its
behalf – here the members of the special litigation committee. Indeed the rule shields the
deliberations and conclusions of the chosen representatives of the board only if they possess a
disinterested independence and do not stand in a dual relation which prevents an
unprejudicial exercise of judgment….
Zapata Corp. v. Maldonado
 Shareholder initiated a derivative action and demand was excused because every board member
was a named defendant. Four board members left, two new members were picked by the
defendant and created an SLC, which decided the shareholder suit should be dismissed.
Shareholder sues and losses.
 Q: whether the Committee has the power to cause the present action to be dismissed?
 “business judgment rule is irrelevant to the question of whether the Committee has the
authority to compel the dismissal of this suit.”
 McKee rule: shareholder may not violate the discretionary field of the board; unless
 (1) Board decision is wrongful, or
 (2) Demand is excused
 Demand was excused here
 “a stockholder cannot be permitted….to invade the discretionary filed committed to the
judgment of the directors and sue in the corporation’s behalf when the managing body
refuses. This rule is a well settled one.”
 Delaware General Corporation Law
 § 141(a): The business and affairs of every corporation shall be managed by or under the
direction of the board of directors
 So why should one shareholder be able to force unwanted litigation on an entire
corporation if demand is waived
 § 141(c) gives the solution: The Board may delegate its authority to a committee
 So even if demand is waived, the SLC can still stop a lawsuit when all the board
members are biased
 How do courts determine whether SLC recommendations are satisfactory under Delaware
law? (only proceed is demand is excused)
 Zapata Two Step
 Step 1
 Inquiry into the independence and good faith of the committee and the basis
supporting the committee’s recommendations
 corporation should have the burden of proving independence, good faith, and a
reasonable investigation, rather than presuming independence, good faith and
reasonableness
 Step 2
 Court may apply its own business judgment to determine whether case should be
dismissed
 This has nothing to do with business judgment, this is really about whether the
court believes the case should proceed
 consider and weigh the corporate interest in dismissal is when faced with a nonfrivolous lawsuit
Page 44 of 81

Zapata is very intrusive into board decisions
 States that even when demand is excused because the majority of the board is incapable
of making a decision
 The tainted board can still set up a SLC to avoid the lawsuit
 Yet this is offset because
 Even if the SLC is found independent and the basis supporting the SLC’s decisions
are sound
 The court can still find a lawsuit is appropriate
 Rule: a stockholder may sue in equity in his derivative right to assert a cause of action in behalf of
the corporation, without prior demand upon the directors to sue, when it is apparent that a demand
would be futile, that the officers are under an influence that sterilizes discretion and could not be
proper persons to conduct the litigation.
 In Re Oracle Corp. Derivative Litigation
 Shareholders brought a derivative suit against the entire board, demand was excused, therefore the
board appointed an SLC of outside directors. Shareholders are able to tear down the SLC and get
their day in court.
 Court applies the Zapata two step to determine if the SLC decision to dismiss will stand
 Step 1
 Inquire into the independence, good faith, and thoroughness of the committee
 How does the court treat this SLC?
 The committee members had ties with Stanford University – they were
professors
 All sorts of ties to Stanford – donations etc.
 convinces the court that this was not really an independent SLC.
 Does the SLC violate this step?
 There are no direct financial ties between the SLC and the board members
 Therefore the corporation argues that the only way this prong should be
overcome is if the board dominates or controls the SLC
 The Court disagrees
 By human nature, if there is a personal connection between the SLC and the
people they are investigating, they would have an interest in the outcome
 Therefore the SLC is not independent
 The court made a subjective judgment in the first step (they are not supposed to do
this until step two)
 Therefore, the court makes it easy to attack SLC’s
 Plaintiff’s lawyers only need to find some connection between SLC
members and board members to attack their independence
 Summary
 Both Delaware and New York have the same requirements for making demand
 Demand is required unless
 (1) Majority of the directors are interested in the challenged transaction
 (2) Directors fail to reasonably inform themselves
 (3) Challenged transaction is so egregious that it could not have been the product of sound
business judgment of the directors
 Delaware requires one of these elements is proven beyond a reasonable doubt
 New York requires one of these elements is complained with particularity
 Further, security for expense statutes are common to deter shareholder litigation
 The Delaware test is best for determining whether a suit is direct or derivative
 Plaintiff can only sue directly if the interest affects him personally
 Only direct suits allowed involve voting rights
 Otherwise the plaintiff will have to sue derivatively
 Derivative suits cover all economic interests
 If a suit is derivative:
 Is demand required?
 If the entire board is implicated, then demand is excused and plaintiff may sue
Page 45 of 81





Use the Marx/Grimes analysis to determine whether demand is excused
 But the board can still create an SLC to investigate and dismiss the shareholder claim
 If demand is required
 Primarily, plaintiff loses because the business judgment rule is applied
 Plaintiffs only argument is that the refusal was wrongful which is analyzed under the
business judgment rule
 Demand might not be refused
 But when is a corporation really going to sue itself?
Why would a plaintiff want to bring a case?
 Plaintiff does not personally profit from winning a derivative suit
 All proceeds of a judgment or settlement go to the corporation
 Plaintiff’s lawyer is the driving force
 Corporation must pay plaintiff’s legal fees if the court finds a substantial non-monetary
benefit of the suit
 Court are generous finding a non-monetary benefit
 Therefore plaintiff’s lawyers like to bring strike suits
 Corporation usually settles because cost of defense is more than settling
 If Plaintiff brings a meritorious claim
 Corporation wants to settle in way that guarantees they are indemnified
 Plaintiffs lawyer wants to settle to get his money
 Little work in this case equals a large payoff
As a final note on derivative suits
 If we follow the efficient capital markets hypothesis, derivative claims do not affect stock prices,
which is backed up by fact
What is the business judgment rule?
 Most courts call this a presumption in favor of the board’s judgment
 It is also spoke of as a standard of review (Van Gorkom) of a gross negligence standard
 Telman and Delaware think of it as an abstention doctrine
 Unless there is an allegation or fraud, illegality… the court will not interfere with the board’s
decision
Why do we have a business judgment rule
 Because businessmen are in a better position to make decisions about their company than judges
 A belief that the market is the proper way to punish a board
 Yet the market also punishes the shareholders whose stock is worth nothing if the board
screws up
 Yet shareholders elect the board
 But in reality there is little democracy in these elections
 Yet, shareholders should know this going in
 Boards are responsible to more than just the shareholders
 They have other constituencies
 Employee
 Creditors
 Consumers
 The Public at large
 The shareholders should not be able to tell the board what to do every time because it
affects more than their share price
CHAPTER FOUR—THE LIMITED LIABILITY COMPANY
INTRODUCTION
 LLC’s are a cross between partnership and corporations
 Have pass through taxation
 But also have limited liability
 Can be run like a partnership (members) or like a corporation (Board of Directors)
 Member’s rights in an LLC
Page 46 of 81


(1) Financial Interest
 Members have rights in distributions and liquidation
(2) Management Rights
 May be a corporate style directorate with a board of directors
 Then the managers owe fiduciary duties to the members
 Members can also govern like a partnership
 Then members owe each other fiduciary duties
FORMATION
 Water, Waste & Land, Inc. D/B/A Westec v. Lanham
 Clark and Lanham formed an LLC named Personal Investors Inc. They entered into a contract with
Westec and gave them their business card which stated PII. Clark and Lanham, nor PII paid Westec,
and Westec sued Clark and Lanham calling them personally responsible.
 Issue: whether the members or managers of a LC are excused from personal liability on contract
where the other party to the contract did not have notice that the members or managers were
negotiating on behalf of a LLC at the time the contract was made.
 Are Clark and Lanham personally responsible
 Trial Court
 No, LLC statute provides constructive notice to anyone who does business with an LLC
of limited liability
 Appellate Court
 Yes. Clark and Lanham did not fully disclose they were working for an LLC.
 Agency law
 Clark and Lanham are personally responsible because they are representing an
undisclosed principal
 Agent liable for the contracts of an undisclosed principal
 Constructive notice statute?
 The court interprets it narrowly because there should be an affirmative duty for agents to
disclose they are working for an LLC
 Otherwise the agents would have an incentive to not disclose their principal and
avoid paying any money
 It would invite fraud
 Correctness of the Rule
 It is much easier to disclose than for a party to research whether an entity is an LLC
THE OPERATING AGREEMENT
 Elf Atochem North America, Inc. v. Jaffari
 Elf had the money and marketing capabilities, Jaffari had the product and management skills to
product it. They formed an LLC to drive this venture, but Jaffari completely screwed Elf by stealing
money, interfering with business contacts… Elf sued in the Chancery court, but the claim was
dismissed because the LLC agreement called for arbitration in California.
 Primary holding
 Though the default LLC rule is that the parties can go to court when their agreement is
breached, it can be contracted around.
 Because the policy of the Uniform Limited Liability Company Act (ULLCA) is to give maximum
effect to the principle of freedom to contract and to the enforceability of LLC agreements, the
parties may contract to avoid the applicability of certain provisions of the Act
PIERCING THE “LLC” VEIL
 Kaycee Land and Livestock v. Flahive
 Kaycee land contracted for surface rights to Flahive’s land and contaminated the surface. Flahive sued,
Kaycee, an LLC, claimed it was insolvent, and Flahive pierced the veil of the LLC.
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Rule
 Piercing the veil of an LLC is done in the same manner as piercing the corporate veil
 The court found no legitimate reason to treat LLC’s different than corporations for veil
piercing
CHAPTER FIVE—THE DUTIES OF OFFICERS, DIRECTORS, AND OTHER INSIDERS
(CONTINUED)
DISCLOSURE AND FAIRNESS
 Definition of a Security
 Securities Act § 2(a)(1): The term security means any note, stock, bond, debenture, investment
contract, or, in general, any interest or instrument commonly known as security
 Robinson v. Glynn
 Plaintiff claims securities fraud in connection with his purchase of an interest in an LLC. The
court had to figure out if an interest in an LLC was a security.
 First Question:
 Why did plaintiff claim securities fraud rather than good old fraud
 Securities fraud is easier to prove and treble damages
 Second Question
 Is a partnership interest in an LLC a security
 No
 Test to determine whether something is an investment contract
 Howey Test (Investment contracts and securities)
 (1) A contract, transaction or scheme whereby a person invests money
 (2) in a common enterprise
 (3) and is led to expect profits
 (4) from the efforts of the promoter or a third party
 Point is that the investor has no real control of his money
 Test to determine whether something is a stock
 Forman Test (Must have five characteristics to be a stock)
 (1) Right to receive dividends (not necessary under Stroh)
 (2) Negotiability
 (3) Ability to be pledged or hypothecated
 (4) Voting rights in accordance with shares owned
 (5) Ability to appreciate in value
 Weighing of factors test
 Doesn’t matter what it is called, matters what it is
 When do securities laws apply?
 Public Corporations
 This is the common case
 Closed corporations
 Even if you are purchasing 100% of the stock of a close corporation that involves securities
 Doesn’t apply to the sale of assets of a corporation
 Partnerships
 Don’t apply to general partnerships
 Do apply to limited partnerships if the limited partners have limited control
 LLC’s
 Fact specific inquiry
 Use the Howie and Forman Tests
 The Registration Process
 Securities Act prohibits the sale of securities unless the company issuing the securities has registered
them with the SEC. § 5 imposes three requirements:
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Security may not be offered for sale through the mails or by use of other means of interstate
commerce unless a registration statement has been filed with the SEC
 Securities may not be sold until the registration statement has become effective; and
 The prospectus must be delivered to the purchaser before a sale
Doran v. Petroleum Management Corp.
 Doran invested in an oil company with a small number of sophisticated investors. The oil
company extracted a plethora of oil, in excess of environmental regulations and lost its ability to
drill for one year. Duran’s note goes into default and he sues the oil company under a 10b-5
securities fraud claiming that the security was not properly registered.
 Question: was this a public or private offering?
 First Question, what is the test to determine if his investment was a security
 Use Howie and Foreman
 Howie indicates that this is an investment contract
 Doran invested to make money off of other people’s efforts
 Duran claims that since this was a security, the oil company should have filed a registration
statement before it sold the security
 Oil company claims it did not have to under the § 4(2) private placement exception
 Private placement test (if satisfied, the § 4(2) exception overrules § 5 requirement of filing a
registration statement before selling stock)
 Four factors
 (1) Number of offeree and their relationship to the issuer
 Small number
 The first factor is the touchstone of the inquiry
 There is a twenty-five person rule of thumb, anything larger is too much
 Needs to be a small number of people
 Relationship to the issuer
 Offerees knowledge and sophistication
 Offeree’s access to information
 How can the information be obtained
 Through a private memorandum
 Through access to information
 How much information needs to be offered
 As much as would have been in the registration statement
 (2) Number of units offered
 (3) Size of offering
 (4) Manner of offering
 No general advertising or solicitation
 Q: Did the offerees know or have a realistic opportunity to learn facts essential to an investment
judgment? - this is the issue for remand
 the Securities Acts focuses on facts – facts disclosed, facts known, or access to facts;
evidence of a high degree of business or legal sophistication on the part of all offerees does
not suffice to bring the offering within the private placement exemption; the more offerees,
the more likelihood that the offering is public; - a total of 8 investors would be entirely
consistent with a finding that the offering was private.
