BIZ ASS OUTLINE
I. Various Types of Business Organization
A. Corporations = A Fictitious Legal Person, Separate & Apart from its Owner (NOTE: Even 1 person can
incorporate; Can either be PUBLICLY-ISSUE CORPORATION OR CLOSED CORPORATION.)
1. Formation = Formed RIGHT When Articles of Incorporation are Filed (its like a Birth Certificate)
a. Articles of Incorporation = VERY Simple Document (Just Requires NAME, ADDRESS, etc.)
b. GR from Statutes = Corp. can be Formed for ANY Legal Business Purpose
i. This Renders the “Ultra-Vires Doctrine” Basically USELESS B/C the Purpose/Powers of the
Corp. DON’T Matter Much Anymore
- The ONLY Ultra-Vires Test Q we might get is a Charitable Contribution issue which is more
of a “Business Judgment” question
2. Governing Law
a. Structure of Authorities: US Const.  Fed. Statutes  State Const.  State Statutes  Articles of
Incorporation (aka Certificate of Incorporation)  Corporate By-Laws (incl. SH Resolutions, Board
Resolutions, and “Soft” Regulations for Public-Issue Corps whose Stock is Publicly Exchanged)
i. State Statutes Comprise MOST of our Authority for this Class
3. Limited Liability = GR is that assets of SH’s are NOT liable, only assets of the corporation, BUT the
“Corporate Veil may be Pierced” IF an exception is found to hold a SH/Owner Personally Liable
a. Public Policy: This ENCOURAGES Business-Creation & Risk-Taking
i. So Generally, the Owners of a Corporation can limit the amount of their liability by controlling
the amount they invest in the Corporation b/c their Personal Assets are NOT subject to liability
- Unless EXCEPTION Applies to “Pierce the Corporate Veil”
b. Piercing the Corporate Veil
i. In General Partnership, Partners ARE Personally Liable for business obligations
ii. In Corporations, SH’s are NOT personally liable for corporate obligations, unless Veil is Pierced
iii. 2 General Piercing Situations:
1) Closed-Corp. w/ very few SH’s – 3rd Party seeks to hold SH liable
- General Rule: 1) unity of interest and ownership that the separate personalities of the
corporation and the individual no longer exist; and 2) inequitable result
- examples: equitable owners of the Corp. treated it as their own and withdraw capital
from it at will; or Corp. it was inadequately capitalized AND the SH actively
participated in the conduct of the corporate affairs, etc
- In CA: undercapitalization may be enough alone in parent-subsidiary case,
but not in a closed-corporation like Minton (it’s still a really big factor though)
- slippery slope when a court is trying to figure how much capital is enough for
diff business; clearly w/ 0 capital it’s easier to find undercapitalization
2) Parent Corp. has Various Subsidiaries – 3rd Party seeks to hold Parent Corp Liable
- Rule: to prevail under alter ego theory, DE law requires you to show 1) that the parent and
subsidiary operated as a single economic entity; and 2) that an overall element of injustice or
unfairness is present
- don’t have to show fraud, although that would be an easy case for a P
- factors for finding that 2 companies operated as a “single economic entity”:
- whether corporation was adequately capitalized for their corporate undertaking;
whether corporation was solvent; whether dividends were paid, corporate records
kept, officers and directors functioned properly and other corporate formalities
observed; whether the dominant SH siphoned corporate funds for himself; whether
in general the corporation simply functioned as a façade for the dominant SH;
parent pays losses/expenses of the subsidiary; parent and subsidiary have crossovers
on their Boards; subsidiary has no business except w/ the parent and no assets
except those given by parent; parent uses the property of the subsidiary as its own
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- what does undercapitalization mean?
- having insurance usually counts in figuring out whether you’re
adequately capitalized
- adequate capitalization is usually a CBC thing depending on the type of
business, how big the business is, and whether the State Legislature set
some sort of Minimum # on how much Insurance you need
– In these cases NO veil has ever been pierced to get to the SH’s, instead, the veil is
pierced b/c you pierce through the subsidiary that is owned by another corporation and
get to the Parent company. One would have to allege that the SH of the Parent Corp.
was shuttling personal funds in-and-out of the Corp. w/o regard to Corp. Formalities. In
this situation, the parent company is a SH of the subsidiary (and of course the parent
company has its own SH’s)
- Note: When parent owns many subsidiaries, the parent is the SH of those subsidiaries.
The various subsidiaries are called sister-companies usually
- Note: subsidiaries can be wholly-owned by parent company or partially owned
- Limiting your liability is a perfectly good reason to incorporate, but some other
factors tend to show the company is not sufficiently separate from the owner and the
veil can be pierced
- Just having a 1 shareholder corporation designed to limit your liability is not reason
enough to pierce the veil
- Contract situations – less likely to be able to pierce the corporate veil when in a
contract situation
- More likely to have voluntarily put yourself in the situation and theoretically
investigated so its not as inequitable
- Counter-argument: maybe the corporation violated the contract
intentionally so should be punished rather than just committing an tort
unintentionally
Kodak v. Atex:
- Atex functioned as a separate entity, had their books, filed taxes, observed corporate
formalities, etc. Although Kodak may have had some sort of dominant presence on Atex
and Atex needed their approval for leases, major expenditures, etc. that was NOT enough
to say they were a “single economic entity”
- Kodak was just doing typical and sound business conduct that typical majority SH’s do
- Kodak had a cash management system and all their subsidiaries took part in that system
and had to maintain zero-balance bank accounts, BUT the Court did not say this is
enough to find that there was a siphoning of money out of the company (its just sound
business conduct by Kodak)
- maybe in other cases it would be enough but P offered no facts to support their
speculation that there was siphoning or complete commingling going on
- not enough here b/c there was a strict accounting going on and a credit given by
Kodak to Atex so that it wasn’t all siphoned. There was money in Atex to pay off
legitimate claims against them in contract or tort. It may not be adequate enough to
pay a whole claim but the money they earn is being accounted for
- P tried to say Kodak dominated Atex’s board; although Kodak elected the board
b/c they were the sole SH of Atex, there was only 1 director on Atex’s board
that was also on Kodak’s board
- overlap was negligible
- even though there was some domination, not nearly enough and not
enough to show unfairness
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Sealand Services Inc.
- Similar to the Cab case, all the diff corp’s are commingling. But this is also an
alter ego of the individual D b/c he always borrowed money from the corp to pay
his bills so they could hold D individually liable unlike the Cab case. The Corp was
D’s “play-thing”
- No separateness satisfies the 1st part of the Alter Ego Test; 2nd part is fraud or
injustice. The injustice has to be more than just the P not being able to collect his
judgment b/c that would just make the 2nd prong fold into the 1st prong
- just P not being able to get paid is NOT enough for injustice
- Ct said 2nd prong of injustice/fraud was satisfied by the fact that D was
“unjustly enriched” by breaching the K after P performed
4. Constituencies in a Corporation
a. SH’s = The Equitable Owners of the Corporation b/c they Own the Stock
i. SH’s CAN: ELECT Directors (who then SELECT the Officers of the Corporation), VOTE on
Certain Things, AMEND By-Laws, REMOVE Directors, etc.
ii. SH’s CANNOT: Do ANY Hands-On Management -- they can ONLY Elect the Managers (NOT
Manage themselves)
- if you don’t like the directors, you can sell your stock in the publicly traded company, try to
remove the directors, vote in the next election of something, etc
- but once elected, you can’t tell them what to do
b. Management = Elected Directors of the Corporation who can then SELECT their Officers
i. Board of Directors = Make the BIG Business Decisions
ii. Officers (Prez, VP, CEO, CFO, etc.) = Run the Day-to-Day Business Operations
- NOTE: An Officer CAN ALSO Be a Board Member
iii. How Does a Board Act???
- traditionally statute required board to meet in a quorum setting, and the majority of the
Quorum is needed to pass any resolution
- Quorum = minimum # of people req’d to be there (usually a majority of the full board)
- Statutes let certificates of incorporation raise or lower the quorum requirements
- Very common for certificates of incorporation of public issue corporations to lower
the quorum requirements
- Closed Corporations often increases it (makes the majority negotiate w/ the
minority)
- Meeting used to be in person, but modern statutes allow to be by telephone conference, video
conferencing, etc where everyone is heard in real-time
- statutes also adjust the quorum and majority requirements for the board and times when notice
of special board meetings can be waived
- even when majority or quorum requirements aren’t fulfilled, resolutions are often upheld
anyway, particularly when there is a unanimous vote
- for voting, usually you need more than just a quorum of the votes but need a super-majority
- in elections of directors, unlike other voting and quorum requirements, directors are elected by
a plurality
- some actions can be approved by a pre-selected committee of board members (and a
committee is allowed to just be 1 board member), but some actions cant be done by committees
but only by majority of the board in general, etc
- Example: Sarbanes-Oxley Act (designed to prevent accounting fraud and excessive
compensation of executives) requires company to have Audit committee with
independent/outside members
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c. Others? Environmental Concerns, Community
i. Questions arise as to whether & how much Management should consider Environmental
Concerns & The Community when making Business-Decisions, as opposed to ONLY considering
the Bottom-Line
- ALI Principal of Corporate Governance (influential but not binding authority) = The
objective of the Corp. is to ENHANCE Corp. Profit & SH Gain, by Conduct that is
LAWFUL (can’t consider illegal options)
- BUT a Corp. MAY Take Ethical/Humanitarian/Philanthropic Purposes into Account
EVEN if Profit is NOT Enhanced (To a Reasonable Extent At Least)
- Some Statutes put a CAP on it, but basically IF you DONATE SO MUCH that it
actually HURTS the Corp’s Sustainability to Survive = CANT DO THAT, Violates
your “Duty of Care”
- AP Smith Mfg. v. Barlow – Does NOT matter if the Articles of Incorp. DON’T
- Otherwise, it’s on a CBC-Basis UNLESS it’s NOT an Arms-Length Transaction
(ie. donating to the charity run by the Board President’s Wife – this looks shady)
- Public Policy: GOOD for Society as a Whole when you have Generous Corp’s
- NOTE: Sometimes Charity = GOOD WILL for the Corp (So there’s
BENEFITS too)
- When deciding to do something like a merger, the director shall also consider the interests of
employees, suppliers, community, creditors, etc. (some states say shall like Connecticut, others
say may like New York)
- So if the directors do make contributions or look at other constituencies, it wont violate the
duty of care requirement of the directors
- if the managers role was limited to just the bottom line then they CANT consider
these other constituencies
- Often times corporate managers get the benefit of the Business Judgment rule
ii. Maximizing SH Wealth & Corporate Gain is NOT Necessarily the SAME Process
- Brealey & Myers principles – if you have equally risky options, taking the higher rate of return
makes the most sense and that’s where the extra value comes in from. You have higher present
value when you take the higher rate of returns on investments that are equally risky to
comparable investments with lower rates
- For corporations, one has to worry about investments and returns for BOTH SH’s & Corp.
- Corporate Managers, in looking out for the SH, can either diversify to lower risk, OR,
since the shareholders presumably are already diversifying, the corporate managers
should probably be GREATER risk-takers to maximize current consumer wealth. By
putting the corporation at a greater risk of failing, they can probably do better for the
shareholders
- So maximizing SH wealth & maximizing Corporate gain are NOT necessarily the
same thing
- in taking this to an extreme, corporations who do this can risk the entire industry
though and we’ve seen many industries come crashing down now due to incredibly
risky investments
- so although the primary objective for corporations is to seek profit, there’s
many ways to go about that given the above, and whether you look at short-run,
long-run, shareholder gain, corporate gain, etc
5. Free Transferability = GR is that SH’s can freely transfer their shares
a. CLOSED CORP. EXCEPTION – Valid SH Agreement to RESTRICT Free Transferability
6. Life of Corporation = GR is that it Continues to Exist Indefinitely UNLESS Life is Limited by Articles
of Incorporation
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7. Internal Affairs Doctrine (aka Conflict of Laws) = State of Incorporation is the State whose Law
applies WHEN There’s a Dispute b/w the Corporation & SH’s OR for Conflicts INTERNAL to the
Corp.
a. Idea is that a Corp. should be subject to the Laws of ONLY 1 State so that the Rules are Predictable
(but our EXAM Uses fictional jdx so IA Doctrine prolly WONT be an Issue)
i. VantagePoint v. Examen - Internal affairs doctrine requires uniformity, or else it will produce
inequalities and inconsistencies. Constitutional Idea of DP is Important in this Doctrine too.
- What would be EXTERNAL to the Corp? Tort claim b/w a customer or victim of the
public for example = Internal Affairs doctrine does NOT apply so state of incorporation’s law
does NOT necessarily need to apply (as opposed to VantagePoint’s involvement of voting rights
issues)
- It’s often a CBC-basis and depends on the Facts & what Court is hearing it when deciding
whether the IA doctrine applies or if the issue dealt w/ is NOT Internal to the Corp
- Ex: Friese Case – CA Court said IA does NOT Apply for Issue of Securities & Insider
Trading b/c CA securities regulation statute is designed to protect investors in the
marketplace as a whole, not just the relationship b/w management and its shareholders
- serving more broad public interests here even though it has an affect on SH’s
8. Public Issue Corp = Highly Regulated, NOT Flexible (Must Follow Statutory Mandates)
a. 1934 Securities Act brought about the “Proxy” Rules. This Led to MUCH More Disclosure then
State Laws generally req’d
i. Disclosure & Info is VERY Important for SH’s and Potential SH’s to Make INFORMED
Decisions
9. Closed Corp = MUCH more Flexible now (used to be treated same as PI Corp). Now it’s treated
more like a Partnership
a. Can have SH Agreements where you agree to IMPINGE upon the Boards Ability to Manage, or
Restrict a SH’s Ability to SELL Stock to Someone Else, etc.
i. Similar to P’nships, Closed Corp’s are HIGHLY CONTRACTUAL
b. General Definition of Closed Corporation = 1) Small # of SH’s; 2) NO Market for Corporate
Stock; & 3) Substantial Minority Participation in Management & Operations of the Corporation
i. It gets some of the BENEFITS of a PI Corp. (like Limited Liability) BUT Also some of the
BENEFITS of a P’nship (more contractual, less regulated, etc.)
B. Partnership = A Business Jointly-Owned by 2+ People (Usually Family or Friends) -- See Below Outline
1. Formation: CAN Be Formed when 2+ People enter into a Business FOR PROFIT
a. INTENT/LANGUAGE IS IRRELEVANT; WE LOOK AT THEIR ACTIONS
C. Other Unincorporated Business Entities: LP, LLP, LLLP, LLC -- See Below Outline
II. Corporation: Allocation of Power b/w SH’s & Management
A. Business Judgment Rule
1. Generally speaking, Directors who are reasonably well-informed about a particular issue, acting in good
faith, and not directly financially interested in the issue (no conflict of interest), have the benefit of the
business judgment rule when they make a business decision. This is a very deferential standard, and the
court usually wont question that business decision
a. when you knowingly make a bad decision, or you do have a financial conflict of interest, then that’s
different
2. Biz Judgment Rule DOES NOT APPLY WHEN SH VOTING RIGHTS ARE AFFECTED
a. when Directors make decisions, even in good faith, that conflict with the SH’s right to vote, this is
totally different then just business decisions
i. this is a question of are you infringing upon a SH’s right to vote (which is a statutory right
they have in certain areas of the corporate decisionmaking)
- the business judgment approach and deferential standard does NOT apply when SH’s right to
vote is being infringed upon
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- so even though Directors have great deference, when have they crossed the line and stepped on
SH’s right to Vote, and when are SH’s stepping on the Directors right to manage
B. Voting
1. the fact that there are SH’s who can have a big % of stock, increases the likelihood that they will do a
takeover attempt at the next proxy vote. This increased tension also increases the likelihood that managers
will try to keep themselves in power (although they’ll always argue they are putting the SH’s interests first,
and sometimes they are)
a. since management is charged w/ a fiduciary duty to act in the best interests of the corporation and the
SH’s, they argue yea they’re keeping themselves in power but b/c its in the SH’s best interests b/c the
other management is worse
2. Most Modern Statutes Generally Say that SH’s CAN REMOVE Director’s EVEN Without Cause
a. BUT SOME Statutes say this SH Power MUST Be Written in the By-Laws
3. Changing Dates of Meeting -- Schnell Case - there is NOTHING inherently illegal in changing the date
of meeting as long as adequate notice is given, BUT doing it for the inequitable purposes of obstructing
legitimate efforts of dissident SH’s to exercise their rights to undertake a proxy contest against
management IS illegal
a. P says management did this to give the SH’s little chance to clear material with the SEC and wage a
successful proxy fight, and didn’t give them a list of stockholders, etc. = NOT ALLOWED
4. Straight Voting v. Cumulative Voting
a. Straight Voting = each share you have equals 1 vote, and you have that amount for every director
seat
i. ie. if you have 100 shares and 8 directors are being elected, you can vote up to 100 shares for each
of the 8 directors
- if you have majority of the shares you can elect every single spot
b. Cumulative Voting = # of votes you have equals your shares times the number of directors to be
elected (don’t have to vote for each director, can choose 1 if you want). There’s no cap except your
total amount.
i. ie. if you have 100 shares and 8 directors are being elected, you have a total of 800 shares you can
vote on any single candidate
ii. note that you’re not voting against anybody, you just vote for your own candidate
iii. under cumulative voting, there’s a formula that says how many shares you need to make
sure you can elect the # of people you want
X = (S x N) + 1 = 101 shares needed
D+1
Let S = Total # of Shareholder votes in the total election
Let N = Total # of directors I want to be elected
Let D = Total # of directors to be elected in the election
c. DEFAULT RULE = EACH Directorship Spot is Elected EVERY Year
i. but most companies change it to staggering elections
- staggering = the board is partly elected each year, so 2 spots this year, 2 next year, 3 the
following year
- staggering elections create more continuity on the board (which could be good or bad
depending on whether the board is good or bad)
- w/ staggering votes, the fewer the number of directors that are voted each year, the more
votes you need in a cumulative voting system (lessens the minorities power in cumulative
voting because you need much more shares to have the power to elect someone)
- if only 1 director is to be elected each year, it turns cumulative voting exactly equal to
straight voting
- most state statutes say you can stagger the board, BUT classes need to still have
at least X amount of people
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d. Tension b/w cumulative and staggering is less of a problem today
i. CA Statutes say cumulative voting is allowed but NOT required.
ii. Some State Constitutions guarantee cumulative voting which is WHY there’s this tension when
staggering voting reduces it to only 1 director spot elected -- (in that case you can argue state
statutes allowing staggered voting of 1 spot is unconstitutional – States though have laws saying
you need X amount of election spots even in staggered voting)
- tension reduced b/c we’ve moved away from constitutional protections of cumulative
voting by State statutes saying things are permissive but not required (so the statute is
NOT unconstitutional)
e. Remember from earlier: Statutes now allow SH’s to remove directors even w/o cause
i. if cumulative voting is in effect, does this power of removal without a reason make a
mockery of cumulative voting?
- DE Law § 141(k)(2) – if there’s cumulative voting in effect, and the formula above shows
you need 101 shares to be able to vote 1 guy as director, then all you need is 101 shares in
your favor when there’s a vote to remove you from office. So even if 799 shares vote
against you, and 101 vote for you, you still stay in office b/c the 101 shares were enough to
guarantee in an 8-director election that you would be able to elect at least 1 director
5. Management CANNOT Act for the Principal Purpose of Impeding the Effectiveness of a SH Vote
UNLESS They have a “Compelling Interest” & Took Proportional Actions to the Threat Faced
a. Blasius v. Atlas – B was trying to wage a fight to increase the board from 7 to 15 members, and that
way they could get a majority of the Board on their side (15 was the max allowable w/o amending the
certificate of incorporation)
i. B’s reason for this was b/c they had different plans for running the business than A
- B held significant block of shares for a publicly traded company -- 9% (don’t necessarily need
50% or anything)
ii. as a pre-emptive move, A’s management added 2 to the 7 member board. This negated B’s
attempt to get a majority on the board unless they could amend the certificate of incorporation
- if this is allowed, it allows management to perpetuate itself in power
- this wasn’t just a personality conflict or a grab for more power; there were fundamental
difference in business policies between the current A management and what B wanted.
