Corporations
Professor Bradford
Summer 2005
Exam Answer Outline
The following answer outlines are not intended to be model answers, nor are they
intended to include every issue students discussed. They merely attempt to identify the
major issues in each question and some of the problems or questions arising under each
issue. They should provide a pretty good idea of the kinds of things I was looking for. If
you have any questions about the exam or your performance on the exam, feel free to
contact me to talk about it.
I graded each question separately. Those grades appear on your printed exam. To
determine your overall average, each question was then weighted in accordance with the
time allocated to that question. The following distribution will give you some idea how
you did in comparison to the rest of the class:
Question 1:
Question 2:
Question 3:
Question 4:
Range 2-8; Average = 5.27
Range 3-9; Average = 5.58
Range 3-8; Average = 5.64
Range 3-8; Average = 5.85
Total (of unadjusted exam scores, not grades): Range 3.38-7.77; Average = 5.64
Question 1
Section 8.08 of the MBCA governs the removal of directors. Unless otherwise
provided in the articles, shareholders have the power to remove directors with or without
cause.
Election by Voting Groups
If, as here, a director is elected by a voting group of shareholders, only those
shareholders may vote on whether to remove him. MBCA § 8.08(b). Thus, only the
Class B shareholders may vote on Dan’s removal, since only they get to vote on his
election.
Cumulative Voting
The first sentence of § 8.08(c) also applies here, as cumulative voting is
authorized. Dan may not be removed if the number of votes against his removal would
be sufficient to elect him using cumulative voting. At a regular meeting, four Class B
directors would be up for election. There are 105 Class B shares represented at the
meeting, so the total number of votes would be 420 (105 x 4). See MBCA § 7.28(c). The
formula for the number of shares required to elect a single director is [S/(D + 1)] + 1,
where S is the total number of shares voting and D is the number of directors to be
elected. Thus, it would take [105/(4 + 1) + 1 = 22 shares to elect Dan cumulatively at a
normal election. If 22 shares vote against removal, he would be retained. In a regular
election, the 83 shares would have 83 x 4 = 332 votes. Split four ways, that would be 83
votes per candidate. Dan would have 22 x 4 = 88 votes, so he would be one of the
candidates elected. If Dan had less than 22 shares in his favor, he could not guarantee his
election. Therefore, Dan stays on the board if at least 22 shares are voted against his
removal. Assuming all 105 shares vote, 84 of the Class B shares must vote for removal
to remove Dan.
Question 2
Smith has potential liability under § 16(b) of the Exchange Act, under Rule 10b-5
and § 10(b) of the Exchange Act, and for breach of duty under state corporation law.
Section 16(b) of the Exchange Act
Section 16(b) applies to trading in Alpha stock because Alpha’s stock is registered
pursuant to section 12 of the Exchange Act. See § 16(a)(1), 16(b) (“any equity security
of such issuer”). Initially, Smith is not in one of the covered categories of traders: she
was not an officer, director, or 10% beneficial owner of Alpha. However, after her Feb. 1
purchase, she owns more than 10% of Alpha’s stock (10,000 out of 100,000 shares), so
she is covered from that point forward. The Feb. 1 purchase is not itself covered by §
16(b) because, immediately prior to the transaction, she was not a 10% owner. Both her
Feb. 5 purchase and the Mar. 10 sale are covered because, immediately prior to the
transactions, she is already a 10% owner. The Mar. 15 sale is not covered because,
immediately prior to the transaction, she only owns 9,700 of 100,000 shares, less than
10%. However, the Feb. 5 purchase and the Mar. 10 sale are a matching purchase and
sale within six months. Smith has a profit because she purchased at $25 a share and sold
at $30 a share. there are 1,000 shares that can be matched; the other 800 shares sold on
March 10 can’t be matched with any purchased shares that are covered by 16(b). Thus,
Smith would be liable to disgorge $5,000 to Alpha (1,000 shares x $5/share profit). She
would be liable whether or not she used inside information, as § 16(b) is a strict liability
statute not requiring proof of any actual misuse of information.
Rule 10b-5
Smith does not appear to be liable under Rule 10b-5. She clearly traded on the
basis of material, nonpublic information, but Chiarella makes it clear that not all trading
on nonpublic information is actionable under Rule 10b-5. There must be some breach of
fiduciary duty. Smith herself owes no fiduciary to Alpha or its shareholders. She is not a
director or officer of Alpha, only a shareholder. Thus, this is not classical insider trading
in the Texas Gulf Sulphur sense. Smith is also not a temporary insider as defined in fn.
14 of Dirks. She hasn’t agreed to any special confidential relationship with Omega;
Omega approached her as a potential party on the other side of a business deal.
Smith is the tippee of an insider and Dirks says a tippee can be liable if the insider
(in this case, Chief) breached a fiduciary duty in providing the information and the tippee
knew or should have known of the breach. The breach of fiduciary duty by the insider
must be for personal gain. Dirks. Chief’s release of personal information was probably
not for personal gain. He is a personal friend of Smith and a gift to a friend can be for
personal gain. Dirks. However, Chief clearly was not providing the information as a
gift. He was contacting Smith because she was a board member of Omega for a
legitimate corporate reason—to see if Omega might be interested in acquiring Alpha. As
there is no breach of duty, Smith cannot have liability as a tippee under Dirks.