Note
 With 10b-5 motions, only those individuals that actually purchase stock and are harmed therefore
can pursue a claim
 In the private context, full disclosure is warranted and therefore individuals who turn down an
illegal offer may also sue
Escott v. BarChris Construction Corp.
 Escott and other purchasers of debentures sued BarChris for material false statements and material
omissions on the registration statement of the debentures
 First question
 Where there material misrepresentations
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 If the plaintiff proves a material misrepresentation, defendants are screwed
Second Question: Can the defendant raise an affirmative self defense - § 11 affirmative
defense (Apply to all but issuer)
 § 11(a)(4): experts are only liable for expertised portions of registration statements
 § 11(b)(3)(A): non-experts have due diligence defense for non-expertised portions
 § 11(b)(3)(B): experts have the same due diligence defense for the portions they have
reviewed
 § 11(b)(3)(C): with respect to expertised portions, non-experts must show that they had
no reason to believe and did not believe that statements were misleading
 § 11(c): standard for reasonable investigation and reasonable belief is the care that a
prudent person would exercise if his own money were at stake
Damages
 § 11(e): damages available are the difference between the price paid for the security and
the present price of the security
 Defendant can reduce the damages by showing a different cause for the change in the
security price
 Argue the market dropped the price anyways
Remember
 Issuer is not privy to these defenses
 Do not sign the registration statement without due diligence
 Rule 10b-5
 Rule 10b-5
 It shall be unlawful for any person, directly or indirectly, by the use of any means or
instrumentality of interstate commerce, or of the mails or of any facility of any national exchange,
 (a) to employ any device, scheme, or artifice to defraud
 (b) to make any untrue statement of a material fact or to omit to state a material fact necessary
in order to make the statements made, in the light of the circumstances under which they were
made, no misleading, or
 (c) to engage in any act, practice, or course of business which perates or would operate as a
fraud or deceit upon any person
 In connection with the purchase or sale of any security
 There is no private right of action under § 10(b)
 The Supreme Court implied a private right of action in 1971
 § 10(b) applies to any security, even those of a closely held corporation
 Elements of a 10b-5 Action
 (1) Jurisdictional
 Someone actually has to purchase a security in order to maintain a cause of action
 “if one decides not to buy based on materially misleading statements or omissions, they
do not have standing to bring a case”
 (2) Misrepresentation
 There must be a material misrepresentation or omission
 Standard
 TSC Industries- substantial likelihood that an ordinary investor would consider the
information important
 Texas Gulf- When the information in question is speculative
 Still apply the TSC standard, but multiple the probability by the magnitude
 (3) Reliance
 Shown in Basic
 (4) Causation
 (a) Transactional
 (b) Loss
 This is tough to prove because the other side will argue that other factors are responsible
for the drop in the securities value
 Have to show that the money lost was because of the fraud
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(5) Scienter
 The test in unclear
 More than negligent
 Less than intentional
 Maybe reckless disregard
Basic Inc. v. Levinson
 Basic made public misrepresentation about merging with another company; they said they were
not planning a merger while in fact they were. When the merger occurred, the shareholders who
had sold their stock sued, stating they had relied upon the non-merger statements and without
those statements, they would have held onto their stock and recognized the price now.
 First, were the statements materially false?
 The test for regular misrepresentation is the TSC
 In general, whether there is a substantial likelihood that a reasonable
shareholder would consider a fact important
 Yet, how can we determine materiality with something like a merger which is speculative
whether it will go through or not?
 When faced with uncertain or contingent facts, use the Texas Gulf probability times
magnitude approach
 Balance both the indicated probability that the event will occur and the anticipated
magnitude of the event in light of the totality of the company activity
 Second, how do we prove reliance, especially since this is a class action?
 Reliance is assumed in omission cases, yet this is a misrepresentation case
 And with class actions, there must be commonality among the class or the action is
impossible
 It would be impossible for every class member to prove reliance
 How can we prove that every investor heard or read and then relied upon a
misrepresentation?
 The court uses the fraud on the market theory to prove reliance for the class
 This theory states:
 That the investors relied on the integrity of the market price and that the
defendant’s misrepresentation affected (or fooled the market)
 Therefore investor does not have to prove they heard the misrepresentation
 Fraud on the market theory
 Must be a material public misrepresentation
 There must be the presumption of efficient capital markets
 Anyone who sold during this time can sue because the market was artificially depressed
because of the misrepresentation
 Rebutting the fraud on the market theory
 Market was not deceived
 Corrective statements
 Show specific investors would have sold anyways
 Show harm was not caused by the misrepresentation, but by some other factor
 Why White and O’Conner disagree with the fraud on the market theory
 First, this was a dumb case to use this in
 The stock price increased during this time period and some plaintiffs who sold made
money
 Some plaintiffs bought after the misrepresentation was made
 Why do we need the fraud on the market theory?
 It is impossible to show direct reliance on misrepresentations in most cases
 Most unsophisticated investors do not read financial statements or understand them if
they do
 How to avoid this problem if corporation is planning a merger
 Corporation might need to keep merger quite, therefore
 Do not make public statements
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Or say that the corporation never comments on mergers, whether true or false
 Then again, this encourages secrecy, not full disclosure
 H: because most publicly available information is reflected in market price, an investor’s reliance
on any public material misrepresentations, therefore, may be presumed for purposes of a Rule 10b5 action; public information reaches professional investors, whose evaluations of that information
and trades quickly influence securities price.
 DISSENT:
 Question the “integrity” of the market in the context of “fraud-on-the-market”
 This amounts to investor insurance, which is really for the legislature to provide
 Works poorly in this case
 P’s made money, and some bought stock after the merger denials
 D’s did not manipulate the stock, so there is no transactional nexus
West v. Prudential Securities, Inc.
 Hoffman, a stockbroker, gave material non-public information (false) to his clients about a
forthcoming merger. He told them the stock price would increase, yet the price declined and
people who bought stock during this period brought a class action suit against Hoffman. Why
should individuals who never spoke to Hoffman be able to sue?
 Easterbrook believes that these individuals are not able to sue
 Fraud on the market theory believes that the stock price reflects all information available to it.
Therefore, if material public information affects the stock price adversely, everyone who
purchased the stock can sue because they relied upon the market price, which was determined
by the false information.
 The fraud on the market theory does not work so well when the false information is nonpublic and therefore assumingly not reflected in the stock price.
 Easterbrook believes that only public information affects the stock price and also that
the efficient capital markets hypothesis is not completely accurate
 Klein and Coffee provide that stock price are affected by material non-public
information
 The stock price in this case rose 20%, possibly on account of the non-public
information
 Holding is that only the individuals who actually heard the misrepresentations from Hoffman
can sue him; no fraud on the market
 The only way Easterbrook believes that non-public information will affect the stock price
is if substantial shares are purchased or traded by the people with material non-public
information, therefore evidencing a shift in the market
 He believes in a horizontal demand curve for securities; i.e., demand does not affect
the amount of shares purchased
 Q: whether the action may proceed, not on behalf of those who received Hofman’s “news” in
person but on behalf of everyone who bought Jefferson stock during the months when Hofman
was misbehaving
 A: First, these were oral statements, which creates a problem for commonality; Second, there
is no support for efficient markets thesis w/ respect to non-public information
 Maybe if the volume of trades was significant it would have had an effect
 Or if insiders were involved, but they weren’t obtained here
 A: The record here does not demonstrate that non-public information affected the price of
Jefferson Savings’ stock - Hoffman’s tips raised the demand for Jefferson Savings Stock and
curtailed that supply (for the tippees were less likely to sell their own shares); that
combination of effects raised the stock’s price;
 H: Can’t claim fraud on the market with respect to stock price on the market
Note on Judicial Limitations on Actions Under Rule 10b-5
 Court has put bite in the rule that protections of Rule 10b-5 extend only to purchase and sellers of
corporation’s securities
 Court held that liability for issuance of a false or misleading statement required proof of a state
mind referred to as ‘scienter’; that is, the person making the false statement must have made it
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with an ‘intent to deceive, manipulate, or defraud.’ The court reserved judgment on the question
whether recklessness would be sufficient, but later decisions have answered that question
affirmatively.
Santa Fe Industries, Inc. v. Green
 Santa Fe merged with Kirby Lumber for the sole purpose of eliminating minority shareholders.
Shareholders were paid a price by the corporation, but stated that they should receive over five
times the amount they received because this is what they would have received had the company
liquidated. Shareholders lose.
 Short form merger is allowed to corporations that own over 90% of the stock which allows
that to merge without a shareholder vote.
 If the shareholders do not like their share price, they have appraisal rights, meaning they
can appeal to have the value of their shares assessed
 The corporation avoids the time, expense, and hassle of a former merger and the
shareholders are protected through appraisal
 Plaintiffs first claimed a violation of rule 10b-5 because they were not given notice and
further because there was no valid business reason for the merger
 Delaware does not require a valid business reason for a merger and the corporation
followed the rules for a short form merger
 Next, the shareholders claimed a breach of the director’s fiduciary duties when they
undervalued the stock (supposedly)
 The federal courts did not want to expand rule 10b-5 reach by allowing plaintiffs to due
for breach of fiduciary duties under it
 The plaintiff’s fiduciary rights are protected by state law
 The only way a court would allow a 10b-5 claim based on a fiduciary duty is if
there was fraud or deception
 Moral- business followed the rules and did not have to pay the shareholders the same amount
as if they were liquidating because they were keeping the corporation alive and needed money
to run it
 2nd Cir. reverses – no we think it’s a sufficient breach of fiduciary duty to qualify for a violation;
 H: you can’t have a 10b-5 violation without some sort of manipulation or deception – provides
three categories of justifications:
 Legislative history on 1934 Act
 Purpose of regulations: to prevent fraud by providing disclosures – once disclosures are
made as a matter of federal law the court is not going to look into the fairness of the
transaction
 H: company disclosed as they had to under Delaware law – that we are merging you
are offered this and have a right to appraisal
 Implied right of action rules
 Don’t think there should be rights without remedies – it wouldn’t make any sense if
Congress want tot eh trouble to say this is a violation and have no remedy for it
 If it does have a remedy – courts shouldn’t rush in – when there is an adequate state
remedy – don’t need to get involved
 H: alleging breach of fiduciary duty – which is governed by state law
 Principles of Federalism
 State governments experiment – hopefully the best solution wins out
 We defer to state governments when it comes to breaches of fiduciary duty
 We don’t want a federal government to come in and swoop down when all this
creativity is happening in the states
Deutschman v. Beneficial Corp.
 Casper and Halvorsen made false statements causing artificial inflation in the market price of
options to buy Beneficial stock. Plaintiff claimed this was a violation of 10b-5
 First question: what is an option? Two kinds
 Put
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Is a contract giving the owner the right to sell a fixed number of shares at a certain
price; this is a way for investors to cut back their losses
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Call
 Is a contract giving the owner the right to purchase a fixed number of shares at a
certain price; is useful if the price per share increase more than the contract cost
Next, are options protected under 10b-5
 Options are securities for purposes of the 1934 Securities Act
 There is no privity requirement with 10b-5 (use fraud on the market)
The last problem is that, though there were misrepresentations affecting the stock price, the
defendant did not buy or sell any stock or exercise any options
 There is no transactional requirement with options, they are different than stock
 See Bluechip Casino
 H: Option purchasers are susceptible to deceptive practices just like any other instrument;
Options are securities for the purposes of the 1934 Act; doesn’t matter that they didn’t
buy and sell the securities – options themselves are the securities
INSIDE INFORMATION
 Goodwin v. Agassiz
 The director and the president purchased plaintiff’s stock without disclosing inside information they
had about a possible copper discovery on their land
 The issues were whether the directors had a duty to disclose material, non-public information
before trading and if this duty ran to the corporation or to the shareholders
 The majority rule:
 Officers and directors may trade with a shareholder without disclosing material information
 It would be too burdensome for the directors to attempt to put everyone they dealt with
on the same playing field as there are
 Further, disclosure in this case would have been detrimental to the corporation’s interests
because they would have lost a considerable deal of money
 Yet, under special circumstances, officers and directors do have a duty to disclose material, nonpublic information when trading
 (1) In face to face transactions (do not happen very often)
 (2) Information is highly material
 (3) Officer concealed his identity or some other type of fraud
 (4) There is an especially vulnerable plaintiff
 Here, the court did not find that withholding this information violated any insider trading laws
 (1) It is difficult to prove information is highly material when it is speculative
 (2) Security transaction took place on the open market
 (3) Director duties in this case ran to the corporation rather than the shareholders (State law,
not federal law)
 Rule: the directors of a commercial corporation stand in a relation of trust to the corporation and are
bound to exercise the strictest good faith in respect to its property and business….