THUS, A DID act in Good Faith
- BUT, A still violated its Duty of Loyalty to SH’s; Even if they acted in Good Faith,
they cant act for the principal purpose of preventing SH’s from electing a majority of
new Directors
- IT IS OK to do this WHEN Directors act advisedly, in good faith pursuit of
corporate interests, and are acting reasonably in relation to a threat to legitimate
corporate interests posed by the proposed change in control (Unocal)
iii. UNOCAL Standard: Did the Board face a Legitimate Threat To Control? If so, did the Board
take Reasonable & Proportional Actions to the Threat Against Them?? If so, then the Board
Impinging on SH’s Right to Vote is OK -- Expands Board Power
- Court said the Board did not face a coercive action from a powerful SH against the interests of
a distinct SH constituency (such as a public minority). Moreover, A had time to inform the SH’s
of its view on the merits of B’s proposal
iv. Directors must prove a compelling justification for their actions so the Burden is on them
- company tried to argue it was compelling reason b/c the SH’s would get confused/tricked
into accepting this deal just b/c it would give them more cash upfront but it would maybe
bring the whole business down
- court said nope not good enough b/c there are other ways you could’ve done this that
would’ve achieved the same result without launching this pre-emptive strike against
SH voting. Could’ve educated the other SH’s
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- management has the right to use a reasonable amount of company funds to wage a
proxy fight and inform SH’s of the options. And the court doesn’t really look to
protect SH’s from their own unwise choice so if they would’ve ended up choosing
wrongly then that’s their own bad
- Example of a GOOD Compelling Interest (b/c usually there wont be in a case like this):
- company buys 25% stock in a company, and tries requiring another 26% to get a
majority of shares…..etc etc – there’s basically a coercive action being taken by that SH
and other SH’s wouldn’t know anything
b. MM Companies v. Liquid Audio – similar facts to Blasius – 7% SH wanting just 2 spots on their
proposed 7 member board so that they have a “substantial presence”
i. So even though SH wasn’t going to get a majority, that doesn’t matter, company still cant impede
SH vote w/o compelling justification
ii. COMBO of BLASIUS + UNOCAL RULES -- Analysis -- When Impeding Effectiveness of a
SH Vote, the Board MUST Show:
1) They had a Compelling Justification (Blasius); AND
2) The Boards Actions were Proportional to the Threat Faced
5. Board’s Defensive Measures Against Takeovers (Aka Anti-Takeover Move) = UNOCAL Std Applies
6. SH Takeover -- Teamsters v. Fleming – SH’s Are AMENDING By-Laws to RESTRICT Board
Implementation of a SH Rights Plan
a. Right to Amend By-Laws is STRONG Right that SH’s have & is Shared by the Board (they can
amend too w/ SH vote)
i. can SH’s amend by-laws to impede the Board’s ability to implement a SH rights plan? YES
- SH rights plan is an anti-takeover mechanism by the board where they can discriminate SH
rights if some events occur or issue more shares, and these things make it more difficult of a
hostile takeover to occur
- incumbent management would want to do this to perpetuate themselves in office or prevent
takeovers that will be harmful to the company
- so it can be good for SH’s, but it can be bad too b/c Takeovers can be both good or bad
for the corporation
- Ct says yes SH’s can do this under Oklahoma law, there’s no statute to prohibits or allows it,
no case law which indicates SH rights plans are somehow exempt from SH adopted by-laws
b. Since SH’s have the right to amend by-laws, how far can they take that to interfere with the
Board?
i. Question has NOT really been answered yet, but its very very doubtful a court would allow
the by-laws to be amended in a way that reallllllly hurts the boards ability to manage (ie.
every single board proposal has to be approved by SH’s)
- tension b/w boards right to manage and SH rights to amend by-laws, usually dealt with on
CBC basis
- Note: SH’s CANNOT Amend By-Laws in a way that CONFLICTS w/ the Articles of
Incorporation
C. Proxy Rules – balance b/w giving SH’s info & letting Management Manage the Corp. w/o interference
1. Federal Laws - 1934 Securities Exchange Act (which created the SEC): designed rules to make the
flow of info from corporations to SH’s more complete, more timely, and easier to maintain
a. Federal rules are designed to supplement the perceived inadequateness of state law
b. Having the right to vote and doing so on a meaningful basis w/ meaningful information is not
necessarily the same thing, that’s why SEC and proxy rules are in place to regulate the info
i. important for the information to be complete and accurate or else all you’re doing is creating
the illusion of a democratic process
- As a matter of routine reporting of financial statements by the company to SH’s, the model act
and some state statutes might require it upon a SH’s written request, but DE and other states
DON’T require Corp’s to do routine reporting even if a SH gives written request
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c. § 14 Proxy Rules
i. They Apply ONLY To § 12 Corps = Those that are publicly traded securities and companies of a
certain size – has to have total assets >$10M and a class of equity security held of record by 500 or
more persons
- On EXAM he’ll say NYSE-traded and it’ll be clearly a Section 12 Corp – we can just
assume and say “it’s a Section 12 Corp and subject to the Proxy Rules)
- if its closed-corp, it’s not gonna be subject to it I think???
ii. § 14a = It’s illegal to for any person, through ISC, to solicit or to use his name to solicit proxies
in violation of the SEC rules regarding Proxy regulation (in terms of the form, timing, manner of the
proxy, etc.)
- On EXAM, you’ll know there’s a solicitation – wont be an issue to dissect
iii. § 14(a)(9) = It’s illegal to provide materially false or misleading statements in the
solicitation of the proxy, OR omit Material facts -- This is Crucial in Enforcing §14
- Courts have found there’s an implied private right of action here too so a SH can sue in
court if the corp violates this rule (the gov’t can also enforce this too of course)
- Borak = case that found a Private Right of Action to exist. Why imply this right? It’s the
best way to supplement and enforce these rules, which helps the policy reasons behind the
Rule
- NOTE On How the Statute Works: Statute makes it illegal to violate the rule (Rule 14a9 for
example), so if you violate the rule then you violate the statute (when I say §14a8 or §14a9 its
actually the Rule – the statute itself only has §14a). When you violate the statute you’re subject
to a private action or govt action.
- In a proxy violation (14a8 and 14a9) you have to link the violation to your loss in both a
transaction causation and loss causation type of way
- Transaction Causation = the violation caused the transaction to go forward
- Does Transaction Causation Just FOLD Into Material Fact?? NO!
- Is causation automatically given if P shows its material, or is there some separate
requirement of causation?
- Mills Court says you DONT have to prove individual reliance on the particular
defect in information (wouldn’t be feasible for a P to show this)
- If P proves that the Proxy Solicitation process itself was an Essential Link
for the Corp. to achieve what they want, then causation is automatically
presumed
- Here the link WAS Essential b/c the Corps didn’t have enough voting
power w/out the Proxy Solicitation – they needed 12% more votes from
SH’s. Thus, it was Essential.
- If the Corp Already Had Enough Votes Then it Would Likely be Diff
Result (BUT the SH can Still Sue for a Breach of Fid. Duty)
- It’s NOT right to say they’ve eliminated causation entirely
- The Rule is if you show its material, then you have to show that w/out the
Proxy Solicitation it would’ve been impossible to get the merger approved b/c
the corps didn’t have enough shares of their own (aka its Essential Link b/c of
mathematical impossibility)
- Conclusion: you satisfy the transaction causation requirement if you show
the Proxy Solicitation was Necessary
- what if its not necessary? This court left that question open if you can
still show transaction causation
- Loss Causation = the violation caused you some loss b/c the transaction went forward
- IF the transaction would have gone through anyway, or it was a fair transaction
so you wouldn’t have gotten any more $ nor really suffered a loss, THEN there’s
NO Proxy Violation
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- Omission of Material Facts – What’s a Material Fact?
- Material Fact = A fact is material when there’s a substantial likelihood that a
reasonable SH would take it into account when deciding how to vote
- NOTE: This doesn’t mean it would necessarily CHANGE your vote - it’s just
something you would WANT to Know before voting (but it’s still “would want
to know” as opposed to “might want to know”)
- Also NOTE: this test slightly changes when the information is not something that is
absolutely certain (it’s just possible or likely) – in that case the test is slightly diff than the
“would standard”
- ie. The info is not 100% certain (its something in the future) then you have to
also balance the probability that it actually happens in addition to whether you
would care about that info
- example: you would care about it if it occurred, but there’s only a 1% chance of
it happening so it may not satisfy the “would standard”
- What if it’s Just an Opinion?
- Virginia Bankshares - P is alleging that the directors don’t believe what they’re
saying when they say $42 is a fair price. Is this opinion? If so, is that ok??
- NO ONE should be in a better position than the Board of Directors to give you
an opinion about what the stock of their corporation is worth
- A Reas. Person WOULD Care about what an Officer or Director would have
to say about a Major Transaction. It may not change how you voted but it’s
definitely important information
- We generally don’t view opinions as facts so how do we satisfy the requirement of
the rule when an opinion is not factual?
- Try to argue the Board is stating their Opinions in a Conclusory way &
making it look like a Fact since they hold these Important Directorship
Positions & would know about it (the SH would believe that it is a fact that
the Board believes that)
- Court Holds: Disbelief of opinion ALONE is NOT Enough, but if you
bring forth other evidence as shown in the lines above, it could pass the
materiality “would standard” as “facts”
- Does the Corp have to knowingly provide the false/misleading statements/omission of material
facts, or is unknowingly sufficient enough??
- The Sup Ct has NEVER decided this question. Lower Courts have different conclusions
- Some Say: NO Intent or Reckless Disregard is Needed; Others say Yes; Others Say
Not sure But Def NOT Strict Liability
- Unlike § 14a which does NOT say anything about State of Mind, § 10b (Insider Trading
Statute) DOES Include State of Mind The Court. BUT Courts Seem to Imply More
NARROW Construction of 14a9, it just hasn’t come right out and said
- § 10b speaks of manipulation/deception/etc – § 14a doesn’t mention that language,
which is typically seen as having an intent behind it or maybe even
recklessness/negligence/fraud/etc  this would lead one to think 14a does not have
intent b/c it doesn’t have that same limiting language
- BUT DESPITE THAT, Courts seem to more narrowly construe 14a, BUT it’s
a GOOD Argument by Lazaroff
iv. § 14(a)(8) – 14a9 is the Centerpiece of Enforcing Proxy Rules; 14a8 is a bit more controversial
& has gone through LOT of Amendments (§ 14a8 ALSO Has Implied Private Cause of Action)
- § 14a8 (subject to some exceptions) = A § 12 Corp. MUST include a SH Proposal (even if
the company disagrees with it) IF the SH has at least $2,000 in Mkt Value of stock (or 1%
of the voting shares) for at least 1 year before submission of the SH Proposal AND the SH
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proposal is less than 500 words. IF this exists Corp must include SH Proposal @ the
expense of the Corp.
- Most SH proposals, even if they meet all the rules and exceptions, don’t get passed, so why
should the corporation pay for this?
- Just b/c the Board shall manage the biz, doesn’t mean SH’s cant ask questions about it.
SH Proposals can be a vehicle towards more social responsibility
- EXCEPTIONS TO § 14a8: There are about 13 Exceptions to Inclusion (p. 1941 supplement)
1) Proposal is improper subject matter under State law (Only the board shall manage
for example) – SH could get around this problem by saying that the proposal is only a
recommendation and not binding on the board
2) Proposal would cause the company to violate a state/federal/foreign law
CA Inc. v. AFSCME:
- SH proposal here was to do a by-law amendment that, under certain circumstances,
would reimburse the SH’s reasonable expenses incurred when nominating candidates for
the Board of Directors
- Issue: Is this a proper subject for proposal, and if so, does it still violate DE law?
- Rule is that both the Board and the SH’s in DE can independently amend the by-laws.
CANNOT Divest SH’s of that power. There are limits to that SH power though in that
the Board gets Business Management Power, so the Board & the SH’s don’t have
coextensive powers to amend/adopt
- Need to reconcile the SH’s ability to amend or adopt by-laws with the Boards
power to manage the corporation
- DE Court says that a Proper by-law, one that is not needed to be in the
articles of incorporation, occurs when the by-law is only defining the process
or procedure of how board decisions are made
- Court also says the “wording” of the by-law is not dispositive of
whether or not it’s process-related (although it’s certainly relevant)
- By-laws that require spending Corp $, like this one here, can STILL Be
process-related
- The by-law at issue here is the process for electing directors, a
subject in which SH’s of DE corps have a legitimate and protected
interest
- purpose of the by-law is to promote integrity of the election
process = Proper subject for SH by-law amendment proposal
- BUT the Proposal is STILL NOT Allowed b/c it COULD Cause the Corp to ,
Violate DE Law, in some situations, by Forcing Corp. to Breach Fid. Duty
- NOTE: Proposal does NOT need to be guaranteed to lead to a violation of state
law, just so long as its possible (like it was here), then the by-law is NOT
Allowed
- DE law = the Board has discretion to reimburse or not if the proxy contest was
for personal or petty reasons. Since the by-law was a “binding commitment” on
the Board to reimburse, this could go against State law when it’s a situation like
this b/c the Board should have the discretion to reimburse and this by-law
imposes on them a binding commitment, that in some cases, could violate
their fiduciary duties
3) Can’t just be a SH pushing a personal grievance against the company
4) Can’t violate the proxy rules
5) Proposal Deals with a Matter Relating to the Corp’s Ordinary Business Operations
- if the SH proposal interferes with the ordinary business/management operations then
the SH proposal can be excluded
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- courts must decide what is ordinary and what is not ordinary. If some important policy
consideration is involved then its POSSIBLE that courts may say it’s NOT ordinary, so
the corporation CANNOT exclude the SH proposal – BUT there’s nothing in the statute
giving guidance to this issue
- Roosevelt v. Dupont – SH Proposal on WHEN to Phase out of using CFC’s
- we’ve seen courts say environmental concerns are not ordinary business
operations, so why was this case different?
- the issue here wasn’t whether or not to phase the CFCs out, but rather how
to do it. The issue was timing. The SH proposal wanted the Corp to do it
quicker than they were already planning on doing it (just a few months
quicker)
- NOTE: The actual details of the SH proposal is important, CANNOT just
say oh its dealing w/ some environmental thing so the Corp cant exclude it
- Hypo: animal testing + cosmetics
 Is alleged animal mistreatment enough to bring it outside the normal business
exception
 Would protests hurt the companies bottom line?
 At least being able to raise the issues suggest that they can be handled internally
instead of making it to the SH proposal level. But it does continue to go on and
take up SEC and tax payer expense.
- The problem with this exception, simply put, is that it is NOT Clear.
6) If proposal relates to operations which account for less than 5% of the company’s
total assets at the end of the most recent fiscal year, AND the for less than 5% of its net
earnings and gross sales for its most recent fiscal year, AND its NOT significantly
related to the company’s business, then the company CAN Exclude Proposal
- Corporations HATE the last “and” b/c if it’s some important policy or something
else that’s significantly related to the company’s business then the Proposal MUST be
Included even though its less than 5% of assets (and some courts take this pretty
broadly saying that human rights or environmental issues are significantly related to
the company’s businesses, etc)
7) Proposal relates to a nomination or an election for membership on the company’s
Board, or a procedure for such nomination or election = Corp may exclude it
- Upcoming SEC Proposal on the books COULD change this by 180 degrees (giving
more power for SH’s to try to have board/election proposals as long as they meet the
Standing requirements of 2k, 1 year, etc). This would be a BIG BIG change
- It would allow SH’s to use managements proxy materials in relation to election
or procedure of election for officers
8) Company lacks power to implement the idea in the proposal
9) Company already substantially implemented that idea in the proposal
10) Another SH is already proposing a duplicate idea in the proxy material
- Note: Corporations can file with the SEC and ask them to issue a no-action letter saying that
the SEC would not recommend or bring forth action against the corporation for excluding it
2. State Law Rules -- SH Inspection of Corp. Books & Records
a. DE Rule: you can inspect the books/records for a proper purpose, w/ credible evidence, AND
rifle precision
i. General Rule: ALL Jdx’s have “Proper Purpose” -- BUT they Vary Widely on the other 2
i. Proper purpose = reasonably related to your interest as a SH, including possible
wrongdoing by the company, financial performance, etc
- once a SH has a proper purpose, any secondary purpose or ulterior motive typically
doesn’t matter under state law
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- P has burden of showing some evidence of mismanagement or waste. All he has to do is
show some evidence to suggest a “Credible Basis” from which a court can infer that
mismanagement or waste or wrongdoing occurred
- BUT: Sometimes the Burden is on the Corp to show Improper Purpose by SH
(depends on jdx and if SH is asking to see Stock Ledger, SH List, etc.)
iii. US Dye Requirement = SH must have rifle precision in what they’re asking for (hard to show)
iv. Some Courts say does NOT matter that P is asking for docs from before the time he got his stock,
OR that the info was prepared by 3rd party financial advisors (source of the docs don’t control the
issue) AS LONG AS SH Meets Requirements
b. General Rule: SH of a parent company isn’t entitled to inspect subsidiaries books unless there
is actual fraud
c. Example: Pillsbury Case – P wanted to get all of the records of Honeywell’s munitions
manufacturing during Vietnam War time. Honeywell was hurting its long term future by becoming a
Corp. the general public hated b/c of war involvement
i. Court gave P nothing; wanting to terminate munitions manufacturing was not a proper purpose,
and even denied giving him a list of SH
- court could’ve just as likely found that it was hurting the companies bottom line and
say it has economic repercussions and say P’s is a proper purpose. But they said nope, this
is just political purpose
d. Federal supplementation of inefficient state law – how is the federal law designed to give people a
more efficient way and more in keeping of giving SH’s an informed way of making decisions
i. federal law enacted so as to help SH Informational Rights
III. Closed-Corporations
A. General Info
1. Planning Devices – there’s various planning devices that allow people to function like partners but still
have a corporate status to the outside world
i. SH agreements at the SH level (as opposed to at the Board Level) regarding how SH’s may
vote their shares
- as long as the agreement doesn’t violate some specific public policy, courts allow a broad range of
SH agreements about how to vote their shares
- traditionally, proxies were irrevocable only under certain circumstances; but here, this agreement
was found lawful and irrevocable in Ringling Bros. Why? They say it’s a valid pooling
arrangement and not a voting trust, etc. – look below for this
ii. Impingement on the Board – restricting in advance what the board can do (this is a delicate
area kinda b/c of some fiduciary duties) -- look below for this stuff
- some laws even allow you to eliminate the election of board of directors altogether!!!!!
iii. Requiring a supermajority for a quorum or a vote to get something passed (increasing the
regular majority requirements that the statutes says)
iv. Restricting free transferability of shares - The reason for this is that we want to keep the close
corporation more like a partnership where you don’t have the freedom to transfer your
governance rights.
- The problem is how should prices be set; this is a problem when developing a buyback price
1. A right of first refusal: LEAST restrictive for the minority shareholder, any shareholder
wishing to sell the stock must first offer it back to the corporation at a price no higher than
offered by a stranger/third party. This allowed SH to test the market and the best offer
for the stock. Ultimately it does not matter where the money comes from when the SH does
actually sell, so this way they are not limited to just what the SH want to offer.
2. Consent restraint – MOST restrictive. Can refuse to give consent for SH to sell the stock
altogether
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3. First option: either sets the specific price of the stock, or agrees that they will have the first
option based on some independent appraisal.
a. Why would people agree to this? You could get some other kind of return/economic
benefit (like being an employee) as a result of agreeing to this.
i. It tends to be enforced EVEN IF at the time of the attempted transfer the
stock is considerably more than the agreed upon price
- Different States have Rules on HOW MANY Restrictions Can Apply @ the same time
- DE Says 1 Restriction allowed at a time
- CA notes the Restriction should be CONSPICUOUS
- The modern statutes broadly endorse a whole variety of restraints as permissible
- Assuming that you have a restraint, if there is a component of reasonableness how
will it be interpreted? Usually need a reasonable explanation for your refusal to do
things, etc, such as keeping the SH number low, keeping business in the family,
qualifying for exemptions, etc.
- Bottom line: transfer restrictions gives CC SH’s a vehicle to control who their fellow
SH will be. But its not without its problems, particularly concerning valuation.
- Indiana law = allows restriction on transferability, so long as the person had knowledge, and the
reason for the restriction is to maintain the corp’s status when it is dependent on the # or identity of
its SH’s, to preserve exemptions under federal/state securities law, or any other reasonable purpose
- FBI Farms v. Moore: This case is a Right of Fixed Option b/c it fixes the option price at book
value rather than allowing shopping around
i. NOTE: Courts are becoming more lenient in what they allow the option price to be. The
restrictiveness on the relationship b/w option price and a fair price at the time the option is
triggered is important if there’s a huge gap, but sometimes its still a good way for the SH to
get benefits b/c you only get shares for being an employee in most circumstances. In 1 case in
particular, the court was lenient and allowed the option sale to go through at $1 per share
if that’s what the parties had agreed upon, even though the fair price was $1060 per share
- Intention of making this agreement was to keep the shares in this family
- These types of restrictions are generally valid when the SH’s agree
ii. Linda also didn’t follow the Right of 1st Refusal rule when selling straight to Moore. Court
says Moore shouldve demanded Linda to comply to it, BUT since the Corp sat back and didn’t
do anything and watched the sale go through, they WAIVED their 1st Refusal Rights
- BUT that does NOT mean that the Restrictions on Transferability are now removed for the
new owner (Moore) b/c had Actual NOTICE of Them
- Constructive notice (putting restriction in stock certificate)= sufficient to bind new SH
- Reasonableness Rule under COMMON LAW:
- A restriction is reasonable IF it is designed to serve a legitimate purpose of the party imposing
the restraint and the restraint is NOT an absolute restriction on the recipients right’s of
alienability
- Model Act & Indiana Statute seem to allow more leniency by saying “Manifestly
Unreasonable”
- Factors for finding Reasonableness:
- size of corp, degree of restraint upon alienation, the time the restriction was to continue in
effect, the method used to determine the transfer price of shares, the likelihood of the
restriction’s contributing to the attainment of corp. objectives, the possibility that a hostile
SH might injure the corp., and the probability of the restriction’s promoting the corp’s best
interests
- MUST Look @ Reasonable @ the Time of Contracting
- Court said it was reasonable here. EVEN having the provision that it should be
offered first to “Blood-Members” IS Reasonable b/c it’s a Family-owned C.C.
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- If this was NOT a Family-owned Corp. THEN the Consent Restraint that limited to
“blood members” is much much stranger
- Being an employee as well as a SH can sometimes give you more or less Protection
- As employee in the CC – your salary is often a HUGE reason why you agreed to this deal
- Also saw this in FBI b/c they put less importance in the Stock since P agreed to the deal
- Example: Gallagher v. Lambert: P’s K said as soon as he’s fired or quits for any reason, his
shares are going to be bought back by the C.C. -- Depending on WHEN they fired him, they
would have to pay a diff price though
- Here, D fired him right before the Valuation Date Change so they could save $3 Million!