The final possibility is misappropriation. O’Hagan. Smith can be liable if she
breached a duty of confidentiality to the source of the information, Chief. Mere
friendship does not create a legal duty of confidentiality, and there’s no evidence that
Smith contractually agreed to keep the information confidential. (If she did, her breach
of that contractual duty without informing Chief would suffice under O’Hagan.) Nothing
in Rule 10b5-2 would create a duty in this case, unless Smith and Chief have a history of
sharing confidences that would cause Smith to know there is an expectation of
confidentiality. See Rule 10b5-2(b)(2). Finally, as explained below, Smith’s purchases
may breach her duty of loyalty to Omega. That duty is not one of confidentiality, as
Omega is not the source of the information. However, one might argue that Smith has a
duty to disclose to Omega her plan to buy Alpha stock. Failure to do so therefore would
constitute fraud and might be a sufficient violation of duty to constitute misappropriation
under O’Hagan.
Breach of Corporate Law Duties
Smith may also be liable for a breach of duty to Omega Corporation.
1. Duty of Loyalty-Corporate Opportunity
As a director, Smith owes a duty of loyalty to Omega. Among other things, it is a
breach of her duty of loyalty to take a corporate opportunity that belongs to Omega. Broz
v. Cellular Information Systems, Inc. The opportunity to purchase Alpha stock based on
the information provided by Chief may be a corporate opportunity.
Delaware applies the Guth v. Loft test to determine whether an opportunity
belongs to the corporation. That test looks at seven factors, no one of which is
dispositive: (1) whether the company is financially able to exploit the opportunity; (2)
whether the opportunity is within the corporation’s line of business; (3) whether the
corporation has an interest or expectancy in the opportunity; (4) whether in taking the
opportunity, the director will be placed in a position inimical to her duties to the
corporation; (5) whether the opportunity is presented to the director in her official or her
individual capacity; (6) whether the opportunity is essential to the corporation; and (7)
whether the director has wrongfully employed the resources of the corporation in
pursuing or exploiting the opportunity.
In this case, some of these factors seem to argue that the opportunity to purchase
Alpha stock is a corporate opportunity belonging to Omega. Omega arguably has an
interest or expectancy in the opportunity because the opportunity was originally
presented to Omega by Chief. The opportunity was presented to Smith in her capacity as
a director of Omega; Chief clearly intended to present the opportunity to Omega, not to
Smith personally. There is no real evidence that Omega would be financially unable to
exploit the opportunity. Smith indicated that Omega had already committed its capital to
other investments, but nothing suggests that Omega could not have obtained additional
funds if necessary. Finally, the opportunity may be within Omega’s line of business.
Omega is an insurance company, and this is not insurance, but insurance companies must
invest the proceeds provided by their clients, and this clearly is an investment
opportunity.
However, many of the factors point away from corporate opportunity status. In
taking the opportunity, Smith will not be placed in a position inimical to her duties for
Omega. She already owns Alpha stock, and it has not affected her duties for Omega as
far as we know. Moreover, it’s a passive investment, so it will not take away from her
time working as an Omega director. Nothing suggests that the opportunity is essential to
Omega. And, other than using information intended for Omega, Smith has not in any
way used Omega resources to exploit the opportunity. Further, the use of the information
does not harm Omega in any way; in fact, it does not prevent Omega itself from using the
information, as information is not wasted by being used.
The Guth v. Loft factors seem fairly evenly split, so it is difficult to determine
how the Delaware courts would decide this issue. The fact that the opportunity was
originally presented to Omega may be determinative in swinging the balance in favor of
liability.
2. Duty of Care-Duty to Inform
Even if Smith is not liable for violating the duty of loyalty, Smith’s action in
rejecting this opportunity could violate the duty of care, particularly her duty to inform
herself before deciding. Smith v. Van Gorkom. She appears to reject Chief’s offer to
Omega fairly rapidly. She doesn’t take any time to explore the opportunity, to determine
if Omega could finance the opportunity, or even to present it to the board. However, it’s
not even clear that this is a corporate decision to which the Van Gorkom duty to inform
applies. Smith by herself has no ability to decide on behalf of Omega whether to take
this opportunity; that would be a decision for the full board. Therefore, her rejection of
Chief’s overture, although perhaps a duty of loyalty violation, may not violate the duty of
care.
Question 3
[Obviously, there is no single “correct” answer to this question. I evaluated your answers
based on how well you justified your ranking. The following answer is just one
possibility.]
Ranking
I would rank these five factors in the following order (going from least important to most
important.
1.The parent caused the incorporation of the subsidiary.
2. The Parent and the subsidiary file consolidated financial statements and tax
returns.