 Directors are not supposed to occupy the position of trustee toward individual stockholders in a
corporation
 Q: whether on the facts found the defendants as directors had a right to buy stock of the plaintiff, a
stockholder
 A: knowledge that naturally comes as a result of the position that a director holds within a
corporation places him in a peculiar obligation to observe every requirement of fair dealing when
directly buying or selling its stock;
 Mere silence is not usually enough to amount to a breach of duty
 A: an honest director needs to be able to sell and buy stock within his corporation without first
seeking out the actual ultimate party to the transaction and disclose to him everything which a
court or jury might later find that he then knew affecting the real or speculative value of such
shares;
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Fiduciary obligations of directors ought not to be made so onerous that men of experience and
ability will be deterred from accepting such office
 Rule: where a director personally seeks a stockholder for the purpose of buying his shares without
making disclosure of material facts within his peculiar knowledge and not within reach of the
stockholder, the transaction will be closely scrutinized and relief may be granted in appropriate
instances…
 H: the knowledge possessed by the defendants not open to the plaintiffs was simply an existence of a
theory – the defendants made no representations to anybody about the theory – the Cliff Mining
Company was not harmed by the non-disclosure; there was no duty on the part of the defendants to
set forth to the stockholders at the annual meeting their faith aspirations, and plans for the
future.
 Additionally, the plaintiff was no novice
 He acted upon his own judgment in selling his stock
 Insiders
 16(b) – insider is ONLY an officer, director, or beneficial owner of more than 10% of the stock
 10(b) – insider is a much broader concept; anyone with inside information must disclose or abstain
 Further, under 10(b), an officer owes a duty to the corporation and its shareholders
 Constructive insider (Dirks) – Individuals who obtain material non-public information from
an issuers
 Individuals acquire information with the expectation that the outsider will keep the
disclosed information confidential
 The relationship between the outsider and the other party implies a duty of confidentiality
 Fall under 10(b) claims but not 16(b)
 Securities and Exchange Commission v. Texas Gulf Sulphur Co.
 TGS conducted exploratory drilling which unveiled the possibility that some of its land had a huge
mineral deposit. An unauthorized press release went out to the public and the very next day, TGS
officials disclaimed the find through another press release. TGS officials then purchased a great deal of
stock and finally publicly announced the mineral find. Shareholder sues and win.
 Legal rule:
 Where an insider has material non-public information the insider must either disclose the
information or abstain from trading until the information has been disclosed.
 Who are the insiders this rule applies to?
 16(b): Officers, directors, and 10% beneficial owners
 10(b): Anyone in possession of material inside information
 Yet this definition is too broad; it includes people who gained the information through
their own efforts
 Should also have some fiduciary duty for insiders under 10(b)
 So when can insiders trade?
 Insider must wait until the market has a reasonable time to disseminate the information before
the insider can buy or sell
 How does the court know the information is material?
 With speculative information – probability times magnitude calculation
 Otherwise, see
 What the company’s response to the information is
 What insiders do with the information
 The market response
 Sometimes these actions compel a finding that the information is material
 General rule on materiality
 If a reasonable investor would want to know the information, disclose or abstain
 Do not forget that the information or ommission must be material
 “material facts” – include not only information disclosing the earnings and distributions of a
company but also those facts which affect the probable future of the company and those which
may affect the desire of investors to buy, sell, or hold the company’s securities.
 Notes and Questions
 In a private action for damages the plaintiff must prove:
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Defendant made a material misrepresentation or omission in connection with the purchase or sale
of a security
 Reliance
 Scienter
 causation
 Introductory Note on Current Law
 Chiarella v. United States
 Chiarella was a printer for a company (acquirer) which he learned was planning on acquiring
another company (target). Once he learned this, he purchased a ton of shares in the target because
those shares were about to be liquidated at an increased value.
 Chiarella did not owe any fiduciary duties to the target corporation
 We do not want people trading on inside information because they have an advantage, yet
we want people to seek out information and invest
 When is there a 10(b)-5 violation in these circumstances?
 Relationship exists giving an individual access to insider information
 It would be unfair to allow an insider to benefit from that information by trading without
disclosure
 But (exception)
 A 10(b) duty to disclose does not arise from the mere possession of non-public
information, rather, there must be some fiduciary relationship
 The printer in this case had no fiduciary relationship, therefore he is good
 H: Chiarella’s conduct was not a violation because he was not an “insider” of the corporation
whose shares he had traded (that is, the target corporation).
 Rule: a corporate insider must abstain from trading in the shares of his corporation unless he has
disclosed all material inside information known to him”
 the duty to abstain arises from the relationship of trust between a corporation’s
shareholders and its employees
 Here: there was no relationship between Chiarella and the shareholders of the corporations
whose shares he trade, he had no duty to “disclose or abstain.”
 Dirks v. Securities & Exchange commission
 Dirks, an investment banker, received a tip that a company was overstating its assets and understating
its debts, artificially boosting the stock price. Even though this was inside information that Dirks
received, he started an investigation and told his findings to multiple individuals. He was sued for
passing inside information to investors, who sold their stock lowering the stock price, yet Dirks wins
this case
 To begin Dirks did not profit from his investigation, his clients profited when he told them to sell.
 The SEC wanted to hold Dirks liable because he had material non-public information that he
passed on to other so they could make a profit
 i.e., SEC wants to hold Dirks (tipper) liable for passing the information to his clients (tippees),
who the SEC also wants to hold responsible
 First, when is the tipper liable?
 The tipper is only liable when he discloses the non-public information with an improper
motive; usually he is after secret profits
 The sceinter requirements seems to be recklessness
 Next, when is the tippee going to be liable
 In general, the tippee’s liability is derivative of the tipper’s, “arising from his role as a
participant after the fact in the insider’s breach of a fiduciary duty”
 Therefore, the tippee will only be liable when:
 (1) The tipper breached a fiduciary duty by disclosing the information to the tippee
 (2) The tippee knows or has reason to know that the tipper breached this duty
 Policy for not extending 10(b) liability
 The court does not want to chill the search for information by holding tippee’s liable;
especially when they are exposing fraud
 Dirks allowed a 10(b)-5 violation for simply the breach of a fiduciary duty
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Santa Fe only allowed a 10(b)-5 violation for a breach of a fiduciary duty only for fraud,
manipulation or deception
 SEC conclusion: where “tippees” regardless of their motivation or occupation – come into
possession of material corporate information that they know is confidential and know or should
know came from a corporate insider, they must either publicly disclose that information or refrain
from trading
 Rule: there can be no duty to disclose where the person who has traded on inside information
“was not the corporation’s agent, … was not a fiduciary, [or] was not a person in whom the sellers
[of the securities] had placed their trust and confidence.”
 TEST: whether the insider personally will benefit, directly, or indirectly, from his disclosure.
 H: we find that there was no actionable violation by Dirks; he took no action, directly or
indirectly, that induced the shareholders or officers to repose trust or confidence in him; Dirks did
not misappropriate or illegally obtain the information about Equity Funding; the tippers received
no monetary or personal benefit for revealing the company’s secrets to Dirks – nor was it their
purpose to make a gift of valuable information to Dirks. – The tippers were motivated by a desire
to expose the fraud.
 United States v. O’Hagan
 O’Hagen did legal work for an acquiring company and learned who the target corporation was.
O’Hagen then started trading in the target company’s shares. O’Hagen losses this case
 The SEC comes up with the misappropriations theory
 The misappropriations theory holds that a person commits fraud in connection with a
securities transaction, and thereby violates § 10(b) and Rule 10b-5, when he misappropriates
confidential information for securities trading purposes, in breach of a duty owed to the
source of the information
 The misappropriations theory outlaws trading on the basis on nonpublic information by a
corporate outsider in breach of a duty owed not to a trading party, but to the source of the
information
 The misappropriations theory is thus designed to protect the integrity of the securities
markets against abuses by outsiders to a corporation who have access to confidential
information that will affect the corporation’s security price when revealed, but who owe
no fiduciary or other duty to that corporation’s shareholders
 Supreme Court holdings of misappropriations theory
 A fiduciary’s undisclosed use of information belonging to his principal, without disclosure of
such use to the principal, for personal gain constitutes fraud in connection with the purchase
or sale of a security and thus violates rule 10b-5
 With misappropriations, there is no fraud or any misrepresentations, simply a breach of a
fiduciary duty
 Yet, O’Hagen could have gotten around this rule if he disclosed his plan to his law
firm which was the acquiring corporation’s agent
 Rule 14e-3
 When substantial steps have been taken toward a tender offer, anyone with nonpublic,
material information to purchase or sell, or cause to be purchased and sold, any securities in
the target corporation
 This rule is only applicable in very specific cases
 (1) Tender offer (not mergers)
 (2) Individual has nonpublic material information
 (3) who trades or sells in the target corporation’s stock
 This rule prohibits trading on undisclosed information in tender offer situations, even where
the person has no fiduciary duty to disclose the information
 “TRADITONAL” or “CLASSIC THEORY”
 Rule: § 10(b) and Rule 10b-5 – are violated when a corporate insider trades in the securities of his
corporation on the basis of material, nonpublic information.
 “deceptive device”
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a relationship of trust and confidence exists between the shareholders of a corporation and
those insiders who have obtained confidential information by reason of their position with that
corporation”
 that relationship gives rise to a duty to disclose or to abstain from trading because of the
necessity of preventing a corporate insider from …taking unfair advantage of …uninformed
…stockholders”
 applies not only to officers, directors – but to attorneys, accountants, consultants, and others
who temporarily become fiduciaries of a corporation.
“MISAPPROPRIATION THEORY”
 -a person commits fraud “in connection with” a securities transaction, and violates § 10 (b) and
Rule 10b-5, when he misappropriates confidential information for securities trading purposes, in
breach of a duty owed to the source of the information.
 A principal’s information to purchase and sell securities – in breach of a duty of loyalty and
confidentiality, defrauds the principal of the exclusive use of that information
 **Misappropriation theory = outlaws trading on the basis of nonpublic information by a
corporate “outsider” in breach of a duty owed not to a trading party, but to the source of the
information
 designed to protect the integrity of the securities markets against abuses by “outsiders” to a
corporation who have access to confidential information that will affect the corporation’s
security price when revealed, but who owe no fiduciary or other duty to that corporation’s
shareholders.
 Full disclosure – forecloses liability under the misappropriation act
 rids of the “deceptive device” then an no § 10(b) violation –
Rule: a fiduciary who “pretends” loyalty to the principal while secretly converting the principal’s
information for personal gain “dupes” or defrauds the principal.
Conclusion: trading on the basis of material, nonpublic information will often involve a breach of a
duty of confidentiality to the bidder or target company or their representatives.
 “disclose or abstain from trading” – does not require specific proof of a breach of a fiduciary duty
 Rather – a means reasonably designed to prevent fraudulent trading on material, nonpublic
information in the tender offer context.
SHORT-SWING PROFITS
 § 16(b) of the 1934 Securities Exchange Act: officers, directors, and 10 percent shareholders must pay to
the corporation any profits they make, within a six-month period, from buying and selling the firm’s stock.
 Penalizes insiders for trades unrelated to non-public information
 Misses many trades based squarely on this information
 Provided that the owner of the 10% shareholder had more than 10% at the time of the purchase and
sale
 Reliance Electric Co. v. Emerson Electric Co.
 Emerson purchased 13.8% of the stock in Dodge in an attempted takeover and Dodge merged with
Reliance to avoid the takeover; White Knight defense. Emerson then intentionally sold 3.9% of its
stock in order to bring its holdings to 9.9%. It then sold the rest of the Dodge stock after the first
transaction, in order to purposefully avoid 16(b) liability. The court finds this is permissible
 16(b): This subsection shall not be construed to cover any transaction where such beneficial owner
was not such both at the time of the purchase and sale, or the sale and purchase, of the security
involved
 Therefore the first transaction was exempted because Emerson was not a 10% when it first
purchased the shares
 The second transaction is exempt because Emerson is not a 10% owner when it sells the
shares
 16(b) promotes form over substance (proverbial period)
 Rule: a person avoids liability if he does not meet the statutory definition of an “insider,” or if he
sells more than six months after purchase….