- Majority Court overlooked the Fid. Duty claim & said NO -- this is what you
bargained for in your K -- NOT going to let Fid. Duty Trump That
- Dissent says NO they violated Duty of Good faith in ALL K’s
- If this was a NORMAL SH (not an employee) then the Majority would’ve
found this to be a Breach of Fid. Duty, it was only b/c he was employee that
they did NOT. Dissent says still, there should be Good Faith in ALL K’s, plus
Corp-SH have Strict Good Faith, etc
- We also see below in Merola that the Court may treat you diff if you were an employee first
and a SH second
- BUT Gen. Rule = The C.C. STILL Has a Duty to Disclose Material Info When Buying
Back Shares
- Jordan v. Duff = Company did NOT tell him they were about to merge w/ another
company next month, so when P sold his shares he got a lesser deal)
v. Classified Stock & Weighted Voting
- Allowing class A or class B stock and each class votes x and y directors.
- Lehman v. Cohen: you can do it in a way that gives the majority investor control, or not.
- This demonstrates a deviation from the norm of the corporate model, legislation saying there
is nothing wrong with this and we will broadly endorse this as an option and allow people to
build their corporations accordingly
2. Closed Corps laws came about b/c of good public policy to encourage people to form businesses and
foster free enterprise
i. one downside: hard to figure out what the value of the shares and business is w/o a stock market
- other restrictions exist too: maximum # of SH’s allowed, etc.
ii. still, only a very small % of corps are closed corps
3. Definition of Closed Corp = Small # of SH’s, w/ NO Ready Market Corporate Stock, & Substantial
Minority SH Participation in the Management & Operations of the Corp.
i. CA requirements are: 1) Statement that it’s a C.C. and 2) No More than 35 SH’s
B. Fid. Duties in C.C.
1. Meinhard v. Salmon: Salmon imposed STRICT Fid. Duty of Partners to CC’s as well b/c they
function similarly
2. Donahue v. Rodd Electrotype Co.
a. FACTS: The company buys back a majority block of shares from one of the owners Harry Rodd at
$800 a share based on a traditional valuation of stock on corporate books + liquidated value. P offered
to sell her shares to the corporation too at the same price BUT the corporation said NO
i. P seeks to rescind this transaction and says the purchase of these shares violated the
corporations fiduciary duty to her.
b. There’s no legal bar generally for a company to buy back stock, and there’s no claim here that this is
an unfair or excessive price
i. So what’s the problem? Court says in a corporation the majority may oppress the minority;
and in a closed corp there is no open market to sell shares too. Here the Court says there is a
Breach of Fiduciary Duty for a Closed Corp – the Duty of STRICT Good Faith & Loyalty,
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and that is Violated WHEN a Majority SH sells their Shares to the Closed Corp AND the
Minority SH is NOT given that opportunity
- equal opportunity is NOT needed for every decision, but it is here for the sale of stock
- Court borrows the STRICT duty of good faith from Partnership Law
ii. THUS, b/c she gets the equal opportunity here, she can either sell her shares at that price or have
the other guys sale rescinded
- court concerned about the danger of being oppressed & the fact that the C.C. offered her only
25% of what they offered the guy b/c she had no other options (they were Freezing Her Out)
3. Wilkes v. Springside Nursing Home: 4 Equal SH’s Operating the CC
a. Bad Blood arose & Wilkes was aced out – he lost his salary, no longer elected as a director, etc
i. There was no written K necessarily that there was a lifetime job or anything, he basically just got
out-voted. So there was no misconduct or neglect, yet Court Held they Breached Fid. Duty
- They FREEZED Wilkes out here; Denial of salary REALLY bad in a CC b/c that’s often
how minority owners make a return on their investment. And here Wilkes was denied equal
return on his investment
- gotta balance the rights of the minority SH vs. the rights of the majority to do what
they think is needed
- so you cant just use the Fid. Duty Rule to create Minority Veto Power for Everything
b. RULE: So what does Strict Good Faith Duty Require?
1) Can Majority show a legitimate business reason for their actions??
2) If so, can P show there was a LESS harmful alternative available
- Here the Court said D failed #1 b/c there was no legitimate purpose – they were just trying to
freeze him out b/c of personal feelings against him and b/c the Court felt they were just
pressuring him into selling his shares to the Corp at a below-market price
4. Smith v. Atlantic Properties: CC got hit w/ lots of Taxes b/c they didn’t pay ANY Dividends
a. D wanted to use Profits to re-invest in the company (which might be a good biz decision) while the P
and other SH’s wanted to use it to pay Dividends (which might also be good biz decision)
i. Provision in SH Agreement said you needed unanimous approval so the $ didn’t go ANYWHERE
- P is saying here that D actually Breached the Fid Duty to them even though they
specifically agreed to put the 80% provision in the Certificate and By-Laws
- Court agreed w/ P; It was Wolfson’s fault that they kept violating US Tax Law
- IF There were NO Tax Penalties would the same result be reached???
- D’s actions would be fine if he just had a disagreement for what was best for the business
(re-investing vs. dividends) b/c that would be a legitimate business reason (prong 1 met)
- BUT it’s possible it would still violate Fid. Duty if P can show a less harmful
alternative in coming to a compromise and using some $ for each (prong 2 depends)
5. Merola v. Exogen Corp: Former minority stockholder, minority SH terminated him, employee at will.
The reason that Merola ended up working for exergen was because he was enticed to leave his full time job
with the offer of eventually being a majority SH.
a. He had a Reasonable Expectation to expect continued employment that was frustrated. This is
the same court as Wilkes and yet they STILL DON’T see a break of fiduciary duty
i. He was an employee first and happened to become a shareholder second. There was nothing in
Wilkes or Donahue as to how you became a minority shareholder and of the fiduciary duty
according to when you became one. But here it seems like because he wasn’t a founding
minority shareholder they are not applying the same standard of fiduciary duty.
- Also, he did not bargain for anything more than an at will employment, and he was
getting his fair returns on his investment, there was no attempt to buy out at an
unreasonable price.
- So, the court says he has a fair price, significant return independent of the salary as an
employee so as a minority SH he was treated fairly.
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- Holding: P being out of a job is NOT relevant and he should have had a better
employment contract that was not at will
ii. Bottom Line: Court is NOT treating him like a Minority SH but as an Employee first, but
when do you know to do this?
- This is why relying on the fiduciary duty cause of action is difficult & unpredictable
C. Proxies giving Votes to 3rd Parties & Voting Trusts
1. “Right of Exit”: although in Public Corps when SHs are not happy with Management (BOD) they have a “Right of Exit) 
this Check on Management action is imperfect in Small/Closely Held corps b/c “right of exit” requires that there be a Market
where the SH can easily sell his shares  However in small corps this does not exist b/c Shareholder are the same people who
are running and managing the Corp  hence Shareholders can be stuck getting no more than the Min for their Shares by the
Existing Shareholders
a. Default RULE: Straight Voting  one share one vote – thus Unhappy SHs in Closely Held Corps can never really get
their way under Straight Voting
i. HOWEVER: Shareholders can ELECT to deal with the Imperfectness of Closely Held Voting by having:
Cumulative Voting w/ a Voting Pool Agreement
2. Special Voting Mechanism – To Deal with Above Imperfectness
a. Shareholder Voting Agreements (aka: Voting Pool Agreements)
i. Definition: Agreement among Shareholders where they decide how they shall vote their shares and make this Binding
on each other  these agreements are usually say:
1. SHs will Elect Themselves as Directors  this is VALID b/c election of directors is a Shareholder Action
2. SHs will Elect certain SHs as Officers or Employees  this is harder to pass muster b/c Directors are the ones
that Elect Officers and Employees and since SHs (instead of Directors) are creating this Voting Agreement, there is
a feeling that Minority SHs voices are being locked out and thus such a provision is usually AGAINST PUBLIC
POLICY.
ii. Requirements for Valid Shareholder Voting Agreement:
1. Agreement is Signed by ALL SHs (Old Rule)
a. If there is a Minority of SHs left that have not signed, they CANNOT be Objecting to the agreement
(Modern Rule)
2. No Fraud or Apparent Injury to the Public
3. No Injury to Creditors
4. Agreement CANNOT violate Statutes or Laws
5. Voting Trust (Del §218) or Irrevocable Proxy (Del §212) (used when voting via Proxy) Needed to Enforce
such agreements in cases of Dispute  these agreements are enforceable as long as:
a. Offends No Rule of Law
b. Offends No Public Policy
c. Does Not Take Advantage of Minority SHs
d. The Trustee Acts in GOOD FAITH when voting (according to the terms of the Voting Pool Agreement)
6. Remedy: if SH Agreement Breached  see Damages, Injunction, Specific Enforcement
3. CA & NY
a. Cal Corp Code parallels what we have already seen, it deals with irrevocable proxies and we see
language similar to model act. The discussion of shareholders on how to vote - you may give an
irrevocable agreement to a person designated under 706(a). 706(a) is a parallel to the voting agreement
requirements. This statute allows two or more shareholders, if they do so in writing, to make an
agreement as to how they will vote or give their voting power to a third party. The irrevocable proxy
statute by cross-referencing to this means you can have this agreement with an irrevocable proxy.
b. NY accomplishes this same compromise in it’s statutes (irrevocable proxies, you can/may give an
irrevocable agreement to a person under §620a which is an agreement between 2 or more SH in
exercising their voting rights can promise to vote the same or have a third person)
- DE has similar stuff too. All of these statutes are undoing the uncertainty of Abercrombie
and Ringling, if this is what you want to do by contract, that is fine, and it is creating a vehicle
by which you don’t have to separate the votes and shares and create a voting trust.
- This makes voting trust a much less frequently used device today, before if you wanted to
separate votes and shares you had to comply with voting trust statute, but you don’t have
to do that anymore per the change in legislature we see above
- Ringling Bros:
- 2 lady SH’s have agreement regarding how they will vote their shares
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- and b/c cumulative voting was in effect for this Closed Corp, they were trying to pool
their resources b/c it would be most beneficial for them
- their agreement was they’d confer w/ each other and vote based upon what they agreed upon
- they anticipated difficulty of agreeing as well and said if the conferred but couldn’t
agree, then they would have an arbitrator resolve their issues
- what power does the arbitrator really have here though? Can he vote the shares or can 1
of the ladies vote the shares of the other lady? No, the ladies just separately vote their
shares based on his decision and instruction
- Here, the ladies couldn’t agree, so they invoked the arbitrator clause. Arbitrator came to his
decision to adjourn the meeting, however the meeting went on anyway despite this ruling
- Trial Court said this SH Voting Agreement WAS VALID. If 1 of the ladies did not go along
w/ the arbitrators agreement, Trial Court went on to say that there was a Proxy Agreement
created whereby the 1 lady not going along with it has now lost her right to vote the shares b/c
the other lady has an irrevocable proxy to now vote both her and the other ladies shares
- Del Sup Ct says this is a Valid Pooling Agreement but this does NOT Imply an
Irrevocable Proxy
- there is nothing in the agreement that gives the arbitrator the power to carry this
out, he’s not a party to the agreement, and no mention of irrevocable shares, etc
- Holding: The lady breaching their agreement just does NOT have her votes
Counted (so really no party gets what they want)
- New Modern Statutes since this case = Specific Performance is really the
Remedy that’s given (meaning the lady would’ve gotten what she wanted)
D. Agreements Impinging on the Board & Controlling Matters that were w/in the Board’s Discretion
1. SH’s usually want to plan in advance in close corporations because there is no public market to sell
their shares if they are unhappy. This creates a situation where the shareholders end up wanting to
manage which is exactly what they are not supposed to do.
a. Evolution of principles that eventually allow shareholders to do this, first by piecemeal case-law and
then by more comprehensive legislation which acknowledges that this is a departure from the
traditional model but if people want to take that route the legislature will authorize it.
2. McQuade v. Stoneham: As Part of P’s 50k stock purchase, he had K providing who would be Manager
& Director for the CC & restricting Changes in Salaries. Breach of K happens b/c 10k salary is later paid.
a. BUT STILL, the Court Holds for D -- It VOIDS the K b/c of Public Policy & Rules on
Hamstringing the Corporation
- a contract is illegal and void in so far as it precludes the board of directors, at the risk of
incurring legal liability, from changing officers, salaries or policies or retaining individuals in
office, except by consent of contracting parties. Stockholders may of course combine to elect
directors, but they cannot in advance hamstring the board.”
b. Galler v. Galler: Illinois decides that the close corporation is special. They really have no
authority to rely on at all, but they say the close corporation is (sui generous – unique case) that it is not
like an ibm, people expect to be involved in the business. That there is no objecting minority interest,
no public detriment, these agreements are necessary for the protection of the parties
3. Statutes Now Allow What The Above Cases Did NOT – BROAD Restrictions Allowed
a. NY = you can provide in the cert. of incorporation a provision that might otherwise be
prohibited b/c it improperly restricts the board of any or all management authority (allows impinging
and completely sterilizing the board)
i. BUT ONLY for C.C.’s AND everyone has to agree (UNANIMOUS SH Approval), and
transferees have to have knowledge of this before it applies to them
- some courts allow it anyway even if its not in the original cert. of incorporation and allow
amending the certificate to incorporate the new agreement
b. DE = generally says its ok to treat the CC like a P’nship
i. DE only requires a MAJORITY of SH’s to agree to completely sterilize the Board!!
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- the Certificate can allow SH’s themselves to manage and they don’t even have to elect
ANY Board of Directors!!!!
c. Model Act says – through a SH agreement you may eliminate or limit discretion of the Board
d. CA law = Requires UNANIMOUS SH’s to agree when sterilizing the Board
4. Providing for unanimous vote of SH basically gives EACH SH a Veto Power
a. When SH’s get this power to manage, then they INHERIT the Fiduciary Duties the Board
would ordinarily have
E. Dissolution & Deadlocked Boards
1. 2 Types of Dissolutions: Involuntary (aka Judicial Dissolution) & Voluntary (Non-Judicial)
a. Judicial Dissolution INCLUDES Dissolution by Deadlock (Statute allows P to Sue b/c the Board
has Irreconcilable Differences on an Equally Divided BOD)
i. But Courts RARELY DO THIS -- the statute does NOT require dissolution, and Courts will
usually NOT just use a nuclear device to blow things up, rather they explore other alternatives (ie.
a buy-out, or other ways to keep the corporation going)
2. When the Board is Equally Divided w/ Irreconcilable Differences -- What Alternatives Exist?
a. Provisional Director can be appointed who has NO Relationship or Bias w/ anyone
i. he will govern until the Deadlock is Broken
- Pros of provisional director: can keep corporation going, needs to make good faith decisions
- Cons: you’d have to pay him, and the tie may be broken in ways that the parties don’t agree
but it is binding on them (taking control away from the people who own the corporation; just
b/c the party is neutral doesn’t mean he’ll make a decision that even one party will like)
b. Custodian can be appointed
i. custodian can’t liquidate assets but has BROAD powers to run the business
- a provisional director functions along w/ the other directors of the business, whereas a
custodian basically has the sole control (broader powers)
3. Oppression = persistent unfairness, fraudulent or illegal conduct, etc
a. When the directors are acting or will act in a manner that is oppressive to SH’s = Court can order
Dissolution OR mandatory BUY-OUT @ fair value (by either party) OR Re-Hiring?? (see below)
i. NY RULE: SH w/ 20% stock can sue for dissolution when being oppressed, but an alternative
for dissolution is a buy-out of the oppressed SH @ fair value
- not every state has an Oppression Statute – would have to rely on Fid. Duty
- some States that do don’t require 20% like NY does
ii. Duty of care and duty of loyalty is often insufficient protection for the SH b/c the BJ Rule
could protect the C.C.’s actions -- so oppression rule fills in those gaps
b. RULE for Oppression:
i. C.C. or the Majority SH acted in a Way that Defeated the SH’s Reas. Expectations; AND
ii. They either knew or should’ve known what the SH’s Reas. Expectations were
- When these things are found COURT HAS DISCRETION TO RESTORE REAS. EXP.
- if someone is wrongfully terminated, maybe the remedy is re-hiring him (usually does
NOT make sense to force the parties like this though)
- the remedy should generally be to restore the parties reasonable expectations, rather
than giving either party a windfall. So courts have discretion in what remedy to give
c. Matter of Kemp & Beatley: There was 2 long-term employees, 1 who quit and the other fired. They
were supposed to receive dividends and compensation based on their being a 20% SH, but then when
they were let go the corp changed its policy so that they wouldn’t have to pay them so much
i. Holding: C.C. Acted Oppressively against the SH’s Reas. Expectations
- FACTORS: 1) The timing of the change of the policy was found to just be intentional way of
freezing out the SH’s; 2) If liquidation of the Corp is the only feasible means to protect the
complaining SH’s expectation of a fair return on his investment; and 3) whether dissolution
is reasonably necessary to protect the rights or interests of a substantial # of SH’s
- NOTE: look at totality of the circumstances
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- NOTE: Reas. Expectations can CHANGE Over Time – must look @ the Entire
History (although some Courts focus on Reas. Expect. @ the time of the inception of
the relationship)
- Reas. Expectations can include the SH’s expectations to be employed by the Corp, etc
d. Muellenberg: Court said the Minority SH can also Buy-Out the Majority SH!!!
i. usually just doesn’t happen b/c the Min. SH often doesn’t have the $$ to do this
4. Again, Valuation Concerns Abound when you order a buy-out
a. How do you value these shares? Use book value, earnings, cash flow, appreciated/depreciated value
of hard assets, good will?
i. even when appointing an appraiser, you still have these problems
- do you discount for a minority SH? Minority and Majority Shares don’t have the same value
to a buyer b/c buying a Majority position gives you CONTROL (so buyers pay a premium
for that)
- when you have majority shares, only the marketability discount situation comes up,
not the minority discount anymore
- do you discount for lack of marketability? Lack of marketability means the new buyer
of the shares may have a harder time selling these shares when he no longer wants them
5. The KEY is that you DON’T want to give anyone a Windfall -- Just Want to Restore Equity
a. for all this stuff today, if you’re a corp, you can have provisions that set some of these problems
instead of having the Court do so
i. SH’s can even agree on a discount but it has to be expressly said that they agree on a
discount even when it’s an involuntary dissolution and not just voluntary
IV. Partnerships (ONLY General P’nships)
A. General Info
1. LAW: State Laws vary -- use UPA & RUPA for Persuasive Authority (most State Laws borrow
more from RUPA)
2. Unlike Corp’s, the DEFAULT Rule for a General Partnership = Personally Liable for the
Obligations of the Business – Dangerous form of Business unless you have a lot of insurance
a. Less & Less People form General Partnerships now, BUT they can be Formed Unintentionally!
i. It is NOT an Issue of Subjective Intent, BUT RATHER IF you Act like a Partner you will be
Treated like a Partner and Subject to Personal Liability. DON’T have to File any kind of Form.
- Definition of Partnership = Association of 2+ People to Carry On A Business For PROFIT
b. Just because individually liable doesn’t mean they have no recourse, between each other they
have a right of contribution from other partners and from the partnership itself (treatment of
partnership as an entity here)
3. Fid. Duties & Management
a. Partners OWE A Fid. Duty of: Duty of Loyalty & Duty of Care to the Other Partners
i. 5 partners, 4 partners agree, what do you do with the last one? You have to at least tell them. If
the action taken by the majority amounts to a breach of fiduciary duty, minority must at least be on
notice so they can take action.
ii. RUPA Duty of Care = partners CANT engage in gross misconduct acting manifestly
unreasonable
- RUPA duty of care may be reduced by partnership agreement however you CANT
eliminate the Duty of Loyalty
iii. Meinhard v. Salmon:
- Court Said Fid. Duty here = relationship of the finest trust and confidence; more than just
honesty alone is needed. It’s a STRICT Good Faith & Loyalty that gives rise to this duty
- Management power here was vested only in Salmon, and so the Court said the heavier
duty rested on him
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- Salmon here went into a new venture agreement w/ someone else for a new deal. How
did Salmon violate his strict duty then just by agreeing to go into another business deal
himself and not including his partner? Does he have to always include his partner in
everything he does?
- Court says to satisfy his strict duty of the finest loyalty, Salmon had the duty to
disclose this business opportunity/information to his current partner as well to
give him a chance to enjoy the opportunity of benefit instead of doing it secretly
- why? here, the new deal was somewhat related to the old deal b/c Salmon is
misusing his position as the front-man for that joint venture to personally
benefit
- if the new location was far removed then maybe its not owed, but here it was
only an extension of the original venture
b. Traditional rule: ordinary matters majority of partners can decide, on extraordinary matters,
it must be unanimous decision (even if 1 guy puts in 90% of the $, default rule is 1 vote each)
B. Cases Re: Existing of a P’ship
1. Martin v. Peyton: Allegation that Defendants became a partner in KNK based on their entering into
contracts with KNK. Profits, evidence of a loan, a mortgage, certain rights given as consideration for giving
the money to the partnership. If KNK cant pay, the lenders have to pay by virtue of this relationship.
a. If you are operating as a co-venturer, intended or not, you can be held responsible for partnership.
But here, court did not find it to be a partnership, why??
i. They can’t initiate transactions and they cannot bind the other partners. What this means is
that the failure to have those powers means they are something other than a partnership.
- The power to veto is a governance right, but without the ability to initiate you aren’t
sufficiently involved in business as a manager to be deemed a partner. Even the Statute
says the payment of a debt via profits does not create a partnership
2. Lupien v. Malsbenden: P made a K with a 3rd party who bailed, but he claims the K was with the
Partnership (3rd party & D were partners). D argues no we were NOT partners.
a. D making same argument as the D in Martin -- that he was Only a LENDER and not a Partner
i. Court says NO YOU WERE A PARTNER
i. So what distinguishes this case from Martin?
- D had TOTAL INVOLVEMENT in the Business
- He called it a loan but there was no interest, he was getting paid back when profits
were made and not on some regular schedule. He had a right to participate in the
business, even if he did not actually go out and sell the car/cars he was making
overview decisions.
- There was a joint control of the business. Remained present through part of every
day, had final say on ordering parts, paid for parts & equipment & 3rd parties salary, etc.
b. The Above Factors for Deciding on Existence of Partnership = SAME in UPA & RUPA.
Generally, The Factors are:
i. Control – generally all partners have some control
- UPA: ALL partners have Equal Right in the management & conduct of the p’nship
- Veto Power: if one partner has more control but the other has veto power then that is still
evidence of partnership
ii. Sharing Profit is Evidence of a P’nship but NOT Conclusive
iii. Share Loss/Liability – Partners generally share losses (this helps differentiate b/w partner and
employee)
iv. Representation to 3rd parties – partners usually hold themselves out as partners
v. Intent of the Parties – look at the action of the parties, not just the agreement  Did they
intend to carry on a business as “co-owners for profit?” (It doesn’t matter if they weren’t aware
of the legal consequences)
vi. Capital Contribution
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vii. When a Partner leaves the partnership it is dissolved (UPA default rule)
viii. Each partner has One Vote – this can be ALTERED based on the Partnership Agreement
C. Partner as AGENTS of the Business
1. Authority of a partner: Under UPA and unlike corporate law, partners are an agent of the
business. The scope of authority of a partner requires a contrast between RUPA and UPA
a. Statute saying that to contrast with SH of a corporation, partner has apparent and actual
authority to do what the section says. RUPA EXPANDS the authority granted in the UPA
i. UPA = about apparently carrying on in the usual way the business of the partnership for which
he is a member.
ii. RUPA = makes it broader by adding language of “business of the kind”
- meaning if your business is narrower than those that engage in similar types of business, it is a
trap for the unweary and the third party will think the person has authority. What this is saying
is that apparent authority is not limited to the course of conduct of the specific business but
rather the business type in general
iii. RNR Investments Limited Partnership v. Peoples First Community Bank:
- Limited partnership, action by a general partner. The limited partnership agreement
expressly limits what the general partner has authority to do. Partner is expressly limited
in terms of the amount of monetary authority it has, and bank gave out loan anyways.
- No actual authority here. Can this agent still bind the partnership when it defaults, the
answer is yes and why is because of apparent authority and a reasonable third party without
knowledge of this restriction would reasonably believe a general partner would have the
power to do this. Regardless of the claim that may be available to the different partners in
dealing with each other, the bank can proceed against the partnership. To a third party this
was the kind of activity that would appear to be within the scope.
- Apparent authority can bind the partnership regardless of whether the partners have
claims against each other, and this is clearly within the scope of what a reasonable
person would believe the partner had the authority to do.
b. RUPA: allows a partnership to file a statement that may limit the authority regarding real
property and it can be binding on a third party. It may also grant supplementary authority. This
prevents problem under UPA.
i. Absent something like this if you go back to the general provisions because the partner is deemed
to have apparent authority, he could execute transfer of real property and may not be able to get real
property back.
- This is a significant change that has NO parallel in the UPA. Even though a filing
regarding a non real property is not binding to the extent a third person should know about it.
2. UPA §9: PARTNER AS AGENT OF PARTNERSHIP AS TO THE PARTNERSHIP BUSINESS
a. (1) Ordinary Business Matters: Every partner is an Agent of the Partnership for the purposes of its business, AND
i. the Act of Every Partner (including the execution of any instrument in the partnership name) for Apparently carrying
on matters in the Usual Way of Business binds the partnership; UNLESS
1. the Partner so acting has in fact No Authority to act for the partnership in the particular matter, AND
2. the Person with whom he is dealing (T) has Knowledge of the fact that the partner has no such authority
b. (2) Non-Apparent Action Not Binding: An Act of a Partner which is Not Apparent for the Carrying on of the Business
in the Usual Way does Not bind the Partnership; UNLESS Authorized by the other partners
c. (3) Extraordinary Matters: Unless Authorized by the Other Partners or Unless they have Abandoned the Business, one or
more but Less than All the Partners have No Authority to (aka: Less than all the partners cannot – UNANIMOUS
CONSENT OF ALL partners is needed for the following):
i. Assign the partnership property in trust for creditors or on the assignee’s promise to pay the debts of the
partnership
ii. Dispose of the Goodwill of the Business
iii. Do any other act which would make it impossible to carry on the ordinary business of a partnership
iv. Confess a judgment
v. Submit a partnership claim or liability to arbitration or reference
d. (4) Contravening Acts Non Binding: No Act of a Partner in contravention of a restriction on authority shall bind the
partnership to persons having knowledge of the restriction. (a partner’s conduct will NOT bind the partnership if it was
contrary to that which he was not authorized to do and the T knew that the Partner was not authorized to do the act)
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3. UPA §16: PARTNER BY ESTOPPEL:
a. (1) When a Person by words spoken or written or by conduct, represents himself, or consents to another person to
represent him to anyone, as a partner in an existing partnership or with one or more persons not actual partners he
is Liable to any such person to whom such representation has been made, who has, on the faith of such representation,
given credit to the Actual or Apparent Partnership, and if he has made such representation or consented to its being made
in a public manner he is liable to such person, whether the representation has or has not been made or communicated to the
person giving credit by or with the knowledge of the apparent partner making the representation or consenting to its being
made. (aka: existence or absence of knowledge by the one extending the credit is not necessary to make the person faking
the partnership liable)
i. (a) when a partnership liability results, he is liable as though he were an actual member of the partnership
ii. (b) when No partnership liability results, he is liable jointly with the other persons, if any, who consented to
the contract or represented as to incur liability
b. (2) When a person has been thus represented to be a partner in an existing partnership, or with one or more persons not
actual partners, he is an agent of the persons consenting to such representation to bind them to the same extent and in the
same manner as though he were a partner in fact, with respect to persons who rely upon the representation. Where all the
members of the existing partnership consent to the representation, a partnership act or obligation results; but in all other
cases it is the joint act or obligation of the person acting and the persons consenting to the representation. (aka: if a person
represents himself to be a partner and the others consent to it  he is an agent of those persons  and all are bound
to the same extent and in the same way as though a partnership did in fact exist)
4. UPA Rules that Define Partnership Liability
a. UPA §13: PARTNERSHIP BOUND BY PARTNER’S WRONGFUL ACT:
i. Where, by any wrongful act or omission of any Partner acting in the ordinary course of the business or with the
authority of his co-partners, loss or injury is caused to any person, not being a partner in the partnership, or any penalty
is incurred, the partnership is liable therefore to the same extent as the partner so acting or omitting to act.
b. UPA §14: PARTNERSHIP BOUND BY PARTNER’S BREACH OF TRUST:
i. The partnership is liable for the loss:
- Where one partner Acting Within the Scope of his Apparent Authority receives money or property of a Third
person and misapplies it; AND
- Where the partnership in the Course of its Business receives money or property of a Third person and the
money or property so received is misapplied by any partner while it is in the custody of the partnership
c. UPA §15: NATURE OF PARTNER’S LIABILITY:
i. ALL Partners are Liable:
- Jointly and Severally for everything chargeable to the partnership under Section 13 and 14
- Jointly for ALL other debts and obligations of the partnership; but any partner may enter into a Separate
Obligation to perform a partnership contract
d. UPA §17: LIABILITY OF INCOMING PARTNER
i. A person admitted as a partner into an existing partnership is liable for all the obligations of the partnership arising
before his admission as though he had been a partner when such obligations were incurred, EXCEPT that this
liability shall be satisfied only out of a partnership property
e. UPA §18: RULES DETERMINING RIGHTS & DUTIES OF PARTNERS:
i. The Rights and Duties of the Partners in Relation to the Partnership shall be determined, subject to any agreement
b/w them, by the following rules:
- Contribution/Profit/Losses: Each partner shall be repaid his contributions, and share equally in the profits
and surplus remaining after all liabilities, including those to partners, are satisfied; and Must contribute toward
the Losses, whether of capital or otherwise, sustained by the partnership according to his share in the profits;
(aka: however much he would be entitled to in profits, that his how much he is liable for in losses – equal share
among all  i.e. if 2 partners 50-50, if 3 partners 33-33-33)
- Indemnification by Partnership: The Partnership must INDEMNIFY every Partner in respect of payments made
and personal liabilities reasonably incurred by him in the Ordinary and Proper conduct of its Business, or for
the preservation of its business or property
- Management and Conduct: All Partners have equal Right in the Management and Conduct of the
partnership business
- Becoming a Partner: No person can become a member of a partnership without the consent of ALL the
partners
D. Limited Partners Apparent Authority
1. RNR Investments (see above): A limited partnership has at least 1 general and 1 limited partner
and allows limited partners to invest passively without being exposed to liability while the general
partner absorbs the liability.
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a. Even though it is very clear that the general partner here knew that it had no actual authority to enter
into the agreement with the bank that it entered, to a reasonable 3rd party, ie the bank without any
knowledge or notice, this was within the scope of authority of the general partner.
i. They could have limited the apparent authority of the partner by notifying the bank and
then there would be no basis for apparent authority but because the knowledge of the
limitation was confined to the partner, there was apparent authority.
- This is consistent with the RUPA’s broadening of apparent authority by saying that it is not
just the particular business but the type of business and if it is customary around the type of
business then the 3rd party will succeed under claims of apparent authority
E. More RUPA v. UPA
1. Unlike UPA, the RUPA takes an entity approach to collecting judgments and if you want to go
against the partner you need a judgment against a partner and a partnership.
a. However, RUPA adds a new barrier to collecting against the individual partner, it adopts the
Exhaustion rule, under which in a suit against a partner based on a claim against the partnership,
partnership assets must be exhausted before a partner’s individual assets can be reached. Also adds
that a judgment against a partnership is not by itself a judgment against a partner, and cannot be
satisfied by a partner’s assets unless there is also a judgment against the partner.
But what about states that have not adopted RUPA, is there an exhaustion requirement? There are
cases that support both positions. And a state could adopt a statute that they must exhaust going
against partnership assets first, but by no means does it eliminate personal liability of partnerships.
And states that have not adopted RUPA, and absent an express statute, this question exists.
2. RUPA = Partnerships are Entities that Can Sue & Be Sued Under Its Own Name
a. UPA = you can sue partners individually or under joint and several if the law allows it (ie. in
torts) but you CANT sue the entity – can go after the individuals personal assets or partnership
assets, then that D gets contribution from his partners
- Many states have statutes to change that, or allow suing under joint and several for everything
b. RUPA = allows suing entity under joint and several theory so that all partners would be liable, but
some states you must first exhaust the partnerships assets before going to their personal assets
3. P’nship Interest & Property
a. GENERAL RULE: you cant become a partner unless you get the consent of the other partners
(except when the partners have some sort of agreement allowing them to add people w/o full
consent)
i. Partners CANT transfer their economic interest in the partnership, but absent full consent
or a contrary agreement, the partners only transferable interest is their share of the profits.
The new guy doesn’t become a partner in the business but rather just gets that share of the $
(rappaport v. perry)
- Cant otherwise transfer your governance rights in the partnership
- Very diff. than the transfer or sale of voting shares in a corporation
- NOTE: There is still a duty of good faith and fair dealing owed in each K that
perhaps a P can argue about
b. RUPA = there’s no such thing as tenancy in partnership like there was in UPA. RUPA says the
partnerships property belongs to the partnership and not to the individuals. If someone has a
personal obligation, you CANT go after the partnerships property
F. Corp’s v. P’nships
1. General partnerships rules/statutes doesn’t require any filings (although RUPA permits some), you can
even form one w/o knowing it. It’s a highly contractual form of business b/c most of the rules only apply
when the partners’ agreement says nothing on that point. Personal assets are typically at risk.
a. corporations though is obv different, you need filings, you know you’re doing it, and its highly
mandatory and regulatory laws rather than contractual, and hard to get personal liability unless the
corporate veil is pierced
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i. so there’s good things and you’re not personally liable anymore typically but on the other hand
when you have just a few partners they don’t wanna deal w/ all the corporations rules and creating
board of directors and records and meetings, etc. That’s why “Closed Corporations” came to exist –
to get the benefits of corporate status w/o having to violate the formalities
V. Others Unincorporated Forms (LP, LLP, LLLP, LLC)
*Intent: to create maximum forms of flexibility for people who want to run a business so that they are able to
choose the forms that conform to their needs.
LP, LLP, LLLP
A. Sources:
1. Uniform Limited Partnership Act, ULPA (1916, adopted by every state but Louisiana)
2. Revised Uniform Partnership Act (RULPA) - widely but not universally adopted, reflective of
corporate influence
3. Uniform Limited Partnership Act, 2001 Act (latest revision, only adopted by some states, including CA)
B. Limited Partners:
1. Limited P’nship = MUST Have At least 1 General Partner + 1 Limited Partner
a. General Partner has all the liabilities and duties of a general p’nship
2. To have an LP you have to make a filing stating so in your State, which says your name, biz
address, and the latest date that the LP will dissolve
3. LIABILITY of Limited Partners: Except in certain circumstances, limited partners have no personal
liability for the debts of the partnership. Can lose investment, but not personally liable, nor do they
have any governance rights (They are PASSIVE Partners) – ie. they typically CANT vote
a. Exception: If the L.P. Participates in the control of the business THEN they are personally liable
BUT subject to some stuff (RULPA below)
i. Typically LP’s know this going in; Use this as an investment like investing in CD, Savings, etc
ii. RULPA:
- (a.) Except as provided in subsection (d), a limited partner is not liable for the obligations of a
limited partnership unless he is also a general partner, or, in addition to the exercise of his rights
and powers as a limited partner, he participates in the control of the business. However, if the
limited partner participates in the control of the business, he is liable only to persons who
transact business with the limited partnership reasonably believing, based upon limited
partner’s conduct, that the limited partner is a general partner. [subsection d says also
liable where creditors extend credit to the limited partnership without actual knowledge that the
limited partner is not a general partner when limited partner permits his name to be used].
- (b.) a limited partner does NOT participate in the control of the business within the
meaning of subsection (a) solely by doing one or more of the following:
a. being a contractor for or an agent or employee of the limited partnership or of a general
partner or being an officer, director, or SH of a general partner that is a corporation;
b. consulting with and advising a general partner with respect to the business of the limited
partnership.
c. Acting as surety for the limited partnership or guaranteeing or assuming one or more
specific obligations of the limited partnership;
d. Taking any action required or permitted by law to bring or pursue a derivative action in
the right of the limited partnership;
e. Requesting or attending a meeting of partners;
f. Proposing, approving, or disapproving, by voting or otherwise one or more of the
following matters: dissolution, sale of assets, incurring debt, removing/adding partners,
amendments, etc.
g. Winding up the limited partnership;
h. Exercising any right or power permitted to limited partners under this act and not
specifically enumerated in this subsection.
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- (c) the enumeration in subsection (b) does not mean that the possession or exercise of any
other powers by a limited partner constitutes participation by him in the business.
- Gateway Potato Sales v. GB Investment Co.: P sues General and Limited Partner. This was
a summary judgment appeal. Court remands for factual findings, NOT ENOUGH TO SHOW
LP HAD CONTORL OF BUSINESS, HAVE TO SHOW DOING SUBSTANTIALLY THE
SAME WORK AS THE GENERAL PARTNER.
iii. ULPA: Limited Partner is NEVER liable. B/C LLP’s and LLLP’s already had this law in
place it was becoming a trap for the unweary, thus wanted to fix it.
- Also, you really don’t wanna be an LP unless you know you wont be liable, but they don’t want
people to have 0 participation
C. Corporate General Partners: RULPA and 2001 act recognize that a corporation can be a general partner
in a limited partnership.
1. Although a director or officer of a corporate general partner is NOT liable for the debts of a limited
partnership merely because he participates in the control of the partnership’s business in his
capacity as a director or officer of the general partner, he may become liable if (1) the corporate
directors and officers fail to maintain their corporate identity in conducting partnership affairs through
the corporation, or (2) if the corporate assets are intermingled with partnership assets, or (3) if the
corporation is not sufficiently capitalized
a. In Re USAFacfes: General Partner was a corporation.
i. Held that the Fid. Duties RAN -- ie. Since Directors of a corporation had fiduciary duty to
corporation, and corporation had a fiduciary duty to the partners, The Individual Director had a
fiduciary duty to the limited partners
- Other Jdx may NOT allow this -- they would follow the Rule above
D. Fid. Duties in DE
1. NOTE: Under DE Law, it’s permissible to actually eliminate duty of LOYALTY when contracting,
but CANNOT eliminate implied covenant of good faith and fair dealing
a. ULPA = CANT Eliminate Duty of Loyalty BUT you CAN MODIFTY it
i. DE law goes farther & says having only contractual Fid. Duties is ok so long as the LP
Agreement EXPRESSLY says so
E. Limited Liability Partnerships: Same as general partnership except liability more limited and the LLP
must be registered with the appropriate state office
1. In CA -- ONLY Professional Businesses can be LLP
F. Limited Liability Limited Partnership: Even a general partner can achieve a limited liability, but few
states do this (Not CA).
1. Some states limit this shield by limiting it to certain types of professions, requirement of minimum
insurance, etc.
2. Could be a Trap for Unweary Creditor if he Can’t Collect later (But LLLP requires State registration)
LLC
F. LLC: Really a hybrid b/w p’nship an corporation – LOT less uniformity in LLC then what one might think
1. Formation/Articles of Organization/Powers: Usually need to file a form with a secretary of state. All
statutes allow formation by a SINGLE person.
a. Articles must include the name of the LLC, the address of its principle place of Business or
registered office in the State, and the name and address of its agent for service of process. Many
statutes ALSO require:
i. The PURPOSE of the LLC
ii. If the LLC is to be manager-managed, the names of the initial managers. IF the LLC is to
be member-managed, the names of its initial members.
iii. The duration of the LLC or the latest date on which it is to dissolve.
b. Most statutes say LLC has power to effectuate their purpose or contain a laundry list of powers.
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2. Operating Agreement: Usually more thorough than an article of organization. Aka limited liability
company agreement. Agreement among the members concerning affairs. Usually provides for the
governance, capitalization and admission and withdrawal of members.
3. Management
a. Default rule: members will manage.
4. Voting by Members: 1/2 do pro rata & 1/2 per capita. Usually only need majority but can require
unanimous vote for certain designated actions.
a. DE = Pro Rata (aka proportionate to your investment) -- Follows Corporate Governance model
b. Model Act = Per Capita -- Follows P’nship Model
5. Agency Powers:
a. Member managed LLC’s: Apparent authority can bind the LLC for any act that is for apparently
carrying on the business of the LLC in the usual or ordinary course. Conversely, the members as a
group may withdraw the actual authority of one or more members, and LLC can still be held liable via
apparent authority but indeminificaiton takes place.
b. Manager-Managed LLC’s: Rules comparable to corporation. Managers only have authority to bind
the firm. Members have NO authority (like SH)
c. The Delaware Statute: Gives members wide apparent authority even in manager-managed LLC’s
and it allows the apparent authority of both managers and members to be limited by the operating
agreement, which is NOT a public document!!
6. Inspection of Books and Records: statutes generally provide access, or at least access to some books,
sometimes limit to proper purpose
7. Fiduciary Duties: Statutes largely SILENT. Do include important provisions concerning particular
issues of fiduciary duty. Most specify the elements of duty of care, some provide that a manger will be
liable only for gross negligence, bad faith, recklessness or equivalent conduct. Others require manager to
be prudent person in similar circumstances.
a. Some statutes provide a mechanism for authorization of self-interested transactions by disinterested
managers or members. Also permit limit of fiduciary duties, and some permit the operating agreement
to waive fiduciary duties entirely.
8. Derivative Actions: Usually, if not statutorily then by case law, members are allowed to bring derivative
lawsuits on the LLC’s behalf.
9. Distributions: DEFAULT = In the absence of an agreement to the contrary, distributions to
members are to be made pro rata according to the members’ contributions, rather than per capita
a. But can be BOTH ways if they say so
10. Member’s interest: Usually member can freely transfer interest in LLC, governance rights are
treated differently though, some statutes require majority consent and some unanimous
11. Liability: Not liable unless conditions of piecing LLC’s veil are satisfied.
a. Piercing the veil Absent Fraud: SAME as Corporation Laws -- no reason to treat it differently if
LLC members and officers fail to treat it as separate entity “as contemplated by statute.”
i. EVEN if the Statute is SILENT (ie. Wyoming LLC Statute) -- you can still Pierce the Veil
VI. Agency – See p. 7-19 of Textbook for Illustrations & Examples
A. Introduction
1. How do you find out the authority of the corporate officers (ie. president, etc.). What can the president or
vice-president do?
i. Places you might look Del Gen Corp Law § 142, Articles of Incorporation, By-Laws, Board of
Directors
- it’s usually not in the articles of incorporation
- there’s no typical statutory authority that tells you what authority officers have or what they can do
- it might be in a board resolution or a by-law, but even that is unlikely to cover every
contingency
- President for example often just has “Power as generally pertains to his respective office”
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- So We Look to Agency Law to Develop Predictability
B. Nature of Agency Relationship
1. GR (under K): an Agent (A) is someone who by mutual assent acts on behalf of the other (Principal)
and subject to the other’s (P’s) control.
a. Issue: what constitutes “assent”?
b. General Idea: the above forms of business depend on the ability of having people act on another’s
behalf  hence the need for a uniform set of rules that regulate such relationships
2. Agency-Principal Notion:
a. Corporation is the Principal; Officers are the Agents
b. Sole Proprietor is the Principal; Employees are the Agents
c. Partner is the Principal; Other Partners are the Agents
3. General Issue: Whether P is liable to T for a Contract negotiated by the A or a Tort committed by A?
a. Contract  this is typically where the issue of Agent-Principal arises
i. Typical Scenario: A entered into a K with T, some problem arises and the question is who is
liable on the K: (1) is A liable, (2) is P liable, and/or, (3) is T bound?