 Foremost-McKesson, Inc. v. Provident Securities Company
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Rule
 In a purchase – sale sequence, the transaction by which the shareholder crosses the 10% threshold
is NOT a matchable transaction
 Only purchase – sales after this point are matchable
Q: whether a person purchasing securities that put his holding above the 10% level is a beneficial
owner “at the time of the purchase” so that he must account for profits realized on a sale of those
securities within six months? NO
 A: as of Oct. 20 – Provident’s holdings in Foremost were large enough to make it a beneficial
owner – within the meaning of § 16(b) Principle disagreement is:
 Does the term “at the time of purchase” mean “before the purchase” or “immediately after the
purchase”
 Courts of Appeals are split
 Legislative record suggests that drafters of § 16(b) covered short-term purchase-sale
sequences by a beneficial owner only if his status existed before the purchase, and no
concern was expressed about the wisdom of the requirement
 But this section was omitted during the reconstruction
H: we hold that in a purchase-sale sequence, a beneficial owner must account for profits only if he
was a beneficial owner “before the purchase”
INDEMNIFICATION AND INSURANCE
 There are several different situations that might give rise to liability
 Claims by third persons (where an officer or director is driving a company car on company business
and negligently injures someone)
 Where officers or directors are defendants along with the corporation
 Risk of liability may be remote – amount of damages can be large  Corporations may be able to buy insurance to cover damages and expenses of defense
 Officers and directors need to be concerned about the possibility that the corporation will be taken over by
people hostile to them
 All states indemnify the officers and directors of corporations, otherwise the liability would be too great for
any person to take the job
 § 102(b)(7) – A corporation may elect to limit an officer or director’s liability for breach of fiduciary
duties
 § 145(a) – Corporation MAY indemnify any person against liability for direct and derivative actions if
the officer or director acted in good faith
 § 145(b) – No indemnification if officer or director is found personally liable in a derivative action
(corporation cannot pay the money it owes to itself)
 § 145(c) – Corporation MUST indemnify defendants covered by (a) and (b) if they are successful on
the merits or otherwise
 § 145(e) – Corporation MAY advance defense costs to officers and directors
 § 145 (f) – The rights to indemnification in this section are not exclusive
 § 145 (g) – Corporation CAN buy insurance to protect officers and directors from liability
 Waltuch v. Conticommodity Services, Inc.
 Waltuch was (probably rightfully) sued for fraud and market manipulation. He was a director of Conti
and many people respected his opinions. Waltuch spent 2.2 mil defending himself and stated that the
corporate charter stated the corporation had to reimburse his costs.
 Q: Does Article 9 of Conticommodity’s articles on incorporation require indemnification in this case
despite Waltuch’s lack of good faith?
 In other words, does § 145(f) permit a corporation to indemnify beyond the scope permitted
under §§ 145(a) and (b)?
 Does § 145(c)’s mandatory indemnification language apply with respect to the private litigation,
even though Conticommodity paid a large settlement?
 First, the Conti charter stated that the corporation had to reimburse legal costs if the defendant director
was not found guilty
Page 59 of 81
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§ 145(a),(b) define the outer limits of what corporations can indemnify for their directors/officers
 It requires that the officer or director act in good faith while the Conti charter only asked for a
not guilty plea
 The court struck this clause as violating § 145(a)’s good faith requirement
 Good faith is the outer limit corporations can indemnify to
 If a director did not act in good faith, the corporation is not allowed to indemnify by law
 Yet this can be avoided with § 145(g) by purchasing insurance
Conti settled all the claims against Waltuch, rather than taking the case to the merits and judgment
 § 145(c) provides that a corporation must indemnify a officer or director if they are successful on
the merits
 Unfortunately, this does not mean moral exoneration
 Further, § 145(c) does not contain a good faith requirement
 The court is simply to look at the judgment to determine whether the defendant was
successful on the merits
 Here, even though the corporation paid big bucks to get the plaintiffs to drop the suit, this
is considered success on the merits
How does this rule affect policy?
 It promotes corporations settling cases quickly therefore avoiding a director’s personal liability for
his court costs
 Plaintiff’s attorney’s win another round
CHAPTER SIX—PROBLEMS OF CONTROL
PROXY FIGHTS
 Most shareholders do not own enough shares to influence the outcome of any vote
 Those who do own enough shares, usually the board of directors, sends out proxy statements outlining
their proposed actions and asking shareholders to let the director vote for them
 Asking shareholder to vote as the director does
 There are two types of shareholder meetings
 (1) Annual – Shareholders vote on directors and proposals
 (2) Special – Special meetings are required under state law for (a) mergers, (b) changes in certificate of
incorporation, (c) sale of assets, and (d) liquidation
 As described above, most shareholders designate a proxy to vote on their behalf
 It is not cost effective to show up and vote for themselves
 A proxy contest is where an insurgent group wishes to use the proxy system in order to obtain shareholder
votes to push their agenda or get themselves elected
 These are electoral proxy contests or issue proxy contests
 Ordinarily, the corporation will pay for managements expenses incurred in the proxy contest
 The corporation can pay the director’s expenses when the amounts are reasonable and the contest
involves policy questions rather than just a purely personal power struggle
 “proxy fights” – when an insurgent group tries to oust incumbent managers by soliciting proxy cards and
electing its own representatives to the board.
 Subject to the 1934 Securities Exchange Act – and to state corporate statutes
 Strategic Use of Proxies
 Levin v. Metro-Goldwyn-Mayer, Inc.
 The O’Brien Group was the incumbent board who was in a proxy contest with the Levin Group.
Levin sued because he did not believe the O’Brien group should be allowed to use corporate funds
to support their proxy contest
 As outlined above, as long as the expenses are reasonable, the incumbent board may use
corporate funds while conducting a proxy contest
 Rule: a court should not get in the way of influencing a stockholder’s decision as to which faction
should receive his proxy –
 Can management use corporate funds to pay for expenses they incur in conducting their proxy
solicitation?
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Yes, as long as the amounts are “reasonable” and the contest involves “policy” questions
rather than just a “purely personal power struggle”
 Were the expenses reasonable in Levin?
 We do not find the method of operation disclosed by MGM management to be unfair or
illegal
 Reimbursement of Costs
 Rosenfeld v. Fairchild Engine & Airplane Corp.
 Incumbent board spent corporate money in defense of a proxy fight, and lost. The insurgent board
then reimbursed the incumbent board its expenses not reimbursed to that point and then
reimbursed itself
 The question is, can insurgent use corporate funds to pay for their expenses in a proxy
contest? Yes, but there are steps
 (1) The board must vote to reimburse the insurgents (yet insurgents have usually taken
over the board at this point, so vote will pass)
 (2) A shareholder vote is necessary to approve the expenditure
 (3) The expenses still must be reasonable and in defense of corporate policies
 Before this test, ask
 (1) Were the expenses reasonable?
 (2) Was the contest over corporate policy or personal objectives?
 It is extremely difficult to decide if something is personal or corporate policy
 This case passed the corporate policy test and it was about a director’s salary
 Finally, the shareholders cannot vote to reimburse insurgent or incumbent board for expenses
that are ultra vires (not in their power to do in the first place)
 Examples might be “making it rain”
 This is more of a personal expense
 Yet, most of the soliciting money will be spent wining and dining significant
shareholders, which is acceptable
 Just not interesting entertainment venues
 Note on proxy fights:
 Directors can choose one of two options regarding incumbent proxies
 (1) Mail the adverse proxies to the shareholders themselves
 (2) Give the insurgents a shareholder list
 Not likely to happen without a fight
 Rule: in a contest over policy, as compared to purely personal power contest, corporate directors
have the right to make reasonable and proper expenditures, subject to the scrutiny of the courts
when duly challenged, from the corporate treasury for the purpose of persuading the stockholders
of the correctness of their position and soliciting their support for policies which the directors
believe, in all good faith, are in the best interests of the corporation.
 TEST: when the directors act in good faith in a contest over policy, they have the right to incur
reasonable and proper expenses for solicitation of proxies and in defense of their corporate
policies, and are not obliged to sit idly by…
 Private Actions for Proxy Rule Violations
 J.I. Case Co. v. Borak
 Shareholders approved a merger and the plaintiff sued stating that the proxy materials were
misleading.
 § 14 of the Securities and Exchange Act of 1934 protects shareholders from fraud in the
context of proxy statements
 So, first question, does § 14(a) allow a private right of action (he must be claiming this hurt
his voting rights)
 No, but the Supreme Court implies one
 The SEC cannot monitor the veracity of all proxy statements and shareholders are in a
better position to recognize misleading statements because of their economic interest
 Yet, the court will only imply a private right of action when no other remedy is
available on a case by case basis
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purpose: prevent management or others from obtaining authorization for corporate action
by means of deceptive or inadequate disclosure in proxy solicitation.
 What damages is the plaintiff seeking in this casse
 Usually, he would want to rescind the merger, but it is far too late for that in this case
 Damages to make him whole
 Elements to bring a § 14(a) claim
 (1) Misstatement or omission
 (2) Materiality
 Substantial likelihood that a reasonable investor would find the information
important in forming their vote
 (3) Causation
 If a proxy is needed to accomplish the merger and the misrepresentation is material,
causation is satisfied
 (4) Reliance
 In § 10(b) and § 14(a), reliance is assumed with omissions
 There is a circuit split whether this element is needed or not
 (5) Sceinter
 Probably negligence
 (6) Damages
 Additional Notes
 Shareholders who being a derivative claim and establish a securities violation by the
corporation or its officers should be reimbursed for their expenses, if they are successful
 Yet, they are not always reimbursed
 It is unlawful to solicit proxies when
 (1) There is a false or misleading declaration of material fact
 (2) There is an omission of material fact that makes any portion of the statement false or
misleading
 A fact is material if there is a substantial likelihood that a reasonable shareholder would
consider it important in deciding how to vote
 Rule: it is unlawful for any person to solicit or to permit the use of his name to solicit any proxy
or consent or authorization in respect of any security registered on any national securities
exchange in contravention of such rules and regulations as the Commission may prescribe as
necessary or appropriate in the public interest or for the protection of investors.
 Mills v. Electric Auto-Lite Co.
 Issue: what causal relationship must be shown between such a statement and the merger to
establish a cause of action based on the violation of the act
 Petitioners alleged that the proxy statement was misleading in that it told shareholders that their
board of directors recommended approval of the merger without also informing them that the
nominated directors were under the control and domination of Mergenthaler
 Court noted that if the respondents could show by a preponderance of probabilities that the merger
would have received a sufficient vote even if the proxy statement had not been misleading in the
respect found, petitioners would be entitled to no relief of any kind.
 Where there has been a finding of materiality, a shareholder has made a sufficient showing of
causal relationship between the violation and the injury for which he seeks redress if, as here, he
proves that the proxy solicitation itself, rather than the particular defect in the solicitation
materials, was an essential link in the accomplishment of the transaction.
 Shareholder Proposals
 Rule 14a-8 permits qualified shareholders to put a proposal before their fellow shareholders (at the
corporation’s expense)
 Requirements
 Shareholder must hold 1% of all outstanding shares or $2,000 worth of shares
 Must hold shares for at least one year before making the proposal
 Proposal cannot exceed 500 words
 Corporations do not have to include all shareholder proposals in the proxy statements
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If the corporation wishes to exclude the proposal, they must write a letter of intent to do so to
the SEC
 SEC will
 Issue a no actions letter; meaning the Sec will not find a violation of 14a-5 if
corporation excludes the statement
 Issue an enforcement action telling the corporation to include the proposal
 Intermediate action; SEC will allow the statement, but only if it is rephrased
 If a no action letter is issued, the shareholder can
 (1) First appeal to the SEC commissioners
 (2) Appeal to the D.C. Circuit Court
 If a shareholder meets the above requirements, how can the corporation still exclude the proposal
from the proxy
 Rule 14a-8(i) lists the exceptions to the rule
 (1) Not a proper subject for shareholder action
 The proposal is something only the board has power to do, not the shareholders
 (4) Personal Grievance or Personal Benefit
 The proposal is simply a personal grievance or the benefits of the proposal would
only accrue to the proposal provider and not the shareholders at large
 (5) Not significantly related
 If the proposal relates to a subject which accounts for less than 5% of the company’s
total assets and less than 5% of the companies net earnings
 Yet, there is an exception for public policy arguments under this section
 (6) Beyond the power of the corporation to effectuate
 The company does not have the power to implement the proposal
 (7) Relates to ordinary business operations
 Examples are dividends, employee salaries (executive salaries are not ordinary
matters)
 (12) Proposal already recently submitted and overwhelmingly rejected
 If 97% of shareholders reject a proposal, there is a five year waiting period before
the issue can be brought up again
 If 94% of shareholders reject a proposal, there is a three year waiting period before
the issue can be resubmitted
Lovenheim v. Iroquois Brands, Ltd.