- The answer is based on whether A was an agent of P and what TYPE
ii. Tort  GR is that P is Vicariously Liable for the Tort of it’s A when the A acted within the
Scope of the Agency
iii. Typical Scenario: In employment contract  A inflicts a Tort on T while acting in the Scope of
his employment  P is vicariously liable to T
4. Principals
a. Disclosed Principal = 3rd party knows principal exists AND knows their identity
b. Partially-Disclosed Principal = 3rd party knows they exist BUT does NOT know their identity
c. Undisclosed Principal = 3rd party does NOT Even know that there is a Principal (or that the
agent is an agent)
i. An Agent for an Undisclosed Principal subjects the principal to liability for acts done on his
account IF they are usual or necessary in such transactions (even if forbidden by principal)
d. IF a Principal RATIFIES an Agent’s Forbidden Act, he is liable for it
i. Ratification = Principal has Knowledge of the MATERIAL Facts AND EITHER:
1) AFFIRMS the Agent’s Conduct by Manifesting an Intention to Treat The Agent’s Conduct
As Authorized; OR
2) Engages in Conduct that is Justifiable ONLY IF He Has Such An Intention
e. A Principal is LIABLE to 3rd Parties IF the agent had Actual, Apparent or Inherent authority (or
agent by estoppel applies or the principal ratified the Agents acts) -- This is True EVEN IF the Agent
i. Note: Actual Authority can be Express or Implied
ii. EVEN IF The 3rd Party does NOT Know an Agent Actually HAS Actual Authority (or the
3rd Party does NOT EVEN Know the Agent is Actually an Agent Rather Than a Principal) =
Principal is STILL BOUND
ii. Agency By Estoppel – a Person who has NOT made a manifestation that an actor has authority
as an agent AND who is NOT otherwise liable as a Party to a transaction purportedly done by the
actor on the person’s account IS STILL LIABLE To 3rd Parties Induced to make a detrimental
change in position b/c the transcription is believed to be on the Person’s account IF:
1) The person intentionally OR carelessly caused such belief; OR
2) Having notice of such a belief and that it might induce others to change their positions, the
Person did NOT take Reasonable Steps to NOTIFY them of the Facts
- Agency By Estoppel (For All Intents & Purposes) Is Almost Equal to Apparent Authority
5. 4 Types of Authority
a. Express actual authority – if the principal gives to the agent the express authority to conduct a
transaction
b. Implied actual authority - what a reasonable officer would believe he has authority over based on
manifestations given to him by supervisory people or by his general office position
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i. BOTH of These are ACTUAL Authority & Binds EVEN Undisclosed Principles
c. Apparent authority - what a Reasonable 3rd party would believe the principle had authorized the
agent to have authority over (no actual authority here by the agent, but b/c of the 3rd party’s reasonable
belief, the company is bound. The principle can sue the agent though for his act -- P CANNOT Sue
For Indemnification Though If A had Express/Implied ACTUAL Authority)
i. W/ Corp’s getting bigger & bigger, the Board Typically ONLY Plays a Supervisory Role & It is
the Officers who Run the Day-To-Day Business
- BUT Remember – there’s typically NOTHING you can look at that tells you what kind of
Authority even a PRESIDENT Has in a Company (Even Though He’s the Highest Officer)
- Thus, in AGENCY Law, It Becomes more and more about Apparent Authority, which is
often based on the Perceived Power of One’s Position
d. Inherent Authority – R.3d of Agency does NOT have this anymore; ONLY R.2d
i. Inherent authority – some cases, an agents acts may bind a principal even though the agent didn’t
have actual or apparent authority
ii. R.2d says: For Disclosed or Partially Disclosed Principals – the Principal is LIABLE for an
Act done on his behalf by an Agent (even if agent is forbidden to do so) IF:
1) The Act usually accompanies or is incidental to transactions that the agent IS
Authorized to conduct; AND
2) The 3rd Party Reasonably believes the agent is authorized to do the act
- For Undisclosed Principals – only #1 is needed (#2 CANT exist since its undisclosed)
6. Liability
a. P is Liable to 3rd Parties IF the Agent Had ANY Authority, OR Estoppel OR Ratification
b. 3rd Parties are Liable to P IF the P Would Have Been Liable to the 3rd Party
i. Exception: When there’s an Undisclosed Principal, AND the U.P. KNOWS the 3rd Party
would NOT have done the deal had he known the U.P.’s Identity
c. A’s Liability to the 3rd Party:
i. When P is Disclosed: IF A had Actual/Apparent/Inherent Authority OR Estoppel OR
Ratification = A is NOT LIABLE to 3rd Party
ii. When P is UN-Disclosed = A IS LIABLE EVEN THOUGH P CAN BE LIABLE TOO
iii. When P is Partially-Disclosed = A IS LIABLE EVEN THOUGH P CAN BE LIABLE TOO
iv. When P is NOT Bound to the 3rd Party = A IS LIABLE to the 3rd Party
d. A’s Liability to the P:
i. GR: IF A took Action that he had NO ACTUAL Authority to take (either Express or Implied),
AND the P is STILL Bound b/c A had APPARENT Authority = A IS LIABLE TO P
e. P’s Liability to the A:
i. GR: IF A Acted w/in his ACTUAL Authority, Then P MUST INDEMNIFY A
7. The Problem of Pre-Incorporation Contracts By Promoters
a. In advance of forming the incorporation, people often contract with a line-up of suppliers, etc. BUT
You CANNOT Be an Agent for something that does NOT Exist Yet
i. This means you CANNOT From a K FOR The Corporation BEFORE It Exists -- so who’s
liable??
- R.2d Agency § 326 – GR is that unless otherwise agreed, a person who, in dealing with
another, purports to act as agent for a principal whom both know to be nonexistent or wholly
incompetent, becomes a party to such a contract (so the Promoter, aka “Agent” is liable)
ii. Different Matters of Interpretation for the Promoter Problem: Revocable offer, or
irrevocable offer, or Novation, or no Novation, etc.
- Contractual interpretations of what the contract or offer are: 1) revocable offer that only
results in contract IF the Corp is formed and accepts the offer prior to withdrawal
(This is the typical understanding); OR 2) irrevocable offer; OR 3) when the contract is
formed there may be a substitution of obligors, and so we have a novation here because
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the corporation takes the place of the promoter in adopting the K; OR 4) Another
possibility is that the promoter remains an obligor
b. Goodman v. Pottery Warehouse (promoter liability)
i. IF BOTH Parties know that there is NO Corporation yet formed, and the 3rd party agrees, w/ that
knowledge, to look Solely to the Corporation for Payment, this is the STRONGEST case that there
is Merely an OFFER & NOT yet a K
ii. if only the corporation is the party to the “contract” then no K is formed yet since the corporation
is non-existent still, so it’s just an offer. But when performance is going on (like in this case) it’s
hard to argue no K is formed; and since the K is formed, that has to be with the promoter
- Here, Pottery looked solely to the Corporation for satisfaction of the K BUT the promoter was
held liable b/c PERFORMANCE was going on
- BUT when a K is formed with the Corporation (after the Corp is formed), THEN the
Corporation would be liable and maybe the promoter would be released, or maybe not.
Often times Novation kicks in and promoter is no longer liable when the corporation has X
amount of capital, etc.
VII. Duty of Care & Duty to Act in Good Faith: People count on Directors to operate corporation in competent,
profitable manner. At the same time, unfair to hold them responsible for variables they do not have control over.
Standards vary from state to state, but ALL DIRECTORS ALWAYS SUBJECT TO THE DUTY OF CARE
ANYTIME THEY MAKE A DECISION, THE STANDARD DEPENDS ON THE SIGNIFICANCE OF THE
DECISION. DUTY IS OWED TO SH’S, CREDITORS, & CLIENTS.
A. Duty of Directors to get the best price for the Shareholders/Maximize SH profits and no court can tell
Directors exactly how to accomplish this, because they will be facing a unique combination of circumstances,
many of which are outside their control. (Revlon)
B. Standard of Conduct versus Standard of Review: On their face, the duties of directors are really
demanding (the Std in the Statute is Negligence), in practice, the standards of review applied to the
performance of these duties are less stringent than the standard of conduct on which the duties are based
(Courts Apply Gross Negligence)
C. Duty of Care:
a. 1) Statutory Standard of Care + 2) Causation:
1. Duty:
i. ALI: director/officer’s business judgment rule is ok if making it in good faith AND is not
interested in the subject of the biz judgment (not a self-interested transaction), is informed
about it to the extent he reasonably believes to be appropriate under the circumstances, AND
rationally believes its in the best interest of the corp.
- if they fulfill the no self-interest and reasonably informed, then generally negligence wont
help you in Case Law unless you show the action was just irrational
- Directors/Officers actions are usually rational, so if they fail BJR its b/c of the
procedural prong -- aka they fail to be sufficiently informed & NOT self-interested
ii. CA Statute: Director shall perform duties in good faith…as an ordinarily prudent person in a like
position would use under similar circumstances (CA = Good Faith is part of Duty of Care)
- ON EXAM: Argue Both Sides as to Whether Duty of Good Faith is Included in the Duty
of Care (most jdx’s seem to say in the Statute they are the same -- CA, DE, etc.)
- Some Say Duty of Good Faith is Actually in the Duty of Loyalty; Some Split All 3 Up
- Most Duty of Care & Duty of Loyalty Statutes Refer to Good Faith
- Note: Good Faith is generally an OBJECTIVE Term
- Note: Gross negligence is NOT the same as acting in Bad Faith
- Good faith can be violated by Conscious Disregard OR Subjective Bad Faith
(intending the harm)
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iii. Model Act: Each member of the board of directors, when discharging the duties of a director,
shall act: (1) in good faith, and (2) in a manner the director reasonably believes to be in the best
interests of the corporation.
iv. Paraphrased, seems like negligence standard, but upon closer review of application in
conjunction with Business Judgment rule, one sees that really not just negligence standard.
v. Common law standards to meet duty (Francis)
2. Causation:
i. Show Proximate Cause, OR D’s conduct was a substantial factor in loss, OR make it a
presumption of causation once breach is shown and D must prove otherwise.
ii. Francis v. United Jersey Bank: Woman inherited position as director of the company after her
husband passed away. Sons were stealing from the company to the point of leaving it completely
looted. She Never did anything to take part or inquire about the company.
- Duty: Directors must discharge their duties in good faith and with that degree of diligence,
care and skill which ordinarily prudent men would exercise under similar circumstances in like
positions. Though it varies, some general guidelines for Directors, at a minimum:
- Should become familiar with the fundamental business the corporation is engaged in.
- Directors should be informed.
- If unsure as to how to act, should acquire the knowledge by inquiry or refuse to act.
- Not a detailed inspection, but a general monitoring of corporate affairs and policies.
- Regular attendance of meetings, and for those meetings they do not attend, it is assumed
they are in concurrence, unless they otherwise file with secretary.
- Not required to audit books, but should be familiar with financial status.
- The review of financial statements, may give rise to a duty to inquire further into matters
revealed by those statements and upon discovery of illegal course of action a director has to
object and if not corrected, resign.
- Causation: must show negligence is the proximate cause of the loss. Here it seemed
as though the D’s non-feasance was interpreted as being a substantial factor in the loss
- VERY LENIENT CAUSATION ANALYSIS DONE BY THE COURT,
ALMOST SEEMED TO ELIMINATE IT!
- OTHER CASES DON’T DO THIS
- This would be a harder case if we were to ask what if she did have a general knowledge of
what was going on and she knew about the loans and confronted the sons and the sons told her
that they were going to repay just like their father had, and she made a decision then to say ok
iii. Barnes v. Andrews: Director made a mistake in managing when product was being released.
- Causation re-emphasized: P must show that had the director done his fully duty, the loss
would have been avoided.
- This does not eliminate causation requirement the way Francis may have a bit.
- BUT the difference in the facts between the cases is pretty great. In Francis it was not
just general mismanagement the way it was in Barnes.
- When you have a discreet transaction or discreet set of transactions that you can
address, the substantial factor test is more readily usable. Had Francis taken steps, it
would have made a difference. In Andrews it is unclear what the Defendant could
have or should have done.
- Barnes can be read for more MODEST Proposition that Director WONT be liable if
attentiveness by ALL directors would NOT have made a Difference
iv. Cede v. Technicolor:
- DE: Causation presumed unless the D can prove otherwise
– This doesn’t really work in non-feasance cases like Francis
 On an EXAM we don’t talk about causation too much because he prefers a
focus on duty of care -- FOCUS ON THE DUTY OF CARE!!!!!
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- If you are dealing with an affirmative action by the board that is based on
inadequate procedure of gathering information, one could see why putting
burden on D, but if you take the facts in Francis and use this test, it might be
problematic.
D. Business Judgment RULE: Shield for officers and directors who make risky decisions that really bring in
high rates of return. When business judgment conditions met, standard of review drops and decision not
judged. The prevalent formulation of the standard of review is that the decision must be rational
1. Director must have made a decision for the Rule to Apply: a director’s failure to make due inquiry, or
any other simple failure to take action (as opposed to a deliberative decision not to act), does not qualify for
protection under the business judgment rule.
2. Need BOTH Procedural & Substantive Prong (Substantive Prong is Almost Impossible for P to Beat)
a. Procedural = If Director takes reasonable steps to become informed AND isn’t self interested
AND made in good faith
b. Substantive = Director action is NOT Irrational
i. IF Both are Shown then BJ Rule Applies & Court is Deferential to Director’s judgment
- Plaintiffs burden is to show the Directors actions were so out there as to be irrational,
Thus breaching the Directors duty of care. Otherwise, very deferential.
- CANT JUST ALLEGE “BAD DECISION”
- Kamin v. American Express Co.: 2 things they could have done, one of which meant
selling Amex. Had shares in a company that was only worth 5 million but had paid 30
million for it. If they sold it on the market the loss would off set taxes and lower net
profit tax by 8 million. But, they wanted to divide it up as a dividend instead to avoid a
negative statement on their financial statement in light of it being a publically traded
company they didn’t want it to make their value go down.
- Held: That they may be mistaken, that other courses of action might have
differing consequences, or that their action might benefit some SHs more than
others presents no basis for the superimposition of judicial judgment, so long as
it appears that the directors have been acting in good faith. The court will not
interfere unless a clear case is made out of fraud, oppression, arbitrary action,
or breach of trust.
- SH Lost on Summary Judgment!!! Cant get passed complaint stage if all they
can allege is that they made a bad decision
- a director is not chargeable with ordinary negligence for having made an
improper decision, or having acted imprudently
 Trying to distinguish between malfeasance and nonfeasance:
o Here there was an actual business decision.
o To make a decision based on a foundation of information
collected by a reasonable effort.
o The facts of this case indicated that a few of the Directors got paid
depending on earnings of company. This does create a conflict of
interest because they benefit pecuniarily.
 Court says this is a board of 20 directors & only 4 of
them would be effected and no indication that the 4
dominated in anyway this discussion and the
overwhelming majority had no conflict of interest. So,
having that done, we are not going to let SH get passed
complaint stage if all they can allege is that they made a
bad decision.
- Informed basis: whether directors have 1) informed themselves prior to making a
business decision, of all material information reasonably available to them, then get
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benefit of BJR UNLESS 2) made no good faith effort in actual implementation of this
system then violation of Duty of Care.
- Smith v. Van Gorkom: One of the directors was pushing for the merger and none of
the directors made a reasonable inquiry as to why he was pushing for the merger or what
his information was based on to push for the merger.
- in DE, the Standard of Care applicable to a Directors Duty of Care = Gross
Negligence
- Here, D got a Premium on the price – but just b/c he lucked out on the price, does
NOT mean the director’s did not violate their duty of care by being uninformed
- It was NOT enough that the directors were all businessmen with lots of experience,
what mattered was that they were not informed about THIS transaction.
- They may have had experience, but they did not utilize that experience in this
transaction, AND there was no sufficient report by the officers in order for the
Board to be able to say they relied on the Officers informed decisions.
- THUS, NO BENEFIT OF BUSINESS JUDGMENT RULE b/c they
FAILED THE PROCEDURAL PRONG (LACK OF INFO)
- The speed with which they made the decision (2 hours), the lack of
information, and the importance of transaction (a merger) was probable
what amounted to “gross negligence.”
- The Board CAN RELY on others BUT the Court said VG wasn’t even
informed himself really AND the Board FAILED to ask if he was
informed. The BOD should have the duty to inquire, especially when
dealing with such a merger
- maybe the Board should require reports, and here there was just a
quick presentation by VG – that wasn’t enough
- What IS Gross Negligence? Largely thrown away as a legal term, but DE
uses it -- it’s something beyond negligence but short of conscious disregard
- what constitutes the “gross” departure from ordinary standards yet
doesn’t equate to a conscious disregard? I dunno, that’s why some think
Gross Negligence is meaningless
- The SH’s overwhelmingly voted for the merger b/c they were getting a
higher price than the market, but this happens all the time when you give
SH’s a higher price than the mkt price
- so how come this did not cure the biz judgment rule?
- b/c the proxy materials failed to adequately disclose info to the SH’s
– so SH approval is irrelevant in saving the Board here
- Stone v. Ritter: Once some system of oversight is implemented, have you acted in
Bad Faith in running that system (is there no attempt to actually implement a
system and/or is there conscious disregard in the follow through)?
- Self-Interested Transaction = NO BJR
- Gantler v. Stephens: Instead of selling the company, Directors decided to reclassify
the shares. Motion to dismiss granted in favor of defendants (directors) but court of
appeals overturned dismissal, finding that there was enough asserted in the pleadings to
survive a motion to dismiss.
- Holding: P’s have alleged that the directors were personally motivated to sabotage
the merger/sale. This is a big claim and must be heavily supported because otherwise
people could always assert that Directors voted against a merger to keep their jobs.
Here in the case of each director and in light of their actions during the ongoing sale
proceedings, there is reason to suspect that they were personally motivated
- Court Also found Directors & OFFICERS Have Both Duty of Care & Loyalty
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- Illegal Acts: Business judgment rule CANNOT insulate Directors from liability when they
break the law, EVEN IF it makes good business sense!!
ii. ALI tries to harmonize these: Director/Office business judgment is ok if making in good faith
AND is not self interested, AND informed about it to the extent he reasonably believes to be
appropriate under the circumstances AND rationally believes it’s the best interest of the
corporation.
iii. Duty to ensure corporation has effective internal controls:
- In Re Caremark: Derivative suit brought by the SHs when there was misconduct by the
employees and a failure to properly monitor. Court was only approving a modest settlement.
- WHEN the Corporation has an Internal Audit System & They are Monitoring -- they
have a Duty of CARE to Reasonably Implement that System (the level of Detail Needed
is a Biz Judgment)
- They ALSO have a Duty of GOOD FAITH -- IF P can show the BOD’s Either
Knew OR Should’ve Known the Violation was Occurring AND took No Good Faith
Effort in Stopping = Violated Duty of Good Faith
- This Seems to be a SPECIAL RULE FOR MONITORING SITUATIONS (IT’S NOT
A NEW DUTY OF CARE STANDARD APPLICABLE IN ALL CASES
1. Was there a breach of this new monitoring duty? Since there seemed to be a
good faith effort in place here to implement monitoring devices it was likely that
the Directors would be shielded by the BJR
E. Liability Shields: Exculpatory Provisions
1. Exculpatory Provision (DE, CA, etc) = Cert. of Incorp. Says NO $ Damages for Violations of Duty
of Care (Gross Negligence Stuff) -- Does NOT Apply to Officers or Non-Monetary Relief
a. ALSO DOES NOT Apply if BOD Violated: Duty of Loyalty or Duty of Good Faith, selfinterested transactions, intentional wrongdoings, etc.)
i. IF there is an exculpatory provision for Duty of Care, the burden is on the Defendant
Corporation to show they acted in good faith in order for the Provision to Apply
b. Malpiede v. Townson: Fredericks of Hollywood case where they did not take the highest bidder in
an auction to sell the company. Board tried to use exculpatory provision but P’s said it didn’t apply
because the claim was they acted in bad faith/violated duty of loyalty.
i. Holding: The complaint does not properly invoke loyalty and bad faith claims so Exculp.
Provision Applies to Save D
c. Lyondell v. Ryan: If you are dealing with a company that has an exculpatory provision, have to
plead in a manner that goes beyond gross negligence so its more than just a duty of care claim
F. Duty to Act in Good Faith: Is it a separate standard or part of duty of care/duty of Loyalty?
1. Bad Faith = Conscious disregard of Fid. Duties OR Subjective Bad Faith (intent to cause harm)
2. Independent Duty??
a. Generally part of duty of care and written into the duty of care statutes and exculpatory statutes
protecting against breach of duty of care that say protected except if acting in bad faith
3. Bad Faith + Monitoring systems:
a. Stone v. Ritter: While good faith may be described colloquially as a triad of fiduciary duties, it
NOT an independent duty, it attaches to the Duty of Loyalty!!! NOT Clear if they also mean
whether it’s also attached to Duty of Care or not
i. Caremark is a Duty of Care Case; this is a Duty of Loyalty/Good Faith Case -- Yet they adopt
the Rule from Caremark
ii. Remember you can be Grossly Negligent w/o acting in Bad Faith
iii. RECAP:
- If you Fail to have Monitoring system IF it was necessary = breach of due care
- If you DO Implement the system -- You have a Duty to Reasonably Run the System &
Monitor = Breach of Good Faith
- THUS, in Stone, they only use the bad faith for the 2nd prong of the Caremark case
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- if you take steps to be informed (running the monitoring system) then you can be
protected by the BJR UNLESS you did NOT do it in good faith (gives you MORE
Protection if you are Running the System)
- If you fail to put one in you could be violating duty of care (could rise to gross
negligence, and no bad faith is needed to be proved)
- DE is setting up a special category for monitoring systems
- In Van Gorkom if you take steps to be informed you are protected by BJR
- In Stone if you put in a system, then you may be protected and therefore
these two rules are really reconcilable
- You can show Bad Faith if there’s a conscious disregard in following through with
system. NO need for subjective bad faith
- Stone Holding : no suggestion that there was no attempt to implement a system or
conscious disregard in following through, just because it didn’t work is NOT enough.
b. In states that have a duty of care statute, where there is an attempt to statutize the duty of care,
it is clear that good faith is an element of that. Delaware has chosen to put this in the duty of
loyalty column though
- DE is trying to distinguish (for the purposes of the Exculpatory clause) activity that CANT
be immunized even though Exculpatory clause says you CANT get rid of duty of good faith
- When you merely have the typical kind of duty of care claim, you can immunize gross
negligence, but if it rises to bad faith and conscious disregard of responsibilities, we will
approach this as a bad faith issue and be dealt with as a duty of loyalty case.
- Bad Faith could be enough to satisfy breach of the duty of care or duty of loyalty – BUT
it’s NOT necessary, just sufficient
4. Duty of Care + Bad Faith:
a. In Re The Walt Disney Company Derivative Litigation:
i. Duty of Care, Gross Negligence standard: No violation because the evidentiary record was
sufficient to support the conclusion that the compensation committee had adequately informed
itself of the magnitude of the entire severance package, including the options that Ovitz would
receive in the event of an early NFT (non-fault termination). Ovitz gave up a lot to come to Disney
- Ovitz Had HUGGGGE $$ But DE Sup Ct said it’s b/c they Viewed him as UNIQUE -Board was Adequately Informed (unlike Van Gorkom case) and thought this was a Good
Decision. THUS, Duty of Due Care was OK
- Duty of Good Faith? There was NO Breach. You need either Subjective Bad Faith (Bad
Intent) OR Conscious Disregard (basically Recklessness) in order to be Bad Faith. Here,
there was no even Any Gross Negligence b/c the Due Care Case failed
- THUS, Obv. The Harder Standards weren’t met if Gross Negligence Wasn’t Even Met
5. Illegal Acts + Bad Faith: Violating the law is a breach of Duty of Care AND BAD FAITH. It’s an
Obligation to Follow the Law (there is no other reasonable decision)
a. Miller v. AT&T: P did not collect campaign debt from Democratic Party. Though the company can
have some discretion as to whom they want to collect their debt from, in light of possible policy
decisions that may make it better to not collect. But can never break the law, and here there were
federal laws they were in violation of by not collecting the debt.
i. Exculpatory Provisions + Bad Faith: Showing of bad faith sufficient to get past exculpatory
provision, written right into the statutes. As long as Exculpatory provision applies, no monetary
damages for Directors upon a mere showing of gross negligence.
G. Recap Duty of Care:
1. Negligence/[Gross Negligence in DE] standard, to act as a RPP/SCC
2. Protected by the BJR as long as 1) adequately informed, 2) not self interested, 3) not in bad faith
AND 4) not otherwise illegal activity
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a. Once all of this elements are met, P has a much higher standard to meet -- need conscious disregard,
subjective bad faith or waste (WASTE = NEED RIDICULOUS $ SPENT ON A 0 ASSET – OVITZ
FOR EXAMPLE WAS NOT ENOUGH)
3. Exculpatory provisions means cant get money damages for breach of duty of care unless P can
show bad faith, self interest, intentional wrongdoing, breach of duty of loyalty, OR illegal act
4. Bad Faith – unclear whether part of Duty of Care/Duty of Loyalty or separate -- on Exam argue
all sides
5. Always need to know 1) standard of Duty, 2) what constitutes a Breach + 3) Causation
a. LESS focus on Causation, more focus on Duty and Breach
6. First, if there is an utter failure to become informed = breach of due care
a. Once you have taken steps to become informed = P has to meet a higher standard to have a
breach (harder for P to show breach) -- need conscious disregard or subjective bad faith to have a
breach
b. Any time a director, a board committee, the board as a whole, or an officer make a decision,
they are subject to their duty of care. What is required to satisfy the duty may be determined by
the significance of the decision. But, always subject to a duty of care and officers are too. So,
NEVER can ignore that
VIII. Duty of Loyalty
A. Duty of Loyalty generally implicated if the Officer or Director is on BOTH sides of the Transaction
1. It applies to:
a) Self-Interested Transactions
b) Director/Officer Compensation
c) Use of Corporate Assets, Information, OR Position -- helps D’s argument if his action helps promote
the Corp.
i. could be something as simple as taking the Corporate Jet to the Superbowl
d) Corporate Opportunity Doctrine
e) Competition w/ the Corporation -- can D ever do this and satisfy duty of loyalty? ALI says possibly
i. competition is a legal term though – saying a high-end car dealer competes with a low-end car
dealer is not true competition
- but even true competition of same product in same town – ALI says possible to satisfy duty
ii. NOTE: it’s possible that your same conduct makes you guilty of all 3 of these; it’s also
possible that 1 of these comes up independently of the others
2. OLD Rule: Duty of Loyalty used to mean the above transactions were voidable at anyone’s will
a. NEW RULE: Now there are Curative Steps that can be taken though
i. When Off. or Dir. Is using these Cleansing Techniques = Court is More Deferential
ii. Diff Burdens the Court could Put on Cleansing Techniques
- Court Could say they’re always going to review the transaction for fairness, are they in the
best interest of the company, is the price fair, etc (Common Law Approach - More protection
to SH’s)
- This may deter people from overreaching and it would protect the shareholders.
- Court Could Say If disinterested board members or disinterested SH’s approve the transaction
after disclosure of ALL the facts including the interests of the SH/Directors the burden will shift
to the other party to prove unfairness (CA Approach – medium-approach in protecting SH’s)
- Court Could Say IF disinterested BOD approve, P has to show violation of BJR (aka irrational
Board decision), and IF disinterested SH approve, P has to show waste (DE Approach – less
protection to SH’s)
- Court Could Say IF Disinterested BOD approval after disclosure, then P has burden to show
that a Disinterested Board Could NOT have Reasonable Concluded that the Transaction Was
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Fair (A bit Easier Test to Satisfy then the BJR Rule) and IF SH Approval then P has to Show
Waste (ALI Approach – DE adopted the Waste part changed the 1st part to burden of BJR)
b. BUT, remember, Where the disinterested directors are REQUIRED to vote, it really doesn’t always
mean anything because they may feel some pressure to accommodate a fellow director
i. And with SH, they frequently do not read all the proxy materials even if all the facts are in
there. THUS, these could allow a fiduciary to benefit from a transaction that is unfair
c. Also Remember the Diff Duties
i. The Interested Officer/Director is subject to this duty of loyalty (in addition to due care and
good faith) while the disinterested board is subject to duty of due care and good faith
B. Self-Interested Transactions: Policy that fiduciary should never benefit from an unfair transaction
reconciled with whether a court should interfere with the decisions of informed & disinterested members
of the corporation.
1. Absent the taking of curative steps, the interested Director/SH must affirmatively show Fairness
a. Fairness = Not only that the terms of a self-interested transaction be fair, but ALSO that entering
into the transaction, even on fair terms, is in the CORPORATIONS Best Interest!
i. Fill Building v. Alexander Hamilton Life Ins.
- The self interested transaction of entering into the lease was done at a fair price, BUT it was a
corporation in trouble and entering into a long term lease of this sort would only mean over
extending itself to its possible detriment. Burden on directors to establish fair price MAY
have been met but to establish a showing of the fairness of the bargain to the interests of
the corporation NOT met
ii. Lewis v. S.L. & E Inc: There were 2 corporations. One corporation was owner of the building,
and the second corporation running a business in that building. Mostly same Officers/Directors in
both corporations except for some SH’s in apartment building were not part of corporation being
run in that building and THUS being negatively impacted by the low price for rent being paid
- RULE: Self-Interested Transaction w/o Full Disclosure means NO BJR Applies.
- Full Disclosure + Disinterested SH OR BOD Approval Would CURE Loyalty Breaches
- if there is NO Disinterested SH or BOD Approval after a Full Disclosure, THEN the
Transaction is voidable UNLESS the interested party establishes that it was Fair and
Reasonable @ the time it was approved.
- NO Cleansing Steps could have been taken by the Corp. here SO they would have
to show of FAIRNESS:
- D put on evidence that showed that the property was worth much more by the end
of the relevant period, but did not show rent increase to match that increase in
property value. 15% of the property value (the rental price) would have been 30K
but they were only charging 14K.
- Director’s would have to demonstrate that they could not have found some other
tenant, stronger financially than the tenant corporation, which would have been
willing and able to pay a higher rental.
- Holding: D FAILED TO Meet His Burden of FAIRNESS
b. What is Full Disclosure: Officer or Director, as a Fiduciary of the SH’s MUST make full
disclosure of 1) Personal Conflicts and 2) ALL RELEVANT FACTS
i. Talbot v. James: Apartment building case where they incorporated to run an apartment building.
As a SH/Director D became a sort of General Contractor but did not fully disclose how much
money he would be taking for himself for his duties. The P’s believed his shares were his
compensation because he was making no capital contribution, but he in fact took an additional 25K
as a personal salary -- MUST Make FULL Disclosure of ALL Relevant Facts
- Holding: No full disclosure here b/c even though D told P about the K, he did NOT
disclose the profits or benefits he would be getting from this K
- Burden is on the Director to show Full Disclosure was made
- D argued that the K authorized him to make construction K’s so this should save him
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- Ct says however that does NOT allow you to K w/ yourself and not disclose that info
to anyone – that provision did not expressly approve it and waive this right
- Ct still gave D some compensation though b/c his K called for him to play a
supervisory role in the construction, which is essentially what he did even though he was
the actual contractor who hired to work subcontractors for him
2. Damages: Violation of the duty of loyalty usually only lead restitutionary damages, unlike violating
the duty of care where they may have to pay damages although they made no personal gain from the
wrongful action. So, besides non legal harms, such as damage to reputation or discharge, they are
only returned to the position they would be in if they had not conducted the bad deal. There are some
examples of how they could sometimes only have restitution but still end up worse off:
a. Where Director sells property to corporation for too much money, has to return money, gets back
property but property has fallen far below the value it was at the time of the original transaction.
b. A Dir or Officer who violates the duty of fair dealing may be required to repay the corporation any
salary he earned during the relevant period in addition to making restitution of his wrongful gain.
c. Sometimes courts award punitive damages to directors/officers who breached their duty of loyalty
i. Particularly when there is a showing of fraud. If D is only put back in the same position he
could potentially profit if he always does this b/c they wont always catch him (b/c when they
do catch him he would only go back to status quo) -- this can prevent that
d. ALI provides that a director/officer who violates the duty of fair dealing should normally be required
to pay the counsel fee & other expenses incurred by the corporation in establishing the violation
3. NOTE: Self-interested transactions aren’t always bad -- sometimes these people have important jobs
but wouldn’t take on these jobs b/c the salaries might be low, and having a chance to a self-interested
transaction as a source of income is another way to give them compensation -- but it shouldn’t be a
transaction that hurts the corporation
a. Direct compensation job bonuses for a CEO is even a kind of self-interested transaction, but
this is something that’s probably a bit more necessary -- CEO wont do the job maybe if he’s not
making certain amount of money (although CEOs in US make lot more than in other nations).
Have to strike balance b/w Corporate/SH concern of self-interested transactions and making sure
they do their jobs
- there’s a lot directors who are also executives, but even just directors who are directors can still make
a nice sum (50-100k, etc)
C. Compensation: Very hard for P to win unless he shows Misleading Conduct or Fraud by the BOD
1. DE + Model Act: Unless the certificate of incorporation or the bylaws say otherwise, the BOD have
the authority to Fix the Compensation of Directors.
a. In regards to Stock Options, absent a showing of fraud in the transaction, the judgment of the
directors as to the consideration for the issuance of such rights or options and the sufficiency of
them shall be conclusive -- BUT Remember Still Subject to Duty of Care & Duty of Loyalty
i. AND if you have a compensation committee that decides compensation – they are subject to the
BJR Rule
2. ALI = BOD does NOT have Carte Blanche:
a. Requires you to show that the Compensation amount is fair [assuming you can determine that]
b. If approved by disinterested BOD (after full disclosure), then you apply the BJR
c. If approved by disinterested SH (after full disclosure), then Waste Std applies. [Extremely
difficult to prove waste in a corporate setting]
3. Stock Option Compensation + Duty of Loyalty:
a. Backdating: Applying the price of the stock from x date in the past even though the option is being
taken now. This is NOT ALLOWED IF the Proper Disclosers are NOT Made.
i. Ryan v. Gifford: Options backdated in a way that gave windfall to associates. Even though the
SH’s approved the plan, the Disclosure was false and misleading. Thus State Cause of Action is
shown
- could also give rise to Federal Cause of Action b/c of Possible Proxy Rules Violations
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b. Spring loading stocks: granting an option, at the current price on the current date, but doing it a
couple days in advance of your release of information so price is lower
i. Normal Duty of Loyalty rules, if There is a disclosure, look above for different approaches
ii. It’s a Violation when it hurts the Corporation
iii. In Re Tyson: The Corp. Springloaded shares just before release of information and MADE NO
DISCLOSURE. When you do this stuff without making a disclosure that you are doing it, you are
acting in a deceptive way. No Disclosure means NO benefit of BJR.
- Corporation’s compensation committee adopted stock options for the corporation – the
plan required that the price of the option be no lower than the fair market value of the
company’s stock on day of the grant -- BUT NO Disclosure was Made of Springboarding
- Springloading isn’t as bad as Backdating BUT IT CAN STILL BE A VIOLATION
- Springloading can be violation of duty of Loyalty and Good Faith b/c you’re hurting the
corporation by selling these stocks at a price lower than the value of the corporation.
When No Disclosure is given that Springloading will occur, this MAY be a violation – it
can implicate the Duty of Loyalty so they struck down Summary Judgment against P
- Failure to disclose this can also violate Proxy rules of 14a9 of omission of material facts
4. When compensation is awarded and given as a result of a deceptive plan that is very different from the
deference shown otherwise for director/executive compensation
a. Remember: Where SH’s cant sue, they still have vehicles available to them – they can sell their
shares, they can wage proxy fights, etc.
b. but don’t confuse the deceptive plans and disclosure failures with the regular compensation battles
we saw in Disney/Ovitz that got much more deference
D. Corporate Opportunity Doctrine
1. Definition = involves D taking for himself (often with his own money) a business opportunity,
which by virtue of his fiduciary status should at least be offered first to the company so that they may
use or decline that opportunity.
2. Factors that may influence the court:
a. Financial inability of the corporation to take advantage of the matter
b. Outsider Director (only a Dir in the Corp) vs. Director who’s also employed w/ the corporation
c. Does it have to be opportunities within the line of business the Corp is engaged in?
d. If the opportunity was offered to the Director as an Individual rather than in his capacity as a
director of Corporation X does that change things?
e. Ethical Standards of what is fair and equitable
3. A Few Different Tests (none of these are very good to use anymore)
a. Line of Business Test: DE Sup Ct (very old rule): IF Officer/Director has a business opportunity
which the corporation is financially able to undertake and from its nature is in the line of business of the
corporation and is of practical advantage to it (corporation has an interest or a reasonable expectancy),
then by embracing that opportunity for their own self interest, the officer/director has brought himself
into conflict with the corporation and violated his duty of loyalty.
i. This encourages 1) abuse of information, 2) discourage financial upbringing of company because
they are exonerated if the business could not financially take it on
b. Fairness Test: Rests on the unfairness in the particular circumstances of a director, whose relation to
the corporation is fiduciary, taking advantage of an opportunity [for her personal profit] when the
interest of the corporation justly calls for protection. This calls for application of ethical standards of
what is fair and equitable.
c. Miller v. Miller 2 Step Approach: 2 steps -- Combo of Line of Business & Fairness from above
4. ALI TEST:
a. RULE: A Director or Senior Executive may NOT take advantage of a corporate opportunity
UNLESS:
i. First offers the opportunity to the corporation and makes DISCLOSURE Concerning BOTH
The Conflict of Interest AND the Corporate Opportunity Involved; AND
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ii. Corporate Opportunity is Rejected by the Corporation
- these are similar for what we saw in the Cleansing Techniques analysis
b. DEFINITION -- What is a Business Opportunity?
i. ANY Opportunity to engage in a business activity of which a director or senior executive
becomes aware of, EITHER:
1) In connection with the performance of functions as a director or senior executive, or under
circumstances that should reasonably lead the director or senior executive to believe that the
person offering the opportunity expects it to be offered to the corporation; OR
2) Through the use of corporate information or property, if the resulting opportunity is one
that the director or senior executive should reasonably be expected to believe would be of
interest to the corporation; OR
3) Any opportunity to engage in a business activity of which a senior executive becomes
aware of and knows is closely related to a business in which the corporation is engaged or
expects to engage [This does NOT apply to Directors -- Senior Exec’s ONLY]
ii. NOTE: For ALI -- Financial inability is NOT a bar to define something as corporate
opportunity, corporation may want to raise $, take out loans, etc.
iii. NOTE: For ALI -- does not say in the rule necessarily that it needs to be in the Corp’s Line of
Business, but this may be relevant as to whether people Reasonably believed that the Opp. was
being offered to the Corp.
5. Cases
a. Hawaiian International Finances Inc v. Pablo: D is director of the P-Corporation. D found a Real
Estate deal for HIS OWN Real Estate company on his own time. Offered the opportunity to the
corporation and the corporation asked him to complete the deal for them. He kept half of the
commission for himself as a broker instead of turning it over to the corporation.
i. RULE: Directors (and officers) CANT personally get UNDISCLOSED profits from
Transacting on behalf of the Corp. EVEN IF the Corp. is NOT Harmed By Their Profit
- D Did not give Plaintiff-Corporation an opportunity to negotiate for a lower price had they
been aware that he was going to be getting some commission from this transaction.
- if D had DISCLOSED His Profit then this Rule Would be MET
b. Northeast Harbor Golf Club v. Harris: President of golf course bought surrounding property
without making any prior disclosure. Uses ALI approach, under that approach, as long as business
opportunity must disclose.
i. Was it a Business opportunity? Yes because offered to her in the capacity as a director. And
even though golf course may not have had the means to buy the property, they could have
raised the funds
- NOTE: Vagueness of what actually constitutes a business opportunity could have chilling
effect, discourage people from director position if they are forced to decline what they
think are personal opportunities
- NOTE: EVEN If D offers the Opp. to the Corp & they REJECT IT -- The D CANNOT
Then Take the Opp. & COMPETE w/ the Corp. So Here, D cant run a Golf Course
c. Broz v. Cellular: This court said since the company was not financially able to take advantage of the
opportunity, they didn’t have to tell them. But here the corporation had just declared Bankruptcy
i. This one is Diff from the ALI Model
ii. Court said the Corp. had NO Expectation or Interest in this Opp. (even though it’s in their
line of business) since they had NO Financial Ability to do so & just recently went bankrupt
E. Use of Corporate Assets, Information, or Position
1. In re Ebay: Goldman Sachs gave Ebay IPO stocks which made them millions of dollars in personal
profits, but the stocks were meant to induce the company to do future business with Goldman Sachs, not to
count as personal profit
a. This was misuse of corporate position (and potentially misuse of business opportunity??)