 The patte fois grois case. Corporation claimed that the patte only accounted for less than 1% of the
corporation’s business and therefore did not want to submit the proposal under 14a-5. Shareholder
wins because of the exception in 14a-5.
 Though this proposal should have been excluded because the patte accounted for a negligible
portion of the corporation’s profits, the rule also states that the proposal cannot be “otherwise
significantly related to the company’s business”
 Therefore if the proposal raises a significant policy question that is related to the
corporation’s business, the proxy must be sent out by the directors
 Rule 14(a) = shareholder proposal rule
 If any security holder of an issuer notifies the issuer of his intention to present a proposal for
action at a forthcoming meeting of the issuer’s security holders, the issuer shall set forth the
proposal in its proxy statement and identify it in its form of proxy and provide means by
which security holders [presenting a proposal may present in the proxy statement a statement
of not more than [500] words in support of the proposal].
 General exception of Rule 14a-8(i)(5):
 If the proposal relates to operations which account for less than 5 percent of the issuer’s total
assets at the end of its most recent fiscal year, and for less than 5 percent of its net earnings
and gross sales for its most recent fiscal year, and is not otherwise significantly related to the
issuer’s business…
 an issuer of securities “may omit a proposal and any statement in support thereof” from
its proxy statement and form of proxy
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H: the meaning of “significantly related” is not limited to economic significance; the plaintiff
here has shown a likelihood of prevailing on the merits with regards to the issue of whether his
proposal is “otherwise significantly related” to Iroquois’ business.
The New York City Employees’ Retirement System v. Dole Food Company, Inc.
 Plaintiff wanted Dole to create a board of outside directors to research the effect of different
healthcare policies and determine how they would affect the corporation. Dole attempted to
exclude this proposal, yet lost.
 Ordinary Business Operations--Rule 14a-8[i](7) states that a corporation may exclude a
shareholder proposal from a proxy statement if the proposal deals with a matter relating to the
conduct of the ordinary business operations of the registrant.
 The court found the question of which plan, if any, that defendant should support, and
how defendant would choose to function under the plans could have a large financial
consequence on Dole, therefore the court found the instant proposal did not relate to
“ordinary business operations.”
 NYCERS has shown that the proposal does not relate to “ordinary business operations” –
ordinary business operations determinations are fact dependent – here Dole has not
provided to the Court whether Dole has a healthcare insurance plan, how it operates, or
the amount of financial resources that go into it; instead Dole just argues that it relates to
employee relations and health care benefits – traditionally which is in the category of
“ordinary business operations”
 Insignificant relationship--Rule 14a-8[i](5) states that a corporation may exclude a
shareholder proposal from a proxy statement if the proposal relates to operations which
account for less than 5% of the registrant’s total assets at the end of its most recent fiscal year,
and for less than 5% of its net earnings and gross sales for its most recent fiscal year, and is
not otherwise significantly related to the registrant’s business.
 The court did not address this issue because it found the activity addressed by plaintiff’s
proposal relates to activities that likely occupy in outlays more than 5% of defendant’s
income.
 Beyond power to effectuare--Rule 14a-8[i](6) states that a corporation need not include a
shareholder proposal on a proxy statement if the proposal deals with a matter beyond the
registrant’s power to effectuate.
 The proposal merely calls for the commission of a research report on national health
insurance proposals and their impact on defendant’s competitive standing. Moreover, we
fail to see why such a study necessarily “deals with a matter beyond the registrant’s
power to effectuate.”
 while NYCERS proposal does request Dole to influence the national health care reform
proposals – there is nothing about political lobbying – rather the NYCERS policy simply
calls for a commission of a research report on national health insurance proposals and
their impact on Dole’s competitive standing - the court does not see how such a research
study would “deal with a matter beyond the registrant’s power to effectuate.”
 H: Dole is directed to include it its proxy statement for the June 4, 1992 annual meeting NYCERS
shareholder proposal
Austin v. Consolidated Edison Company of New York, Inc.
 Plaintiff wanted corporation to adopt a new retirement plan, which of course would more
adequately take care of plaintiff’s employees then other shareholders. The corporation sought a no
action letter arguing the proposal dealt with the company’s day-to-day operations and it was
designed to give a benefit and further personal interest to the plaintiffs that was not common to
shareholder generally., received one, and denied plaintiffs proposal. The court upheld this
decision.
 What should we take from this case
 (1) Employee salaries is an ordinary business matter; there is nothing extraordinary about
retirement plans and employee compensation
 There might be with executive compensation and retirement though
 (2) Ordinary business matters can be identified by the ability of the plaintiff to resolve the
issue in a different way
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Collective bargaining would suffice in this case
 This is strong evidence, but not determinative
 Shareholder Inspection Rights
 Introductory Note
 If you pay the costs you may be able to require the corporation to mail your solicitation materials
– when your trying to include your slate on the solicitation materials
 The corporation can choose to mail you the solicitation materials and bill you – or just give you
the names of the shareholders instead - Rule 14a-7
 Its better to get the “shareholder list” – most incumbent managements choose to keep the list
confidential
 Nothing in the federal proxy rules requiring the corporation to give you the shareholder list, but
the federal rules do not impair any rights you may have under state law
 Fights for shareholder lists – are fought under state law
 Crane Co. v. Anaconda Co.
 Crane wanted to propose a tender offer to Anaconda’s shareholders, which Anaconda did not like.
Crane sought to get Anaconda’s shareholder list, but was rebuffed on their first attempt because
they did not own any stock. Then, they started the tender and had some shares in escrow, which
was enough to get access to the shareholder list.
 Q: whether a qualified stockholder may inspect the corporation’s stock register to ascertain
the identity of fellow stockholders for the avowed purpose of informing them directly of its
exchange offer and soliciting tenders of stock? YES
 A: a shareholder desiring to discuss relevant aspects of a tender offer should be granted
access to the shareholder list unless it is sought for a purpose inimical to the corporation
or its stockholders – and the manner of communication selected should be within the
judgment of the shareholder.
 Conceptual basis for this right: derived from the shareholder’s beneficial ownership
of corporate assets and the concomitant right to protect his investment
 DGCL § 220(b)
 Any stockholder, in person or by attorney or other agent, shall, upon written demand
under oath stating the purpose thereof, have the right during the usual hears for business
to inspect for any proper purpose, and to make copies and extracts from: (1) the
corporation’s stock ledger, a list of its stockholders, and its other books and records…
 Therefore, if shareholder is seeking basic materials, he has automatic rights to inspect these
material and the corporation has the BoP to show why he should not be allowed
 Articles of incorporation
 By’Laws
 Minutes
 Yet, if the shareholder is seeking items with restrictive access, the shareholder has the BoP to
show why they need this
 Contracts
 Correspondences
 A request to access such records must be very narrowly tailored; a § 220 proceeding
should result in an order circumscribed with rifled precision
 Yet, federal rules give the corporation options when a shareholder is seeking to obtain the
shareholder list
 The corporation could turn over the shareholder list, or
 The corporation could mail the material for the insurgent at the insurgent’s expense
 Corporation will mail for the insurgent because, (1) corporations do not like to give
out their shareholder list, and (2) if insurgents have the list, they can focus on the
beneficial owner more
 If the corporation mails it, everyone gets the same material, no favoritism
 Final point
 Inspection rights are only granted if there is a proper business purpose for wanting the
materials
 The burden is greater for the restricted items
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H: since the pendency of such an exchange offer may well affect not only the future direction
of the corporation but the continued vitality of the shareholders’ investment, inspection of the
stock book should be allowed so that qualified shareholders may have the means to
independently evaluate the situation
 Anaconda failed to sustain its burden of proving an improper purpose and it cannot be said
that the court below abused its discretion – the inspection should be compelled.
State Ex. Rel. Pillsbury v. Honeywell, Inc.
 Plaintiff purchased shares in Honeywell for the sole purpose of gaining the shareholder list and
distributing information regarding Honeywell’s manufacturing of bombs used in Vietnam. This
was not a proper business purpose for gaining inspection rights under Delaware GCL § 220.
 What is a proper business purpose for purposes of gaining inspection rights under § 220
 The proper business purpose contemplates concern with investment return, not social
policies
 Petitioner should have voiced an economic concern in order to meet the proper
business purpose requirement
 Lesson
 A proper business purpose for § 220 inspection rights requires an economic nexus; no
one cares about social views
 Rule: the act of inspecting a corporation’s shareholder ledger and business records must be
viewed in its proper perspective. In terms of the corporate norm, inspection is merely the act
of the concerned owner checking on what is in part his property.
 Because the power to inspect may be the power to destroy, it is important that only
those with a bona fide interest in the corporation enjoy that power….
SHAREHOLDER VOTING CONTROL
 Stroh v. Blackhawk Holding Corp.
 When we own stock, we own a bundle of rights
 (1) Economic Rights
 Dividends
 Residual claim on assets upon liquidation
 (2) Voting Rights
 Right to elect directors
 Right to vote at special shareholder meetings
 In the case, stock was issued that simply had voting rights and no economic rights
 Plaintiffs claimed this was not stock because it did not possess all the characteristics of stock
under the Foreman test
 Forman Test (Must have five characteristics to be a stock)
 (1) Right to receive dividends
 (2) Negotiability
 (3) Ability to be pledged or hypothecated
 (4) Voting rights in accordance with shares owned
 (5) Ability to appreciate in value
 Court states that valid stock may include proprietary rights that consist of either economic or voting
rights
 It need not have both
 Most states changed their laws after this case to allow valid stock to have one right or both
rights; it doesn’t matter
 Shareholder just need to be aware of what they are purchasing
 Why would corporation want stock with no economic rights?
 Newly forming companies might want to attract top player, but have little cash
 Give employee voting stock to control his working environment
 Firm wants to open, yet the bank will not give a loan without some control
 Issue the bank voting stock during the term of the loan
Page 66 of 81

Q: to what extent should economic attributes of shares of stock be eliminated?
 Section 14 of the Act – expresses the intent of the legislature to be that parties to a corporate
entity may create whatever restrictions and limitations they may want with regard to their
corporate stock by expressing such restrictions and limitations in the articles of incorporation.
 the articles may not limit or deny the voting power of any share
 can prefer a class of shares over another with regard to dividends and assets
 limits the power of a corporation only as to the voting aspect of ownership
 H: the “economic rights” such as the rights to earnings and assets – may be removed and eliminated
from the other attributes of a share of stock – only the management aspect of ownership may not be
removed. – there is nothing wrong in the scheme that enables one class of shares to obtain greater
voting rights with the same or lesser investment into the corporation
 State of Wisconsin Investment Board v. Peerless Systems Corp.
 At its annual meeting Peerless proposed three items. The first and third passed easily, yet the second
dealing with the creation of many options was going to fail when the meeting ended. Peerless did not
close the polls on the vote at the end of the meeting, opting to keep it open as to persuade more
shareholders to vote in its favor. Plaintiffs sued stating that the proposal should have failed and that
Peerless was denying the shareholders their right to vote.
 First point of the case
 A shareholder does not have to be present at a annual meeting and vote against a proposal to
challenge it in court
 This would defeat the entire purpose of the proxy system
 Next, which rule should apply to this case
 Peerless wanted the business judgment rule
 Analysis
 (1) Good faith requirement
 (2) Defer to management
 (3) Plaintiff has BoP to show fraud, illegality, waste, self dealing
 Shareholders wanted the Blasius rule
 Blasius applies where the primary purpose of the Board’s actions is to interfere with or
impede the exercise of the shareholder franchise, and the stockholders are not given a full
and fair opportunity to vote
 (1) Plaintiff has burden of proof to establish Board acted for the primary purpose of
thwarting the exercise of the shareholder vote
 (2) Board has burden of proof to demonstrate a compelling justification for its
actions
 This is a duty of loyalty claim, yet it applies a much stricter standard when the
first prong is proven
 Shareholder voting rights review
 Stroh – freedom of contract reigns, even at the expense of corporate democracy
 Yet, plaintiffs purchased the shares and knew what they were getting into
 State of Wisconsin Investment Board (SWIB) – There are limits to which a Board can
manipulate shareholder votes
 Here, the Board acted with an improper purpose
 Easy solution to this problem
 Vote with your feet rather than deal with a lawsuit and its expenses
 H: defendants have not provided a compelling justification for their actions; nevertheless – its hard to
decide this at the summary judgment level – and thus both claims for summary judgment are denied –
and the issue requires further argument and factual development
CONTROL IN CLOSELY HELD CORPORATIONS
 Closely Held Corporation – A corporation that is held by only a few people (or families) and wherein its
stock is not at all or only rarely dealt in buying or selling
 The stock in closely held corporations is not a liquid investment, there is not a ready market for the
shares
Page 67 of 81
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Investors are not as much concerned with the economic rights as they are with a hand in the
control and profits
Public Corporation Shareholders
 Usually own a small percentage of the shares as part of a diversified portfolio
 Interested in the share price
 Have little if any influence on the directors or management
 If dissatisfied, use the Wall Street Rule
 Easier to sell the shares than to fight
Close Corporation Shareholders
 Often undiversified
 Interested in company’s performance and dividends, not share price
 Minority shareholders usually have no influence on the board
 Personality conflicts can lead to deadlock and oppression
How do close corporations deal with problems of oppression and deadlock?