F. Competition with Corporation: ALI says its possible when competition is at Arms-Length
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1. Agency Law: Throughout the duration of an agency relationship, an Agent has a duty to refrain from
competing with the principal and from taking action on behalf of or otherwise assisting the principals
competitors. During that time, an agent may take action, not otherwise wrongful, to prepare for competition
following termination of the agency relationship
2. ALI 3-Part Test: Directors and senior Executives may not advance their pecuniary interest by
engaging in competition with the corporation UNLESS EITHER:
a. Any reasonable harm to the corporation from such competition is outweighed by the benefit that
the corporation may reasonably be expected to derive from allowing the competition to take place, or
there is no reasonably foreseeable harm to the corporation from such competition;
b. The competition is authorized in advance or ratified, following disclosure concerning the conflict
of interest and the competition, by disinterested directors, or in case of a senior executive who is not a
director, is authorized in advance by a disinterested superior, in a manner that satisfies the standards of
the business judgment rule; or
c. The competition is authorized in advance or ratified, following such disclosure, by disinterested
SHs, and the SHs action is NOT A Waste of corporate assets
i. Burden of Proof is on D to show b or c [disinterested approval] & THEN BOP is on P to show (a)
G. Other Times the Duty of Loyalty & Good Faith is Implicated
1. In C.C.’s
a. Duty of Loyalty & Good Faith is violated if the C.C. offers to buy-back the Majority SH’s stock
at X price but does NOT give that same opp. to the Minority SH’s
i. But Remember in a C.C. it’s a STRICT Duty of Loyalty/Good Faith
b. Duty of Loyalty & Good Faith is violated if the C.C. is Freezing-Out a SH and denying their
right to get a reasonable return on their investment (incl. earning a salary in your position with
the C.C. -- this is especially if you are ALSO removed as a director)
i. Duty is ONLY MET IF:
1) Majority Shows a Legitimate Business Reason For Their Actions; AND
- Wilkes Case (p. 14 in outline): failed b/c they froze him out only b/c they hated him
2) P FAILS to Show there was a LESS Harmful Alternative Available
ii. Merola v. Exogen: Does NOT Apply this RULE even though the P had a Reas. Expectation of
Continued Employed that the D frustrated by firing him. Why?? Ct focused on the fact that he was
not a founding SH, and in fact was an employee first and a SH second. All he bargained for was an
at-will employment K, and there’s no attempt to buy his shares at an unreasonable price = Fair
Return on Investment even though he was enticed to leave his old job b/c the new Corp. was going
to eventually offer him up Majority Shares. (This is why relying on Fid. Duty is unpredictable)
2. In ALL Corp’s
a. Management CANNOT impinge upon the SH’s right to wage proxies or impede the
effectiveness of a SH vote, unless they can show 1) A Compelling Interest; AND 2) That They Took
Proportional Actions to a Legitimate Threat they faced (If BOD had time to inform SH’s of impo. info
then they MUST Educate the SH’s w/ that time rather than relying on the Above Exception to the Rule)
- When Management Violates this Rule = Violation of Duty of Loyalty to SH’s. Even if the BOD is
acting in Good Faith b/c they believe the potential people who want to takeover the company will
cause harm to the company, they STILL MUST satisfy the rule.
IX. Duties of Controlling SH’s
A. General Info
1. When the Controlling SH’s Have A Conflict of Interest = They Have a GREATER Duty than when
the Directors have a conflict b/c the SH’s elected the “disinterested directors”!!!!
2. When does a SH have a Duty?
a) If the SH is an Officer or Director = All the Above Fid. Duties to the Corp.
b) The SH is another Corporation and they had elected some of the BOD’s for this Corp = Same
c) If the SH is the CONTROLLING SH = Owe All the Above Fid. Duties to the Minority SH’s
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i. At a Minimum, Controlling SH’s who have a Conflict of Interest = Must Show FAIRNESS
ii. These Duties are true in both a public-issue corp and a C.C.
- BUT in the C.C. = Scope of the Fid. Duty is probably BRODER & Sweeps Beyond Just
“Fairness”
- In Public-Issue Corp = The Fid. Duty owed is NOT as large (just Fairness perhaps)
3. NOTE: Controlling SH ≠ Majority SH
a. It’s Possible to be Controlling SH w/o Being the Majority SH!
B. Cases
1. Zahn v. Transamerica: Though the actions were technically allowed by the certificate of
incorporation, they rearranged corporate assets to benefit one class of shareholders and hurt the
other.
a. RULE: Controlling SH has to show both good faith AND inherent fairness
b. Facts: Zahn (P) owns shares in Axton-Fisher. He is suing Transamerica b/c they have the controlling
SH’s in Axton-Fisher, and P alleges they breached their duty to P and the whole class of minority SH’s
i. Majority SH has the right to control, but there is an obligation that comes with that to treat
the minority fairly
- Class B is Majority Controlling Vote by Transamerica Corp
ii. the certificate of incorporation said: in the event of dissolution/liquidation, the preferred
stockholders get $105 per share + dividends, then the Class A stock gets paid dividends, then all the
remaining assets of the corp shall be divided up and paid to the Class A and Class B SH’s (Class B
gets 2:1 stock split though)
- instead of doing this though, the Corp did another provision of the cert. of incorp.
- another provision of the certificate of incorp. Gave the Board of Dir’s the option to
redeem any dividend payment by paying $60 per share
iii. Transamerica decided to do this provision of the certificate of incorporation, and thus the
Class A shares got screwed out of more money – while Class B (Transamerica) got big benefit
- The Corp basically did what the certificate of incorporation allowed, so why was this a
breach of Fid. Duty?
- The conflict of interest going on triggers a Fairness standard
- The Corp violated that Fairness standard by liquidating a big Corporate asset after
they bought out the Class A SH’s
- the Corp redeemed and bought out the SH’s for the benefit of the Class B SH’s
(aka the benefit of Transamerica)
- so it breached the Fid. Duty even though the certificate of incorporation
had this provision
- Just the buy out itself wasn’t a breach of duty, but doing the buy out to benefit only 1
Class at the expense of another was a breach
- The real misdeed was that the board failed to disclose to the Class A SH’s what its
plan of action was and given them an opportunity to choose to either sell their shares
at 60 bucks per share, OR, the certificate of incorporation also allowed the Class A
SH’s to sell at a 2:1 ratio and convert their shares to Class B
- so this is the Remedy the Court chose - didn’t want to give the Class A a windfall,
so the FAIR Result was to let them share in the sale of assets at this conversion ratio
b/c that’s what WOULD HAVE happened if there was No Breach
c. DE: has been rigorous in requiring full disclosure by majority SHs when dealing with the
minority SH
i. D (majority SH)’s burden to show that all material facts were disclosed.
- Material facts = IF there is a substantial likelihood that the disclosure of the omitted fact
would have been viewed by the reasonable investor as having significantly altered the ‘total
mix’ of information made available. While it need NOT be shown that an omission or
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distortion would have made an investor change his overall view of a proposed transaction,
it must be shown that the fact in question would have been relevant to him.
2. ALI RULE: Controlling SH must pass Intrinsic Fairness test when they act in their own selfinterest (meaning they gain something from the subsidiary/corporation to the exclusion of and
detriment to, the minority stockholders of the subsidiary/corporation)
a. TEST: (Followed by Sinclair Oil)
1) Duty of fair dealing is fulfilled by showing the transaction is fair to the corporation @ the time
entered into, OR
2) Approved by Disinterested SH’s with full disclosure AND NO Waste
- BUT when there is board approval by a TRULY disinterested board, then the burden
shifts to the P to show the transaction was NOT Fair
- Remember: Disinterested Board approval is suspicious when we’re dealing with
Controlling SH’s b/c the SH controls the Boards jobs – so they are likely NOT TRULY
DISINTERESTED
- Burden of Proof: P MUST Show Sufficient Facts to show there is BOTH a Benefit to the
Controlling SH AND A Detriment to the Minority
- When P has Shown that, The BOP is now on the Controlling SH to show the
Transaction was FAIR to the Corp @ the time entered, or approved by Disinterested
SH’s who had Full Disclosure and it was NOT Waste
- IF There was Approval by TRULY Disinterested BOD though, then the Burden is
back on P to show it was UNFAIR Transaction to the Corp @ time entered into
- Exception: If transaction was done in the ordinary course of business P has the
BOP of showing evidence that transaction was UNFAIR, whether or not ratified
by a disinterested board
b. Application:
i. Sinclair Oil: Minority SH believed there was a breach by majority in 3 different situations. Here
Majority was a parent corporation.
- Paid dividends, but paid the same dividends to everyone, so does not need to meet fairness
test because it did not benefit to the detriment of the minority SH of subsidiary.
- Business Opportunities not given to the subsidiary not within financial means of subsidiary
- Parent company breached a K by not paying the amount due to the subsidiary. This gets
fairness standard because benefited at detriment of minority so intrinsic fairness test applies.
ii. Green Co. v. Dunhill Inc.: P minority SH’s of Spalding who made sports equipment and
educational toys. Dunhill Inc. owned 80% of Spalding; Dunhill then acquired Child Guidance Toys
which also manufactured toys
- Spalding sued Dunhill (Controlling SH) by saying they appropriated a corporate opp that
belonged to Spalding
- Ct found for P by saying the record showed a sufficient biz opp in the line of
Spalding’s business, which would’ve been of practical advantage to it and which it was
financially able to undertake – that opp was taken
iii. Kahn v. Lynch: Though there was a committee labeled an independent committee here to
approve the transaction, there was showing that this was NOT truly an independent committee, they
were in fact bullied by the interested SH who were dictating the terms of the merger. No real power
to say ‘no.’ If there truly was approval by disinterested board, burden would have shifted
- Mere Existence of Allegedly Independent Committee is NOT Sufficient
- When would Committee be TRULY Independent/Dis-interested?
- Maybe if the Minority actually elected the committee OR They elected a director
who was NOT subject to be elected by any Controlling SH
- Besides NOT Being Independent -- The Committee here also did NOT have to accept an
unfair price only b/c there may not have been another offer at that time – the power to say
NO is a BIG power – there was NO arms-length bargaining going on to cleanse transaction
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- DE LAW: Controlling SH standing on both sides of a transaction, as in a parent
subsidiary context, bears the burden of proving its entire fairness
- the case retained the Fairness std even w/ disinterested SH approval
- Compare to ALI – they say the Fairness Std is NOT kept w/ disinterested SH
approval if you show there was full disclosure (the only burden would be showing NO
Waste - it’s a Waste Std)
- ALI and DE however agree when it’s approval by disinterested Board – then the
burden shifts
- Remember: ALI also says for just ordinary transactions in the course of the
Corp’s business – the P has burden of showing unfairness even if there is NO
Disinterested approval by SH or Board (has to be ordinary transaction though)
c. Jones v. Ahmanson: VERY Liberal CA Sup Ct decision that said you don’t necessarily need to
show both benefit & detriment to trigger inherent fairness test -- need ONLY show ONE of them
X. Sale of the Majority SH’s Controlling Stock -- What is the Controlling SH’s Duty?
A. Sale of Control: Fiduciary duty to in the Context of the controlling SH selling their OWN Shares
1. Even in the absence of transfer restrictions, there could be obligations on the Controlling SH in selling
his OWN personal property
B. ALI RULE: A controlling SH has the same right to dispose of voting equity securities as any other SH,
including the right to dispose of those securities for a price that is NOT made proportionately available
to other SHs
1. So its Ok to Sell your Shares
2. BUT the Controlling SH does NOT satisfy his duty of fair dealing to the other SH’s IF:
a. The controlling SH does not make disclosure concerning the transaction to other SH’s with
whom the controlling SH deals in connection with the transaction; OR
b. It’s apparent from the circumstances that the purchaser is likely to violate the duty of fair
dealing in such a way as to obtain a significant financial benefit for the purchaser or an associate
C. Controlling SH does NOT ALWAYS Need to Share His Premium w/ Others
1. General RULE (Zetlin v. Hanson): A controlling SH may sell his shares at a premium w/o being
obliged to share the premium with minority SH’s UNLESS there is 1) Fraud, 2) Looting, or 3)
Conversion of Corporate Property
a. It’s also possible that the minority SH also shares proportionally in the idea that a new buyer of the
controlling shares thinks the company is worth paying that premium price
i. So some think a change in control Could benefit the Corp, which in turns benefits minority SH’s
- the downside is IF the new owner is a CROOK
D. Cases:
1. IF it’s Foreseeable that the New Controlling SH will “Loot” the Company = Triggers a Duty in the
Selling Controlling SH to investigate and protect the Corporation and SH’s
a. Gerdes v. Reynolds: Purchaser Looted company. This case is known as general rule for foreseeable
looting. Though sellers did not have ACTUAL Notice, they may have had CONSTRUCTIVE notice
i. Factors for Constructive Notice:
- Paid VERY high price
- difficult to calculate true value, BUT the buyers paid wayyyyy too much, so this should put
people on notice just as much as a grossly inadequate price would put people on notice that
something was going on
- Wanted control of the company FAST
- Buyers had NO Experience in this Business
- Did NOT Pay FULL Purchase price up front, agreed to installment plan instead
- Duty to Investigate is RARELY Triggered, BUT Triggered Under These Circumstances
2. Sale of Corporate “Office” = A Naked Sale Of Office (w/o also selling Controlling Shares) Is Illegal
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a. Definition: if you’re pouring out a lot of $ to buy a control premium b/c you think a company has
been mismanaged, why would you want to pay that $ and have to wait until the next annual meeting to
get control and take those guys out?
i. NOTE: You can always call a special SH’s meeting to knock people out w/o cause b/c you don’t
need cause for removal of directors
ii. It seems like it would be good for the corp too if you were removing directors who were not
helping the corp
- Yet in Brecher v. Gregg the Court said that immediate Control of the Corp (ie. I choose
some of the directors and management people) was an implied term in the sale, and this is
NOT allowed in some circumstances b/c this is a Sale of OFFICE
b. Brecher v. Gregg: D only selling 4% of shares, this is not a control share, did not actually have
control of directors, therefore it was really a naked sale of office
i. Cannot sell corporate office when you don’t sell controlling shares
c. Essex Corp v. Yates: Similar to Brecher but here it was 28% of the shares. This is not necessarily
control, but it could be
i. Here, The K Had an express provision saying the purchase at a premium price was done b/c
the K included a sale of office (“sellers will deliver to buyers the resignation of the majority of
the board”)
- Holding: Remanded for further fact finding to see if it’s controlling share -- If there is
controlling shares here = it’s ok to sell the office & ok to have this Provision in the K
- The Sale of Office Provisions would be illegal if there’s some looting, fraud,
conversion of corporate property, OR it was NOT controlling shares being sold
3. Corporate Opportunity: SH MAY need to show Entire Fairness If UNIQUE Circumstances Apply
a. Perlman v. Feldman: D was a majority SH but also a top manager of the steep company. And he
had developed a way of getting loans called “Feldman Loans” to build up the company (interest-free
loans).
i. Sold his controlling shares to a customer at a time when steel was in really high demand
because of an ongoing war. So since there is no general duty to share, WHY does he have to
SHARE his Profits with the Minority here since there is no fraud, misrepresentation, looting,
misuse, etc.?
- He lost a huge corporate opportunity for the company to expand and increase its market
influence when the industry was at its best
- Court Held this way b/c of the UNIQUE “Feldman Loans” -- the Opp. to get Feldman
Loans were precluded by the sale since Feldman left -- the problem was that these were
Business Opp’s that Belonged to the Corporation & D just took the opportunity for himself
and made a personal profit
- THUS, D is Held to entire fairness standard.
- In order to SATISFY FAIRNESS -- D had to share his Profits w/ the Corp. b/c he
got Premium due to what was a “Corporate Biz Opp.”
- Even though he was the one doing these loans, he’s a SH, Director & Officer of
the Corp = THUS CORPORATE OPPORTUNITY
ii. Perlman is a rare/unique case but Lazzaroff thinks its absolutely right in these circumstances
4. Theory of Corporate Action:
a. HYPO: Purchaser approaches a corporation to buy them out (paying the same for everyone’s shares)
but the controlling SH convinces him to buy his shares at a premium first and then buy the rest of the
shares.
i. There is NO Need to do this! This will only work against a poorly counseled SH because any
well educated controlling SH knows his shares are worth more and will just vote against any
buy out prices otherwise, so the deal won’t go through unless his control premium is paid
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XI. Insider Trading (SEC Act 10b)
A. Classical Insider Trading Case = insider who is a dir/off who knows something material, and buys or sells
stock based on that information
1. Even under State law or Common law – this would be illegal based on duty of loyalty stemming
from misuse of your corporate position and information
a. however Federal Law came on to institute stronger law – SEC Act 10b
B. Common Law Background:
1. Majority rule: no duty to disclose material non public information concerning the corporation that he
had acquired through his position.
2. Minority rule: (also known as Kansas rule) which required full disclosure by a director or officer, at
least in face-to-face transactions. The court likened a director’s duty to that of a trustee, and said that a
director is under a duty to deal fairly with the SH and communicate all material facts in connection with the
transaction which the director knows or should know.
3. Fraud and Half truths: majority rule does not apply where there is fraud and also when speaker tells a
half truth. “a representation stating the truth so far as it goes but which the maker knows or believes to be
materially misleading because of is failure to state additional or qualifying matter is a fraudulent
misrepresentation…Thus, a statement that contains only favorable matters and omits all references to
unfavorable matters is as much a false representation as if all the facts stated were untrue.”
4. Fraudulent Concealment: it was fraudulent at common law to take affirmative steps to prevent the truth
from being discovered
5. Special facts exception: some cases by reason of special facts, a duty to disclose facts known exists.
This was difficult to administer and really just ate up the majority and gave the lower courts a way to say
they were following it when they really weren’t.
6. Atrophy: majority rule has really become obsolete.
C. SEC -- Securities Exchange Act of 1934
1. §10 Statute: It is illegal to violate the SEC Rule on insider trading by using or employing, in
connection with the purchase or sale of any security registered on a national securities exchange OR
any security not so registered, any manipulative or deceptive device or contrivance in connection of
such rules and regulations as the Commission may prescribe as necessary or appropriate in the public
interest or the protection of investors
a. MUST be “in connection with”
b. Requires Scienter (manipulation/deception) -- THUS, making it NARROWER than §14
c. It’s NOT limited to just §12 corporations on National Stock Exchanges like §14 Proxy Rules
were (THUS, making it BROADER than §14. It’s Both Narrower & Broader)
i. §10b is NOT the RULE
- §10b is merely the SCOPE OF THE RULE & Tells us you CANT Violate the Rule that
the SEC puts in place (but someone CANT be prosecuted for things that go beyond the
SCOPE of the Rule b/c the SEC does not have that power)
- Ernst & Ernst v. Hochfelder: Rule CANNOT go further than the SCOPE of the Statute
- by using the words “any manipulative or deceptive device or contrivance in
contravention of such rules and regulations as the Commission may prescribe” the
Supreme Court said this connotes a requirement of SCIENTER
- so whatever 10b5 reaches, the rule must require some element of intent
- since Ernst & Ernst – other court have unanimously held that Recklessness
satisfies the Scienter requirement!
- Negligence = NOT Satisfy
- Recklessness = Satisfy
- but there are different interpretations of the term “recklessness”
- some seem closer to what we would think of as gross negligence, while others
seem closer to being intentional
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- PSLRA: Exception: when we have a Forward-looking Statement – you gotta
show MORE (Actual Knowledge IF certain things exist -- see below for this
rule)
- also requires you to Plead Stronger you MUST show Cogent Facts that
allege why this Inference of an Insider Trading Violation is AT LEAST AS
STRONG as ANY other inference (see below for this rule as well)
- and you must plead facts w/ Particularity
2. Rule 10(b)5: It’s unlawful for Any person, directly or indirectly, by use of any means or
instrumentality of interstate commerce, or the mail, or any faculty of a national securities exchange,
AND in connection w/ the purchase or sale of any security:
(a) to employ any device, scheme, or artifice to defraud;
(b) to make an untrue statement of a material fact or to omit to state a material fact necessary in
order to make the statement made, in the light of circumstances under which they were made, not
misleading; or
(c) to engage in any act, practice, or course of business which operates or would operate as a
fraud or deceit upon any person
i. if part a covers fraud in connection w/ sale or purchase of security, then why is b and c
necessary? What do they add?
- they broadens the concept of what 10b says is illegal and what constitutes Fraud and Scienter
- it was not necessarily apparent by the language of the rule that you needed scienter b/c the
rule includes both traditional fraud and also conduct of the same effect
- BUT Case Law shows that you NEED Scienter – it narrows the broadness of the rule
- Case Law also fleshes out exactly who can be sued and who can sue on insider
trading claims (who could be a P and a D), and also defines what materiality means
3. Who can be sued/held liable under 10(b)5 claim:
a. The Rule says “Any Person” – BUT ITS NOT REALLY ANY PERSON
i. In Re Cady, Roberts & Co. -- MUST have a Relationship that gives you ACCESS
- Rule 10b-5 applies to securities transactions by ANY corporate insiders, particularly
officers, directors or controlling stockholders, but not limited to those 3 categories. Others
can be sued as well, BUT Obligation rests on 2 principle elements:
1) Existence of a relationship giving access (directly or indirectly) to information
intended to be available ONLY for a Corporate Purpose & NOT for Personal Benefit
of Anyone; AND
2) The inherent unfairness involved where a party takes advantage of such information
knowing it is unavailable to those with whom he is dealing
ii. NOTE: D does NOT have to necessarily be a buyer or seller so long as his conduct is “in
connection w/ purchase or sale of security”
- Example: The D can be the company itself – so long as they had duty to disclose or made a
material misstatement – the company doesn’t have to be a buyer or seller
4. Who can Sue?
a. For a P in a private cause of action = you need to be a buyer or seller of the stock
i. UNLESS you sue for Injunctive Relief – then you don’t have to be buyer/seller
5. When Does a Duty Even Exist?
a. SEC v. TGS made it sound like ANY person in possession of material information had a duty to
disclose or abstain -- this is NOT TRUE (BA D LAW)
i. Mere Possession of Information does NOT trigger a duty to Disclose.
b. ONLY IF one has a Duty arising out of a Fiduciary Relationship OR A Relationship of Trust and
Confidence b/w the Parties in the Transaction do they have a duty to disclose the information or
abstain from trading – so you can ABSTAIN too (don’t necessarily need to disclose)
i. Chiarella v. US: Court narrowed TGS findings and said duty only arises when there is a fiduciary
duty and a relationship of trust and confidence. Here the Printer was not a corporate insider, he
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did not receive confidential information about the target company, he had no fiduciary relationship
with the SH’s of the target company, he was not their agent, they placed no trust and confidence in
him, AND he had no prior dealings with them. Mere possession is not enough.
- BUT D can still be sued under Duty of Loyalty stuff (misappropriation of info, etc.)
c. Material Misstatement Cases = DON’T NEED to Show any Affirmative Duty IF D Made A
“Material Misstatement”!!!
d. Tippees: Mere Possession of material insider information is NOT enough.
a. In order for the TIPPEE to be liable you MUST SHOW TWO THINGS:
1) Tipper Made disclosure to the Tippee for some improper purpose (ie. Tipper acted for his
own Personal Gain); AND
2) Tippee either knew or should have known the Tipper was acting for his own personal gain
i. Improper Purpose = tippee acts for direct OR indirect personal gain, including
“GIFTS”!!!
- Showing needed intent to benefit in tippee liability is not extensive, benefit is defined
in very expansive terms. The court declared that not only does an actual pecuniary gain,
such as a kickback or an expectation of a reciprocal tip in the future, suffice to create a
‘benefit,’ but also cases where the tipper sought to enhance his reputation or to make a
gift to a trading relative of friend (SEC v. YUN)
ii. NOTE: if the Tippee had some Independent Duty he would be liable too (but that is
Rare)
b. Dirks v. SEC: Tipper of Dirks gave him the information so Dirks would expose the fraud taking
place within the corporation, therefore Dirks CANNOT be held liable as a tippee (his tipper did
NOT have an improper purpose). Also he went on to tell other people about the fraud, who
dumped their stocks. But since the first tipper did not breach his duty, there is no 10b(5) claim
against anyone else because no one inherited a fiduciary duty
i. Original tipper COULD have done this for some personal gain, but there was NO Evidence
e. Temporary Insider: An outside agent/professional hired temporary by the company owes a
fiduciary duty to the company (ie. Accountant, Lawyer, etc.)
f. Misappropriation Theory
a. D commits fraud when he misappropriates, aka steals confidential information for securities
trading purposes, in breach of a duty owed or relationship of trust and confidence to the SOURCE
OF THE INFORMATION (10b5-2 describes what Relationships You MUST Have to the Source)
i. O’Hagan (THE Misappropriation Case): Lawyer/partner of a firm and not working on this
transaction, but overhears that Law Firm’s clients will be making a tender offer to Pillsbury and
buys stock with that information. Not Liable under Chiarella b/c no duty to disclose b/c of
mere possession and no duty to Pillsbury, and he only buys Pillsbury stock so no breach to
the people he does owe a duty to (his Law Firm or their clients)
a. D argued his fraud was separate from his deception b/c he did not breach a duty to
Grand Met (his firms client) and his fraud was on Pillsbury (whom he has no relation to)
- Holding: WRONG, Misappropriation is the Theory Here -- you deceived the
SOURCE of the Information to get an advantage in a securities trade. The Source
of that information is your Law Firm
- THUS, D had Duty to Disclose or Abstain
- in traditional 10b5 cases, when you owe a duty to the company, you have to make
disclosure to them
- in this case, he breached a duty to the source, so disclosure must he make?
- he must disclose to the source what he is planning on doing in order to avoid
10b5 liability. When telling the truth to the source (or both sources) then
you’re not committing fraud on the source anymore
- this disclosure satisfies the duty, and the source of the information can
then act to stop the guy from acting
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- BUT SEE Rocklage -- even when you had disclosure that may correct 1
fraud you committed but not necessarily all frauds you committed nor destroy
past giving of information based on trust/confidence, so there is still a
violation
g. SEC Rule 10b5-2 = Passed by SEC in response to family examples/Misappropriation of
information passed between two people NOT involving traditional temporary insiders and NOT
tipped for personal gain.
i. RULE: This section provides a non-exclusive definition of circumstances in which a person
has a duty of trust or confidence FOR PURPOSES OF THE MISAPPROPRIATION THEORY
ONLY of insider trading under Section 10(b) of the Act and Rule 10b-5.
ii. For purposes of this 10b5-2, a duty of trust and confidence exists in the following
circumstances:
1) whenever a person agrees to maintain information in confidence;
2) whenever the person communicating the material nonpublic information and the person
to whom it is communicated have a history, pattern, or practice of sharing confidences, such
that the recipient of the information knows or reasonably should know that the person
communicating the material nonpublic information expects that the recipient will maintain
the confidentiality; or
3) whenever a person receives or obtains material nonpublic information from his or her
spouse/parent/child/sibling; provided, however, that the person receiving or obtaining the
information may demonstrate that no duty of trust or confidence existed with respect to the
information, by establishing that he or she neither knew nor reasonably should have known
that the person who was the source of the information expected that the person would keep
the information confidential, because of the parties’ history, pattern, or practice of sharing
and maintaining confidences, and because there was no agreement or understanding to
maintain the confidentiality of the information.
- UNLESS Proper Disclosure is made to the Source = BREACH of 10b5-2
iii. SEC v. Rocklage: Woman promised to tell her brother if her husband told her anything about
the company.
- 2 deceptions:
- Breach 1: Acquisition of material non-public information through the deception of her
husband because she never intended to protect the confidentiality since she had a prearranged agreement with her brother to give him any information, that her husband did not
know about; AND
- Breach 2: her use of the information to tip off her brother without her husbands consent
- BUT the Wife Made a Disclosure to her Husband & Said she was going to tell her
brother. Was that enough to satisfy her duty??? NO – It ONLY Cured the 2nd Breach
- Though the wife disclosed, this did not cure her first breach of duty to her husband
when she initially made the agreement with her brother to tip him if she received
negative information from her husband
iv. SEC v. Talbot: SEC must demonstrate (1) Talbot breached a fiduciary duty arising from a
relationship of trust and confidence owed to the source of the information on which he traded; and
(2) the information which Talbot traded was material.
- Talbot is a board of director of fidelity, and misuses fidelity’s info, without any disclosure, to
buy lending trees stock (fidelity was a SH of lending tree and was going to approve and vote on
a transaction for a 3rd party to merge w/ lending tree)
- he had fid duty to the source (ie. the company he’s a director of) even though he
defrauded the other company = Misappropriation
- but you still gotta prove the info was material -- remanded for fact-finding
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v. HYPO: If some random guy overhears the confidential info (ie. director says it on the phone in a
taxicab) -- there is NO agreement to maintain confidences b/w the director and the cab driver so you
CANT have a misappropriation theory here
- if it was a limo driver and maybe the company rules were such that you had to maintain
confidentiality with your clients then you probably COULD have a misappropriation theory b/c
there’s a Fiduciary Duty of Trust & Confidence
vi. THUS, Misappropriation theory is 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
the corporations shareholders
- could make an argument that the misappropriation rule goes too far under what the
scope of §10b allows in making 10b5 RULES
6. “In Connection With”:
a. Applies to every element of rule, means P if collecting damages must have either bought or sold.
i. EXCEPTION: does NOT apply for injunctive relief (no need to have bought or sold)
b. D does NOT have to necessarily be a buyer or seller.
c. Applies to ORAL Contracts too (and Note: an option to buy stock = a security)
i. Wharf Holdings: D was a seller of an option to buy stock, P had been involved with the D in
trying to develop a new cable system in Hong Kong. In exchange for services, the P wanted a right
it invest if D obtained the license. No signing but an oral agreement. Once D got license, P raised
money to buy 10% share to exercise the option of which they had been in oral agreement. D say no,
we don’t want to uphold the oral agreement. The question is whether or not the breach of this oral
K regarding the option with the P comes within 10b-5. The court reads the in connection with
broadly and an option to buy stock is in connection with the purchase or sale of a security. D
does not even contest that the option a security. But D says their secret intent to not honor the K is
not securities Fraud, Court says this kind of K is enforceable under UCC, sufficiently common and
this act does sufficiently relate and the court reads this and wholly consistent with the in connection
with requirement.
d. Applies when Broker just steals your money, instead of investing for you.
i. SEC v. Zandford: court allowed it to apply where Broker was in charge of managing a
man’s money and instead just invested it in his own personal account
- Court says you don’t have to make a misrepresentation of the value of the security
- Each sale was part of a lie, and it is enough that the conversion and the sale coincide with
each other
ii. The “in connection” requirement = Read BROADLY by USSC (Zandford)
- so this isn’t a big obstacle generally UNLESS you’re a private plaintiff then you also have to
show loss causation and transaction causation (SEC would NOT have to show that)
- ON EXAM -- it should be pretty obvious which defendants can be sued
iii. BUT THE “Scienter” & who can be sued requirements = Read Narrowly by USSC
(Chiarella & Dirks)
7. Outside the Scope of 10(b)5
a. NO Aiding & Abetting Liability: ALL Requirements for Primary Liability must be met for
EACH D! (Central Bank v. Denver)
i. Stoneridge v. Scientific Atlanta: Defendant company helped another company manipulate their
numbers in such a way that showed more revenue than actually being made. This does not fall
within 10(b)5 because there is no aider/abetter liability, Congress did not add it in the Private
Securities Litigation Reform Act (NOTE: PSLRA dealt w/ Minimum Pleading Standards for
Plaintiff’s) and no duty to disclose to company or their SHs by D. No duty to disclose therefore
no liability.
- Court looked at it as a reliance case (the P didn’t know about any of this so they had
nothing to rely on) BUT LAZAROFF says it was more of a No Duty case, b/c you can use
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the fraud on the market theory for the reliance issue. So Lazz says they had no duty to
disclose to these plaintiffs
- Courts were concerned w/ expanding the rules too far in broadening the private right of
action –this would be a backdoor to allowing aiding and abetting -- This is where the
courts draw the line for expanding the scope of 10b(5)
b. There is NO 10(b) claim where there is a breach of fiduciary duty by majority SH, without any
deception, misrepresentation, or nondisclosure.
i. Santa Fe v. Green: Majority SHs got appraisers to value the company and the Minority SHs said
the appraisers grossly undervalued the company for the Majority. Court held does not matter
because all material information was disclosed, this is not a 10b5 claim.
- whether the controlling SH is being fair raises a Fiduciary Duty claim under State law,
BUT for 10b5 purposes this doesn’t satisfy the rule b/c they need to show a material
misstatement or omission
- 10b5 needs to be confined to Fraud and the court cant find Fraud here b/c it cant find
anything that was left out that should’ve been put in
8. Breach of Duty:
a. Scienter: Intent to deceive, manipulate, or defraud means must be Scienter. Recklessness
satisfies this Scienter requirement though defining recklessness has been difficult. More than
negligence, something beyond the reasonably person standard.
i. Recklessness might be defined differently in diff jdx’s though
b. PSLRA -- At pleading stage, need to show Strong Inference of Requisite Intent/Scienter in
making material misstatements/omissions.
i. they weren’t changing the standard for scienter, but heightened the pleading requirements to
reduce # of frivolous lawsuits that were just filed b/c of a loss in stock purchases and people who
just wanna sue and get to discovery (fishing expedition)
- not just notice pleadings anymore, you need to allege specifically that the misstatement was
made with actual knowledge
- aka need to show a “strong inference” of the requisite intent (aka scienter)
ii. Tellabs v. Makor: Scienter must be at least as compelling as any other inference that one
could allege on the facts of the case.
- inference of scienter must be more than merely plausible or reasonable –you must plead
facts of scienter that must be Cogent and at least as compelling as any other inference that
one could allege on the facts of the case
- on these facts, they said that test was met – the inference of Scienter was cogent b/c
there were 2 possible scenarios and 1 of them was more likely so it was cogent
- ^^^definition of cogent
iii. Recklessness will STILL suffice to constitute Scienter, but you just got a plead it better
- EXCEPTION:
1) Forward Looking Statements: For Most situations, PSLRA requires P to show D
made the statements with ACTUAL KNOWLEDGE that the statement was False OR
Misleading (so long as you put in Cautionary Language stating the important factors why
actual results may vary)
iv. Does P have to show that D possessed nonpublic material information, or that they actually
used that info to their advantage, in order to show that the D purchased or sold stock on the
basis of that information?
- Rule 10b(5)-1: if the D possessed the nonpublic info, and then purchased or sold a security,
then mere possession and awareness of the information is enough b/c they will assume that
the info was used since they knew it and then acted
- is this eliminating the Scienter requirement though to say that if you’re aware of the
info then we’ll assume you used it when making a trade?
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- NOPE, this is NOT an effort to water down the requirement of Scienter – they just
view that as a separate issue. You still have to show they acted with the intent to
deceive or recklessness (aka the Scienter requirement)
- so if the D is aware of nonpublic info and trades, then we’ll assume he
used the material nonpublic info to be the basis of his transaction, but if
he traded w/o any bad intent & was not reckless then you have NO 10b5 claim
c. Materiality: “to make an untrue statement of a material fact or to omit to state a material fact
necessary in order to make the statement made, in the light of circumstances under which they were
made, not misleading”
i. ALWAYS need Materiality, whether “classical” 10b5 claim or Misappropriation claim.
ii. Test by USSC: whether a reasonable man would attach importance…in determining his
choice of action in the transaction in question. AND when information is unsure:
- Balancing test between the indicated probability that the event will occur and the
anticipated magnitude of the event in light of the totality of the company activity (TGS)
- Applies to BOTH classical and misappropriation cases
- Materiality is Always a QUESTION OF FACT, unless very obvious exception
iii. Application:
- TGS: mining case where they where they found lots of stuff but did not disclose to the public,
bought more shares for themselves and told their family members to buy shares.
1. When did information become material? Using the above test (same test from the
PROXY Cases) court finds the info become material a few after the ore discovery, but
still before the company released the info – so the people would be liable for insider
trading b/w the time it was material and the time it was publicly released
2. Factors that supported this finding of materiality?
- a group of employees/executives (around the same time) bought a lot of stock and
employee stock option plans
- this is sort of a dicey factor b/c employees can legitimately do this all the time
and it’s a good form of compensation for them, and it’s a pretty common thing.
When the employees are all doing this at the same time though and there’s
unusual activity going on (ie. its 1 thing getting stock, but getting a call option is
RISKY; your gambling that the price will go up but you can lose a lot if it doesn’t)
- when the employee has a regular pattern of this activity maybe that would be ok,
but for a rookie investors who have NO history of doing any kind of trading and
yet are doing risky activities at the same time together and also did it after
knowing this info = reasonable investor would likely find this info important
- Site was VERY Unique & the people who knew about it attached a lot of
importance to it
3. NOTE: in TGS, the stock options were even trickier b/c the company’s compensation
committee granted these employees some stock options – so what could the employees do?
Probably shouldve said sorry there is confidential info that would make it inappropriate
for me to take the stock options now, so I will defer them
- Maybe you could’ve given them the same private material info in which case the
committee would also have to satisfy the 10b5 rules on Insider Trading Duties
- remember though, the compensation committee members (along w/ the
insiders) have fiduciary duties as well
4. ONLY Use TGS for Materiality Rule (other stuff in it is BAD LAW)
- Basic v. Levinson: Preliminary merger negotiations not fully released to the public. SH saying
it was really far more pessimistic than they indicated in the press. Apply the “would standard”
- the court says that preliminary merger negotiations can sometimes fall through so
knowing about them may make investors go the wrong way in terms of buying or
selling stock. So its not self-evident if the materiality test would be satisfied
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- Factors:
- how probable was the merger? How far along was it? How important was it?
- if Microsoft taking over small company = more material to the small company
than to Microsoft
9. Causation: Need Both Loss Causation AND Transaction Causation for Private Action (Basic v.
Levinson) -- NOTE: UNLIKE MATERIALITY, WHICH WAS THE SAME IN PROXY & INSIDER
TRADING RULES, CAUSATION HAS DIFFERENT RULES
a. Loss Causation: actual $ lost. Does NOT have a presumption, P has the the burden to prove that D’s
action caused the loss that P seeks to recover. P must show proximate cause between misstatements
and loss in $.
i. Mere drop in Stock Price not enough.
- Dura Pharmaceuticals: Many things can effect the stock price, and not necessarily wronged
because at the time you buy a stock it is that value and therefore you possess something of equal
value.
- can show that this stock fell right after information was released though and no other
stocks in this industry dropped
- also you were not jipped technically @ the exact time you bought the stock b/c you had
no loss since the inflated purchase price was offset by ownership of a share that
possessed equal value
b. Transaction Causation there must be a causal connection between D’s violation of 10b-5 and P’s
purchase or sale of the security. Violation of 10b-5 must have caused the transaction in question. P
must allege and show that but for the fraudulent statement or omission, she would not have entered
into the transaction -- BUT P does NOT need to show Individual Reliance
i. Fraud on the Market Theory (Basic v. Levinson): Rebuttable presumption that if the D
committed fraud to the Market in General, that the P’s relied on the D’s misstatement because
they relied on the integrity of the Market, which should reflect all misinformation, in making
their investment decisions.
- P always gets a rebuttable presumption, whether it’s a material misstatement or material
nondisclosure case (or else Impossible to find transaction causation in non-disclosure case)
ii. Rebutting the presumption: Any showing that severs the link between the alleged
misrepresentation and either the price received (or paid) by the P, or his decision to trade at a
fair market price, will be sufficient to rebut the presumption of reliance.
- D can rebut by showing was obligated to trade anyways, had reason to know the truth,
traded even though they knew the truth, etc..
c. Government Action (SEC suits): Reliance requirement applies ONLY to determine when
private parties can bring actions under 10b-5, it does not apply to actions by the SEC.
i. SEC can bring an action for injunctive or other appropriate relief based on a misrepresentation
that violates rule 10b-5 even if no investors have relied upon the statement – because, for
example, trading in the relevant stock was suspended immediately after the statement was made.
RECAP
10(b)5 analysis:
1) Was there Material information? (would standard?)
a. Forward Looking Statements slightly protected to not chill representatives of the company.
2) Was there a Misstatement or omission?
3) Was it In Connection w/ sale or purchase of securities?
4) Was it a Misappropriation or Classical trading claim?
a. Classical:
i. Duty: Mere possession of information is NOT enough need to be/have:
1. Fiduciary Duty/Temporary Insider
2. Tippee reasonably knew tipped by tipper with fiduciary duty for improper
purpose.
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b. Misappropriation:
i. Duty of Trust and confidence to source of information?
1. Tippee Not tipped for Improper Purpose
2. Trader owes duty to source of information (as opposed to the company whose
securities were traded)
5) Causation for Private Suits
a. Loss Causation
b. Transaction Causation:
i. Fraud on the Market Theory
-- NOTE: Congress Creates statutes that give SEC authority to enact the rules (applies for ALL SEC
Rules)
- Neither The Rule NOR the Statute Gives a Private Cause of Action -- BUT Courts have given an
IMPLIED PRIVATE CAUSE OF ACTION
XII. Short-Swing Profits -- SEC Act 16b -- Strict Liability Rule
A. RULE: if a Director, Officer, or More than 10% Shareholder (“Beneficial Owner”) Sells/Buys OR
Buys/Sells their company’s stock and makes a Profit ALL Within a 6 Month Period  the Corp Gets
the Profit (must disgorge).
1. NOTE: ONLY enforceable via Private action, NEVER by Govt
2. NOTE: ONLY Applies to §12 Corp’s Traded on Nat’l Stock Exchange, OR Assets > $10M + 500+ SHs
B. Limitation:
1. If Shareholder: Must be More than 10% Owner (1) Immediately Before the Purchase of the shares
AND, (2) Immediately Before the Time of Sale
2. If Officer or Director: Must be Director or Officer (1) At Time of Purchase, OR (2) at Time of Sale
C. Either Sale or Purchase can come 1st  there just has to be a Profit w/in 6 Months of sale to purchase
or purchase to sale
1. If there is NO Profit – 16b WONT Apply
D. Broader Rule than 10b-5: the trading does not have to be based on “nonpublic info” or “material”
things. IT APPLIES TO ALL VOLUNTARY TRADES (STRICT LIABILITY)
1. Does NOT apply if Involuntary Transaction -- i.e. during a Merger
E. Narrower Rule than 10b-5: it only applies to Directors, Officers and 10%+ SH’s, and it does NOT
apply to sales/purchases AFTER 6 months
F. Method of Analysis:
1. Is Corp registered under SEA §12?
2. Defendant:
a. Director or Officer  either AT TIME of Sale OR Purchase
b. 10%+ Shareholder  Immediately Before Sale AND Immediately Before Time of Purchase
3. Did the defendant make ANY profit by trading the Corp’s stocks w/in a 6 month period?
a. Can you MATCH ANY Sale w/ ANY Buy (DOESN’T MATTER WHICH ONE CAME FIRST)
b. Did D make a Profit: buy low/sell hi OR sell hi/buy low
G. HYPO:
1. officer of company does all of this within 6 months:
a. buy 1000 shares at 30
b. sell 1000 shares at 25
c. buy back 1000 shares at 20
d. sell back 1000 shares at 15
i. he’s essentially lost $10k b/c of these transactions
ii. BUT under 16b the Court will ASSUME you GAINED 5K!
- why? b/c they’ll assume you had inside info, and without that info you would’ve just kept the
stock the whole time and would’ve lost 15k instead
- thus you made 15k-10k = 5k (D MUST GIVE THIS 5K BACK TO THE CORPORATION)
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EXAM INFO
- 1st 30 minutes no writing – just there for us read and be organized in our writing -- organization is important!
- then next 3 hours = writing
- 1st fact pattern with multiple issues of relevant stuff and all laws (fictional jdx) = 100 pts
- apply the law to the facts
- then 4 or 5 shorter essays worth like 100-125 points
- then a few more random questions worth 75-100 points
- NO Testing on Valuation (current net value stuff)
- 16b = 10 points of 300 (3%)
- partnerships and non-corporation law = 30 points (10%)
- public and closed-corp = the rest of it (87%)
- don’t need to cite statutes – but KNOW the CONCEPTS and USE THEM!
- only really need to cite 14a, 14a8, 14a9, 10b, 10b5, etc
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