 (1) Voting Trust
 All shares are transferred to a trustee who votes in accordance with the trust agreement; the trustee
makes the final decision
 Under Delaware law, these can last for no more than ten years
 Courts disfavor this setup because individuals lose their ability to vote their shares
 (2) Shareholder Agreements – shareholder keep stock and make compromises amongst themselves
 (a) Agreements relating to the election of the board of directors
 These are vote pooling agreements
 (b) Agreements relating to limitations on the board’s discretion
 Agreements cannot be struck to pool votes over certain policies
 Manager are in place to make policy decisions
 Managers manage and shareholders sharehold
 Can’t tell directors how to vote once they are elected
McQuade v. Stoneham
Clark v. Dodge
Galler v. Galler
 Two brother in a closely held corporation entered into an agreement which would financially support
one or the other families in case of the death of one of the two brothers. The agreement provided that
each family gets two board seats, mandatory dividends, mandated death benefits (salary continuation).
When Ben died, his brother Isadore did not want to pay his family. Ben’s wife claimed Isadore paid
excessive salaries in order to avoid giving her dividends. Of course, he loses.
 When are shareholder agreements of this sort legally enforceable?
 (1) Corporation is closely held
 (2) Minority shareholder does not object
 (3) Creditors and not prejudiced
 (4) Terms are reasonable
 (a) Duration of the agreement
 (b) In this case, dividends are only paid if there is a certain surplus
 (c) The death benefit was reasonable in amount
 This type of agreement is not allowed in public corporations
ABUSE OF CONTROL
 Ingle v. Glamore Motor Sales, Inc.
 Ingle was hired as a sales manager with no interest in the company and there was no express agreement
between the parties establishing either the duration or conditions of employment. He eventually was
able to acquire stocks and become a minority shareholder
 Plaintiff argued that as a minority shareholder of a closely held corporation, employed without benefit
of a contract containing a durational employment protection and without any limitation on the
employer’s right to discharge, he is nevertheless entitled by reason of his minority shareholder status to
a fiduciary-rooted protection against being fired.
Page 68 of 81

Court noted that a minority shareholder in a close corporation, by that status alone, who contractually
agrees to the repurchase of his shares upon termination of his employment for any reason, acquires no
right from the corporation or majority shareholders against at-will discharge
 Sugarman v. Sugarman
 Plaintiffs brought suit alleging that Leonard abused his fiduciary duty to the corporation.
 Count I sought a derivative recovery against Leonard on behalf of Statler, alleging that Leonard
had caused Statler to pay him excessive salary and bonuses and had engaged in other forms of
prohibited self-dealing.
 Count II sought direct recovery for appellees against Leonard on the theory of freeze-out of
minority shareholders.
 Court first examined the legal standard that must be met to establish a ‘freeze-out’ of minority
shareholders, and then analyze the evidence and findings of the district court.
 It is not sufficient to allege that the majority shareholder has offered to buy the stock of a minority
shareholder at an inadequate price. Majority shareholders have an independent duty to exercise
complete candor with minority shareholders when they negotiate stock transaction; they must fully
disclose al the material facts and circumstances surrounding or affecting a proposed transaction…
if a majority shareholders breaches this duty, and a minority shareholder sells stock at an
inadequate price, the minority shareholder can seek damages based on the difference between the
offered price and the fair value of the stock.
 In a close corporation, a minority shareholder whoe merely receives an offer from a majority
shareholder to sell stock at an inadequate price, but does not accept that offer, can still seek
damages if the shareholder can prove that the offer was part of a plan to freeze the minority
shareholder out of the corporation.
CONTROL, DURATION, AND STATUTORY DISSOLUTION
 Alaska Plastics, Inc. v. Coppock
 Three individuals started Alaska Plastics, which turned into a profitable venture. Then Crow, one of
the founders, got divorced and his ex walked away with a one-sixth interest in the company. Well, the
company neglected to tell her about annual meetings, paid her no dividends, and did not extend any
benefits of the corporation to her. She sued to have the corporation purchase her shares and repay her
for all the fun they had without her. She wins, in a fashion.
 There are four grounds upon which a corporation can be dissolved
 (1) Buy-out agreement in the articles of incorporation
 (2) Petition court for involuntary dissolution (Statutory)
 This is only allowed when the petitioner can show fraud, oppression, or waste
 Is can also be allowed for deadlock or oppression
 Courts are often reluctant to use this remedy absent extreme circumstances
 (3) Appraisal remedy after a merger or liquidation
 (4) Buy-out as a remedy for a breach of a fiduciary duty
 Ex-wife claims oppression, what is oppression
 Conduct that substantially defeats a minority shareholders reasonable expectations
 Now, how do we define reasonable expectations?
 (1) Were the expectations reasonable under the circumstances
 (2) Were the expectations known (or should have been known) to the majority
 (3) Were expectations central to the person’s decision to join the venture
 This is something more than mere disappointment, it must defeat the very
reasons the individual joined the venture
 Ex claims oppression because she did not receive dividends or a salary
 These are the economic rights in a close corporation
 She doesn’t have the option to vote with her feet
 The court finds that the directors may have breached their fiduciary duties under Danahue
 Shareholders in a close corporation owe each other the utmost respect, good faith, and loyalty
 Ex also filed a derivative claim against the corporation for waste because one of the corporation’s
buildings burned down and it was uninsured
Page 69 of 81

This point is added simply because the court sided with the corporation under the BJR
 Though no case has defeated the BJR with waste, this simply shows how strong the
presumption is
 It probably is not reasonable to keep capital assets uninsured, but the court doesn’t
really care
 Haley v. Talcott
 Haley and Talcott are the only members of an LLC, each owning 50%
 Haley brings this action in reliance upon § 18-802 of the Delaware LLC Act which permits this court
to decree dissolution of a LLC whenever it is nor reasonably practicable to carry on the business in
conformity with a LLC agreement.
 The question before the court is essentially how the interests of the members of the LLC are to be
separated
 Parties signed an employment contract, however the court notes that the relationship seemed more
similar to a partnership than a typically employer/employee relationship
 § 273(a) provides:
 If the stockholders of a corporation of this state, having only 2 stockholders each of whom own
50% of the stock therein, shall be engaged in a joint venture and if such stockholders shall be
unable3 to agree upon the desirability of discontinuing such joint venture and disposing of the
assets used in such venture, either stockholder may, unless otherwise provided in the certificate of
incorporation of the corporation or in a written agreement between stockholders, file with the
Court of Chancery a petition stating that it desires to discontinue such joint venture and to dispose
of the assets used in such venture in accordance with a plan to be agreed on by both stockholders
or that, if no such plan shall be agreed upon by both stockholders, the corporation be dissolved.
 § 273 has 3 basic prerequisites:
 Corporation must have two 50% stockholders
 Those stockholders must be engaged in a joint venture, and
 They must be unable to agree upon whether to discontinue the business or how to dispose of its
assets.
 In this case, each of the requirements was met.
 Pedro v. Pedro
 Alfred, one of three brothers running the family business, discovered that hundreds of thousands of
dollars were missing. He asked his brother, who told Alfred to drop the issue. After some bickering,
the brothers agreed to a financial audit, yet the two brothers interfered with the auditor’s work and a
conclusive answer was never reached. After Alfred would not drop the issue, the brother’s fired him,
took away his salary, and told employees he had a mental breakdown. Alfred wins this one.
 First, the brother’s claimed there was no breach of a fiduciary duty because the value of the
corporation did not drop nor did the share price
 The court found that an act depleting a corporations value is not the exclusive means of
violating fiduciary duties
 The courts have broad equitable powers to determine what remedies are available in these
cases
 “Trial courts have broad equitable powers in fashioning relief for the buyout of
shareholders in a closely held corporation. In determining whether to order equitable
relief, dissolution, or a buy-out, the court shall take into consideration the duty which all
shareholders in a closely held corporation owe one another to act in an honest, fair and
reasonable manner in the operation of the corporation and the reasonable expectations of
the shareholders as they exist at the inception and develop during the course of the
shareholders’ relationship with the corporation and with each other.” (This is Minnesota
law)
 The brother fiduciary duties were to deal openly, honestly, and fairly with each other, they
definitely did not do this
 The court found they could look to the plaintiff’s reasonable expectations when they were
awarding damages
 Therefore, the court awarded Alfred more than simply the fair price for his shares, he also
expected to have a retirement plan, a life time salary, and not to pay attorney’s fees
Page 70 of 81
 Stuparich v. Harbor Furniture Mfg., Inc.
 After extended progression of disputes and ill-will between family board members of Harbor furniture
(a close corporation), Ann Stuparick and Candi Tuttleton, minority, shareholders, sued for involuntary
dissolution
 First issue: Minority did not like how Malcom acquired his shares
 With some claim that he acquired the shares improperly, it is recognized that a person with a
majority of the shares in a corporation can sell those shares to whomever he pleases at
whatever price he pleases
 Next issue: Minority has no meaningful imput
 Comes down to this, they are the minority and all they can reasonably expect is to voice their
opinion, not run the corporation
 Third issue: Malcom beat one of the plaintiff’s down
 Court ignores the issue (probably some sort of breach of fiduciary duties, but this is a family
context)
 Plaintiff can send a representative to board meetings to voice her opinions
 Last issue: Minority claims waste because Malcom keeps the furniture business open which is
losing money and employing his wife and son and keeping it connected with the trailer park
business which is tanking
 BJR: It can always be argued that a corporation can make more money
 Yet, Telman believes intrinsic fairness test applies in this situation and should have been
used
 Moral
 Dissolution is not available for boards that simply do not get along
 Q: whether plaintiffs raised a triable issue of material fact as to their right to involuntary dissolution of
the corporation under § 1800(b)(5) which applies where “liquidation is reasonably necessary for the
protection of the rights or interests of the complaining shareholder or shareholders.”
 2 Precedents : addressing the right of minority shareholders to force dissolution of a
corporation because their interests and rights cannot be protected:
 Stumpf: dissolution ordered when required to assure fairness to minority shareholders and at
the same time to lessen the danger of minority abuse
 Bauer: no dissolution where minority has unfairly competed and had no reasonable
expectation of dividends
 Candi and Ann (sisters) – have 4 Arguments
 Malcolm has voting control of the corporation
 sisters (plaintiffs) have no meaningful input/participation in the corporation
 Malcolm roughed up Candi – violent confrontation
 Malcolm wants to continue furniture business because it employs his family
 Court says….
 there is no claim that Malcolm acquired control improperly he’s got 51.56% of the voting
shares – he can outvote plaintiffs on any issue
 they are minority shareholders; if they can’t get along with Malcolm, they should appoint a
representative – an opportunity to participate and speak is all a minority shareholder is
entitled to and may expect
 ?? – nothing to say – court doesn’t care
 Malcolm gets the benefit of the Business Judgment Rule here
 No need for a drastic remedy
 H: no triable issue of material fact is raised – because it can always be argued that more profits could
be made; courts should not be involved “in the tweaking of corporate performance. Such is the reason
for the ‘business judgment rule.’
TRANSFER OF CONTROL
 Frandsen v. Jensen-Sundquist Agency, Inc.
 Walter, 100% owner of the corporation, sold his shares; 52% to his family (majority block) and the rest
to various investors. Frandsen purchased some stock and was able to argue for some protective
Page 71 of 81
measures. The majority block, if selling its shares, had to either sell them first to Frandsen for the same
price (right of first refusal), or alternatively buy his shares at the same price they were getting (take me
along clause). The corporation sold its assets to another corporation, and Frandsen thought he should
get a cut, but his agreement only dealt with stock, not mergers or asset sales.
 First protective agreement: the right to first refusal
 This is where a shareholder contracts for the option to purchase the shares being sold for the
same price the outsider offered.
 This protects minority shareholders from being stuck with a new majority that may be
hostile
 Courts interpret these clauses very narrowly because they add transaction costs to the entire
deal
 Second protective agreement: take me along clause
 This is where a shareholder contracts the right that if the majority shareholder’s stock is
purchased, that the purchaser must also buy the minority shareholder’s stock so as he can get
a piece of the control premium
 Frandsen’s problem
 These agreements related to stock, not to asset sales or mergers
 Frandsen was a savvy business investor and should have known his agreement could
have been avoided in this manner
 Finally, an asset sale still accomplishes his objectives
 The proceeds of the sale will go evenly to the company and shareholders, everyone gets a
piece of the action
 The majority does not get more than the minority through a control premium, there is not
one in this case
 Zetlin v. Hanson Holdings, Inc.
 When the majority shareholders of Hanson sold their shares for double the market value, the premium
price, Zetlin, a minority shareholder, sued because he thought minority shareholders should get a piece
of the action.
 Rule
 A controlling shareholder may sell his stock at a premium without being obliged to share the
premium with minority shareholders, absent:
 (1) Looting
 (2) Conversion of corporate opportunity
 (3) Fraud
 Policy
 There is a chance that everyone will benefit from this deal
 Majority gets out with a premium price per share
 New owner only buys because he believes he can make the corporation more profitable,
and if he succeeds, then the stock price go up as a whole and the minority benefits
 The new owner believes he can raise the stock price above what he paid
 Yet there is a small chance that the new owner will pay himself a monstrous salary and
diminish the stock price, thereby hurting the minority
 Rule (in a different form)
 Absent looting of corporate assets, conversion of a corporate opportunity, fraud or other acts
of bad faith, a controlling shareholder is free to sell, and a purchaser is free to buy, that
controlling interest at a premium price
 Perlman v. Feldmann
 Derivative action brought by minority stockholders to compel accounting for, and restitution of,
allegedly illegal gains which accrued to defendants as a result of the sale of their controlling interest in
the corporation.
 What is the rule of law here?
 Is sharing of control premium required?
 Court says no (page 702-03)
 Sharing required only when
 Sale results in sacrifice of corporate good will &
Page 72 of 81

Unusual profit for fiduciary
CHAPTER SEVEN—MERGERS, ACQUISITIONS, AND TAKEOVERS
MERGERS AND ACQUISITIONS
 Two ways:
 Negotiated: target (board members) want to be bought & are negotiating the mechanics of the deal.
 In these circumstances, the challenge is for the interests of the shareholders against the interests of
the management.
 Preliminary negotiations to have it work out as its planned
 Hostile: third party tries to take over a corporation. Board may know that the third party is going to
liquidate and break up the company for his own benefit
 In these situations, the business judgment rule does not work b/c the managers have an interest in getting
more money for themselves
 There are many different merger techniques
 (1) Statutory Merger
 This is a merger that simply follows statutory guidelines for effecting a merger
 Both companies boards get to vote
 Both companies shareholder get to vote
 Dissenting shareholder can exercise their appraisal rights
 (2) Sale of Assets
 The acquiring company will purchase all of the assets of the target corporation
 The target is an empty shell after this, but the shareholders get paid a liquidation dividend of
either the cash they received or stock in the acquiring corporation
 State laws differ on whether any appraisal rights are available to shareholders
 Delaware does not offer shareholder’s appraisal rights in asset purchases
 (3) Stock Purchase
 The acquiring corporation will purchase a majority of the other corporation’s stock either by cash
or with their stock
 This is usually contingent upon the acquiring getting 90% in order to conduct a short form
merger
 The acquiring company’s board gets to vote
 Dissenting shareholders get no appraisal rights
 (4) Triangular Merger
 Acquiring corporation sets up a subsidiary which then purchases the target corporation.
 The target is then a wholly owned subsidiary of the acquirer
 Target shareholder usually receive stock in the acquiring corporation
 They get appraisal rights and vote, yet the acquiring corporation’s shareholders are
cut out
 (5) Reverse Triangular Merger
 Same as above, but the target absorbs the subsidiary and target shareholder get subsidiary shares
in exchange for target shares
 Target shareholder still get vote and appraisal
 The De Facto Merger Doctrine
 Hariton v. Arco Electronics, Inc.
 Loral Electronics and Arco Electronics agreed to an asset sale which constituted a de facto merger.
Arco sells assets to Loral as governed by DE GCL § 271. Then Arco dissolves as governed by DE
GCL § 275. Arco shareholders approved the transaction, 80% voted yes. Arco shareholder sues.
 Primarily, shareholder wants the court to apply DE GCL § 251, which is the statutory merger
section
 This would give him appraisal rights and a vote
 Corporation follows DE GCL § 271 and 275 which allows an asset sale and dissolution
Page 73 of 81

This allows Loral to purchase all the assets of Arco without their shareholders voting on
the matter
 Once nothing is left in Arco, § 275 allows Arco to dissolve, which was approved by
Arco’s shareholders
 The court acknowledged that Arco shareholders where denied their appraisal rights and are
forced to accept Loral shares because that is what Loral paid for the assets
 This does not matter
 Equal Dignity Doctrine
 Each Delaware statute is of equal significance and weight
 The court explained that the two statutes are independent of each other and they are
independent of the merger statute
 If a corporation follows the rules for one statute, no other statute (the statutory merger
statute) will outweigh that process
 Freeze-Out Mergers
 Weinberger v. UOP, Inc.
 Signal had some money to invest, so they purchased a controlling share of UOP in a highly
oversubscribed tender offer of $21 per share. After Signal could not find anything else to invest in,
they decided to purchase the rest of UOP. Signal was UOP’s majority shareholder and conducted a
study to see what a fair price would be to purchase the rest of the minority shares. The study
suggested $24 was fair, yet Signal did not share this information and offered $21 per share, which
was ratified by only 51% of the vote. Minority shareholders sued when they learned of the
feasibility study, and they won.
 What is a freeze out merger
 Is a merger in which shareholders of the target corporation must accept cash for their
shares
 Was there a breach of fiduciary duty in this case? Yes
 The court applied a standard of COMPLETE CANDOR, or an uncompromising duty of
loyalty
 Why
 This is an interested transaction
 Signal is the majority shareholder
 Since Signal is an interested majority shareholder, Sinclair Oil applies
 BoP when freeze out merger is challenged
 There are disclosure and ratification issues
 Apply intrinsic fairness
 Though BoP is usually on the defendant to show the deal is fair, in this case, the
shareholders ratified the deal because a majority of the shareholders approved the
deal
 Ordinarily, ratification by a majority of the shareholders would shift the BoP to
the plaintiff to show the deal was not intrinsically fair, but here, the vote was not
informed
 Since defendant’s did not disclose all material facts, the shareholder vote is void
 Entire fairness is required between the dominant shareholder and the minority
 What does entire fairness entail?
 Fair price and fair dealing
 There was no fair dealing in this case because there was not full disclosure
 Practically, Signal should have created an outside board to conduct the feasibility study, not
its own, interested members
 And then share the information with the minority
 If this is accomplished, then minority shareholders only have an appraisal right, which is
seldom exercised.
 Delaware Law Today
 Under Weinberger, what factors does a court consider in setting the appraisal price?
Page 74 of 81
 All relevant factors, other than speculative elements of value that may arise from the
accomplishment of the merger, in determining what constitutes a fair price for the
minority shares.
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Note
 § 262(h) provides that shareholders who dissent from a merger and seek appraisal are entitled to
receive a cash payment equal to the fair value of he shares exclusive of any element of value
arising from the accomplishment or expectation of the merger.
Coggins v. New England Patriots Football Club, Inc.
 Sullivan is the founder of the Patriots franchise, sells shares to his buddies, his buddies vote him
out, he gets a monstrous loan and purchases all of the voting shares. As a condition for the loan,
Sullivan must eliminate all of the non-voting stock. Since he is the board, he votes to merge the
Patriots with a new corporation that he also controls, and they pay the shareholders $15 per share.
Coggins liked his shares and sued, and wins down the road.
 First, since Sullivan is an interest director on both sides of the transaction, the court places the
BoP on him to prove there is not a breach of his fiduciary duties:
 Two part test
 (1) Was there a legitimate business purpose
 This prong is failed if a directors uses a corporation to his personal or familial
benefit not in advancement of the corporation
 (2) Entire Fairness Test from Weinberger
 Fair price and fair dealing
 Sullivan fails the first prong, this was a personal reason for privatizing the corporation
 Remedy
 Usually a rescission of the merger, yet the merger had been done for some time
 Therefore, in equity, the court awarded Coggins what his shares would be worth
today, $80 per share
 Telman - DE –is right the legitimate business purpose should not be a part of this test- its always
going to be a business decision arguably; also paying off his loans is a legitimate business purpose
– the court probably decided this wrong
 HYPO: if the court had found that there was a legitimate business purpose and that the transaction
was fair, would Coggins have options?
 Yes, Coggins would still have his appraisal rights at the 1976 price
 But since the court found a breach of fiduciary duty, what remedy is available?
 Rescission, at least in theory
 Damages, since rescission is no longer possible
 Other damages w/in court’s equitable powers
 As a shareholder - if you don’t like the freeze-out you can still have your appraisal rights – and
then if there is evidence of bad, illegal conduct – rescission may be offered
Rabkin v. Philip A. Hunt Chemical Corporation
 Olin purchased a controlling share of Hunt’s outstanding stock and part of the deal was that if Olin
purchased the rest of the corporation within one year, he had to pay the same price for the minority
shares. Right as the year passed, Olin decided he was going to purchase the rest of the stock in a
cash out merger. He had Merrell Lynch determine whether $20 was a fair price (he initially paid
$25 for the controlling share), and Merrell Lynch determined the price was fair, but not generous.
In this case there was no requirement for a majority vote from the minority shareholders, therefore
Olin wins the vote after his vote. Some shareholders wanted their $25 per share and sue.
 The lower court dismissed because they stated the shareholder’s only remedy was their
appraisal rights.
 This court overturned that decision
 Weinberger makes clear that appraisal is not necessarily a stockholder’s sole remedy; the
court has equitable powers when fraud, misrepresentation, self dealing, deliberate waste of
corporate assets, or gross and palpable overreaching are involved
 Therefore, other remedies are available when fair dealing is not upheld
Page 75 of 81
 Fair dealing entails questions of when the transaction was timed, how it was

initiated, structured, negotiated, disclosed to the directors, and how the approvals of
the directors and the stockholders were obtained
 Here, the plaintiff’s “seek to enforce a contractual right to receive $25 per share”
 The Court of Chancery must “closely focus upon Weinberger’s mandate of entire fairness”
 Inquiry is into procedural fairness of the deal
 This court finds the contract to be fair –
 $25/share was the control premium
 If your only complaint is an unfair price – your only remedy is an appraisal, but if you want to
stop a merger – and don’t want an appraisal – you might want to claim there was some unfair
dealing
 Other Issue: Suppose at the time Olin bought the initial block from Hunt, it anticipated buying
the minority interest at $20/share as soon as possible, and said so. Is there anything wrong with
that plan? If they came out and said it right away?
 No, Zetlin says the law seems to be clear that a premium for control is unobjectionable –
doesn’t matter whether or not there is a disclosure
 Assuming $20 was enough for the minority shares, and the extra $5 was a premium – there is
nothing wrong with that, it is difficult to see why appraisal is not the appropriate remedy
Review
 Statutes make it easy for corporations to merger
 Yet, shareholders are protected through appraisal rights
 At least with long form mergers; it is unclear whether appraisal rights apply to short form
mergers
 What are appraisals available?
 (1) Standard Two Party Merger
 Appraisal rights are available
 (2) Sale or all or substantially all of a corporation’s assets
 Appraisal rights are not available
 Equal dignity doctrine prevents this
 What must a shareholder do to exercise their appraisal rights? (DE GCL § 262)
 (1) Dissenting shareholders must hold on to their shares continuously through the effective
date of the merger
 (2) Perfect their appraisal right per § 262(d) by sending written notice to the corporation, prior
to the shareholder vote, the she intends to exercise her appraisal rights (it s not sufficient to
merely vote against the merger at the meeting)
 (3) Neither vote in favor nor consent in writing to the contested merger
 Unfortunately, shareholder usually do not learn about omissions or misstatements, which
they relied upon, until after they have voted for a merger
 Why are appraisal rights weak protection for shareholders?
 Facts showing that the price offered through the merger was unfair usually do not surface
until the vote has already taken place
 Therefore, shareholder will vote and then learn that the price was unfair, yet this is too
late
 There are no class actions for appraisal rights; every dissenting shareholder must exercise this
right independently
 Therefore, it is usually cost prohibitive to seek appraisal rights because most shareholders
do not own that many shares
 Policy wise, how are appraisal rights?
 (1) It an merger, it is the acquiring corporation that will have to pay for the appraisal rights
 It is not known how much this will cost or if the deal is even worth while until after the
merger has taken place
 Primarily, appraisal rights add to transaction costs
 (2) The market offers a fair price for individuals shares
 Yet, the market usually will reflect the price per share offered by the merger
Page 76 of 81
 De Facto Non-Merger
 Rauch v. RCA Corporation
 RCA’s articles of incorporation stated that if the company entered into an asset sale, its preferred
stock would have to be purchased at $100 per share; the market price was $40 at the time. RCA
merged with another corporation and the preferred shareholders got the same price as everyone
else, which was above the market price. Preferred shareholders wanted to have the court call this
an asset sale rather than a merger so they could get their $100, they lose.
 Does the court recognize a de facto non-merger?
 No
 Equal dignity doctrine: have to follow the form over the substance of the deal
because Delaware law allows both transaction
 What does the Equal Dignity Doctrine state?
 “Indeed, it is well settled under Delaware law that action taken under one section of
Delaware corporation law is legally independent, and its validity is not dependent upon,
nor to be tested by the requirements of other unrelated section under which the same final
result might be attained by different means
 Preferred shareholders lose, even though RCA purposely denied them the extra cash
through their planning
 Is this good policy?
 Promoting form over substance gives legal clarity and lowers transaction costs in mergers
and promotes careful planning
 The preferred shareholders received a price above the fair market value for their shares
 If the court would have characterized this as an asset sale, there would be no warning and
the deal would have been too expensive, thus hurting common shareholders
 H: Redemption is always at the control of the corporation – he doesn’t have a preferred right to
require redemption is at the option of the corporation – even if Rauch were entitled- the equal
dignity rule – DE BCL permits this transaction, and courts must respect that, even if it promotes
form over substance
 LLC Mergers
 VGS, Inc. v. Castiel
 Castiel and Sahagen entered into a business. Castiel owned ¾ of the stock, yet Sahagen had more
expertise in the business. The board consisted of Castiel, his appointee, and Sahagen, yet Castiel
won every vote because of his ownership. After Castiel’s appointee realizes Castiel is dumb and
running the corporation into the ground, he and Sahagen secretly perform a merger, by majority
vote, without telling Castiel. Castiel only owns ¼ of the stock in the new corporation. Sahagen
losses.
 First, LLC rules allow a merger to be conducted by a majority vote, as did the articles of the
corporation
 So what is the problem?
 Fiduciary duties (duty of loyalty)
 If the appointee would have informed Castiel what his plan was, Castiel would have
removed him immediately.
 The other board members acted in bad faith not telling Castial about the meeting and the
vote, therefore they lose.
 Equal dignity doctrine does not trump fiduciary duties between board members.
 The court here gets itself in trouble by focusing on substance rather than form
 The LLC Act might make it possible for breaches of fiduciary duties to occur – but a de facto
merger might be a breach of fiduciary duty to minority shareholders – but the court says we don’t
care because the legislature allows it
 Telman: If your going to go with form over substance – in the corporate context – seems like you
should just go form over substance in this context and uphold the legislature
 Business judgment rule does not apply to breaches of the duty of loyalty
TAKEOVERS
Page 77 of 81
 Hostile Takeovers
 Usually take place through tender offers which are favorable to shareholders
 Acquirer goes straight to shareholders with good deal while cutting management out
 Therefore management usually adopts defensive measures to protect their golden parachute.
 Friendly Acquisitions
 Usually occur through mergers which are favorable to the incumbent board
 Here, management makes sure they get their golden parachute at the risk that shareholders will not
get the best price for their shares
 Management usually locks up with a favored acquirer in order to protect that individual from
being a stalking horse
 Defensive Measures Terminology
 Green Mail
 When a target company repurchases stock from an acquirer at, or slightly above the current market
price in order to make them go away
 Golden Parachute
 Generous severance packages
 Self Tender
 The target company competes with the acquirer in purchases shares through competing tender
offers
 The corporate purchases these shares with corporation money, thereby increasing debt and
taking shares off of the market
 Poison Pills
 Shareholder rights plans, exercisable at the option of the board.
 This is an option to purchase new shares in the issue that is triggered by a distribution event
(usually when someone acquires 20% of the corporation)
 Flip In
 Most common – where a shareholder can purchase another share for every share they
have for a discounted price
 Lock Up
 Any arrangement by which the target corporation give the favored bidder a competitive advantage
over other bidders
 Stock Lock-Up – Target gives bidder an option to buy some specific percentage of authorized
but non-issued shares at a certain price
 Asset Lock-Up – Target gives bidder an option to buy a crown jewel
 White Knight
 Another merger partner that comes along and saves management from a hostile takeover
 Crown Jewel
 A profitable subsidiary; money maker in the corporation
 Introduction
 Cheff v. Mathes
 Maremont was attempting to take control of Holland Furnace, and Maremont had a reputation for
taking over corporations and liquidating them. Holland used corporate money to repurchase all the
corporation’s shares at a premium price, including the shares Maremont got his hands on.
Shareholders claimed the only reason this was done was to keep board in power, but shareholders
lose.
 Holland had to show reasonable grounds to believe that a danger to corporate policy and
effectiveness existed
 This was justified because Maremont probably would have changed the corporate
structure and this worried employees
 Corporation could worry about employees interests along with the shareholders
 Holland had to act with good faith and undertake a reasonable investigation
 If he does this, then the BJR applies
 Finally, corporate fiduciary cannot use corporate funds to perpetuate their control of the
corporation
 Their motive matters
Page 78 of 81

DE Supreme Court’s legal standard
 Defendants have burden to show reasonable grounds to believe that a danger to corporation
existed
 Must act with good faith and undertake reasonable investigation
 If they act they must do so with some other purpose then self-preservation
 Development
 Introductory Note
 Before the next case, what is a two tiered front loaded tender offer
 Front end – offer to purchase a certain percentage of the corporation’s stock (usually enough
to get control) for a certain premium price
 After this is accomplished, the acquirer will merge with the target and buy out the
remaining shares (back end)
 Back end – usually accomplished through a freeze out merger which eliminates the minority
and usually offers a lower price
 Are two tiered, front loaded tender offers good or bad
 They are bad (my opinion)
 Place shareholders in a prisoner’s dilemma
 If shareholders hold out, they could get a better price because usually more offers
come and at higher prices
 Yet, shareholders are worried that their fellow shareholders will take advantage
of the front end and they will be stuck on the back end
 Therefore, shareholders will jump on the front end, even if they think the price is too
low because the back end is worse
 Telman argues that this technique might be the only way to acquire a corporation at a
reasonable price
 Unocal Corporation v. Mesa Petroleum Co.
 Mesa makes a two tiered, front loaded tender offer for Unocal shares. To ward this off, Unocal
executed an exclusive tender offer (they will buy all shares except Mesa’s).
 Unocal: Self Tender
 Unocal made a tender offer for its own stock, except that owned by Mesa
 If Mesa gets 51%, Unocal will buy the remaining shares at $72/share (other than Mesa
shares)
 Then Unocal partially removes the condition
 Will greatly increase Unocal’s indebtedness and force it to cut back on oil exploration
 This makes the company less attractive – company is taking on more debt – not worth
$54/share to Pickens anymore maybe
 First question: Is it permissible for a board to ward off a hostile takeover? Yes
 DE GCL § 141(a) respects the management’s business judgment
 DE GCL § 160(a) gives the board broad authority to deal in its own stock
 Since the board has authority to do this, why not simply apply the BJR?
 Because the board has an interest in spending the corporation’s money to perpetuate their own
power
 Therefore, before the board gets the presumption of the business judgment rule, they must pass
judicial scrutiny of an enhanced duty; Unocal Standard
 (1) Inquiry into whether the board has authority
 Look at statutes of by-laws
 2 Part Standard for Authority Requirement
 does the statute authorize this defensive measure
 does the firm’s charter impose any restrictions on this use of this defense?
 (2) Inquiry into whether the board acted in good faith
 The primary purpose of the defensive measures cannot be entrenchment
 Satisfied here b/c the two-tiered tender offer was coercive
 (3) Inquiry into whether the board made a reasonable investigation
 Van Gorkom standard
Page 79 of 81
 Board must inform itself of all information reasonably available to it (financial audit)
(4) Inquiry into whether there is a reasonable relation to the threat posed
 Have outside directors approve defensive measures
 Do not destroy the corporation warding off a hostile takeover
 This analysis only applies if the board is taking unilateral action
 If shareholders approve the measures, apply BJR
Note on SEC Reaction and Poison Pills
 SEC demonstrated its disapproval of discriminatory self-tenders by amending its rules to prohibit
issuer tender offers other than those made to all shareholders. SEC however does not prohibit
poison pills
 Varieties of Poison Pills:
 Flip-in: when triggered, holders of warrants can buy shares of issuer at a reduced price
 Flip-over: when triggered, holders of warrants can purchase stock of the surviving, merged
company at reduced price
 Redemption: board can redeem warrant holders rights at any time at a nominal price
 Dead hand pill – if the company’s merge the directors cannot redeem
 No hand pill – can’t redeem this for a certain time period; a poison pill can’t be redeemed
within 6 months of a board meeting;
 DE Supreme court found dead hand pills and no hand pill void – can’t limit what a
board can do
Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc.
 Perelman wanted to take over Revlon, yet Revlon fought back. Once it became apparent that
Revlon was going to have to sell the corporation, they still placed limits against Perelman, who
sues and wins. Board adopts defenses:
 Poison pill – per share $65 note at 12% with one year maturity triggered by purchase of 20%,
unless there is an all shares offer for $65
 Redeemable
 Discriminatory:
 Permitted any shareholder but the triggering acquirer to exchange one share for one note
 Perelman offer $45 on the first round and $48 on the second round
 Revlon enacts poison pills, self tenders, and other measures which increase Revlon’s debt and
limit its business options
 These are allowed because the directors are acting in good faith that Perelman’s offers are
too low and detrimental to shareholders
 These measures are benefiting the shareholders
 Not only Perelman is bidding, now the white knight Frostman comes in and Revlon accepts his
last offer (which is nearly the same as Perelman’s)
 Revlon did not stop with their defensive measure though
 They gave Forstman option to purchase their crown jewels below market cost, entered
into a no shop clause, and agreed to huge terminations fees
 This lockup benefited Forstman, not the shareholders
 Revlon is liable now
 Rule
 When the board puts the corporation up for sale, they have a duty to maximize the
corporation’s value by selling to the highest bidder
 The director’s role changes from the defender of the corporate bastion to auctioneers with
the one duty of getting the highest price for their shareholders
 This rule is applicable as soon as it is clear the corporation is going to sale; like when
a fair price is offered
 When Revlon comes into play
 The corporation is no longer permitted to think about other constituencies; maximizing
shareholder value is their one purpose
 Under Unocal, the board is allowed to protect the other constituencies
 Once the board enters into this auctioneering phase



Page 80 of 81



They can still use certain defensive measures, yet short of stopping other corporations from
bidding in order to recognize what the best price is going to turn out to be
 Can’t lock up a deal or make the corporation worthless; have to keep bidding alive
 Revlon duties are triggered when cease fighting off a hostile takeover and acknowledge or circum
to the fact that your company is going to change hands in one form or another.
 REVLON DUTIES TEST: Initial duty of the directors is to preserve the corp and make the
company profitable. But if any of the following three scenarios happens, the duty of the
directors is to maximize shareholder value:
 Company initiates an active bidding process
 Company abandons long-term strategy and seeks alternative (Paramount I)
 Company break-up is inevitable – Change of control (Revlon & Paramount II)
Paramount Communications, Inc. v. Time Incorporated
 Time wanted to expand – looked at a number of companies and concluded that Warner was the
best fit because it would protect the “Time Culture.” Time’s board approved a merger with
Warner. Then Paramount announced a tender offer to buy all of Time’s stock.
 The court held that Revlon duties had not been invoked because it was a Merger of Equals:
 Time had a long term strategy
 No big block of shareholders
 Directors are not obligated to abandon a deliberately conceived corporate plan for a shortterm shareholder profit unless there is clearly no basis to sustain the strategy
Paramount Communications Inc. v. QVC Network Inc.
 Paramount and Viacom agreed to a merger agreement. After the merger was publicly announced,
QVC announced a tender off for Paramount’s outstanding shares. Three defensive measures were
set up to protect the Paramount-Viacom merger:
 No Shop Provision
 Termination Fee
 Stock Option Agreement
 Paramount tried to argue that this was a merger of equals. However, the court disagreed. Before
the merger, the shares of Paramount were widely distributed; however, after the merger, 70% of
the shares of the merged company would be controlled by one person. The SH of Paramount no
longer had any control
 Revlon applied because there was a change of control
Page 81 of 81