3. The parent and the subsidiary have common directors or officers.
4. The subsidiary does not keep separate books and records and hold shareholder
and board meetings.
5. The parent pays the salaries and other expenses of the subsidiary.
Discussion
The first two factors really shouldn’t matter much at all. Whether the parent and sub file
consolidated financial statements and tax returns is pretty much a function of accounting
and tax rules. Often, the parent and the sub are required to prepare consolidated financial
statements and file consolidated tax returns. If this is mandatory, it’s hard to see any
reason why it should make veil piercing more likely. It doesn’t in any way distinguish
between those cases where the usual rule of limited liability should be respected and
those cases where the parent has done something wrong and it should not be respected.
The second factor is only slightly more important. In most cases, the parent will have
incorporated the sub, since the parent is the owner of the sub’s stock. The only case
where this won’t be true is where the parent buys a company from someone else.
Perhaps you can argue that the purchase of an existing company is less likely to be for
illegitimate purposes, such as harming creditors, than creating a new sub, but that’s a
pretty marginal reason.
The third factor in order of importance shouldn’t be too surprising. A parent which owns
a sub is likely to want representation in the control of that sub, so some common officer
and directors should be expected. However, it is arguable that those common managers
might be expected to keep the parent’s interests foremost and not manage the sub in its
own best interests. This in turn makes it more likely that the common officers and
directors might prefer the interests of the parent’s creditors to those of the sub’s creditors,
therefore harming the creditors of the sub, and justifying piercing the veil.
The fourth factor—failure to follow corporate formalities—doesn’t directly harm the
sub’s creditors. However, the failure to maintain separate books and records may make it
more difficult to track the flow of assets between the two entities, thereby making it
easier to defraud the creditors of the sub.
The fifth and most important factor is the parent’s payment of the sub’s expenses and
salaries. At first glance, this would benefit the creditors, especially if the money is
provided by the parent. However, this allows the parent to minimally capitalize the sub,
making insolvency more likely and allowing the parent to put very few assets at risk.
The parent can continue to pay the bills as long as it likes and, when it decides to let the
sub fail, none of its assets are lost as a result of the failure, since it has kept all the assets
necessary to operate the sub within the parent, releasing them only as necessary. In
essence, this could be a sign that the sub is undercapitalized.
Question 4
Groucho’s Back Salary
First, it is clear that Groucho is entitled to be paid his back salary just like any
other creditors are paid. UPA § 807(a) says the partnership assets shall be applied first to
discharge debts owed to creditors, including creditors who are also partners. Thus,
Groucho is entitled to his $2,500 before any other allocations are made. After paying
him, the partnership has $12,500 cash left.
Is the Partnership Obligated on the Pacman Contract?
In order to determine the remaining allocation, we must first decide if the
partnership is obligated on the Pacman contract. Section 301(1) says every partner is an
agent of the partnership for the purpose of its business. The agreement specifically
denies agency authority to Harpo, absent unanimous agreement, and the partners rejected
the request by Harpo to have the partnership purchase a video game. Thus, it is clear that
Harpo had no actual authority to purchase the video game on behalf of the partnership.
The partnership agreement provides that the partnership shall not be liable when a
partner acts without authority, as Harpo did. However, that limitation has no effect on
the rights of Pacman, a third party, to recover. UPA § 103(b)(10).
Even in the absence of actual authority, UPA § 301(1) makes the partnership
liable for the acts of a partner “apparently carrying on in the ordinary course the
partnership business or business of the kind carried on by the partnership.” In terms of
the actual partnership business, the Pizza Parlor never offered video games, just pizza.
However, Zeppo’s statement that a lot of other pizza places offer video games make it
clear that ordering video games is ordinarily part of a pizza parlor business. There is still
a question whether Pacman thought Harpo was acting for the partnership at all. He only
signed his own name and the contract doesn’t even refer to the Pizza Parlor. This would
be presumed not to be partnership property under § 204(d). However, Harpo clearly
informed Pacman he was purchasing the video game “for the Pizza Parlor,” so Pacman
should be able to rebut the presumption and show that Harpo was apparently carrying on
the partnership business.
Section 301(1) says such an action binds the partnership unless Harpo had no
authority and Pacman, the person dealing with the partner, “knew or had received a
notification” that Harpo had no authority. As a result of ¶ 2 of the partnership agreement
and the 2-1 vote not to buy a video game, Harpo clearly had no authority. However,
there is no evidence that Pacman knew about this or had received a notification of this.
Therefore, the partnership is liable for the $1,500 liquidated damages under § 301(1).
Groucho’s Dissociation and Liability
One further issue must be dealt with before the allocation among the partners may
be made. Groucho published his notice withdrawing from the partnership on April 1.
This contract was not made until April 2. Ordinarily, Groucho’s dissociation would
dissolve the partnership, as it is an at-will partnership. § 801(1). However, ¶ 1 of the
agreement specifically overrides this default rule, as allowed by § 103(a) (since it is not
one of the mandatory rules listed in § 103(b)). Therefore, the partnership had not been
dissolved and could still incur the new obligation on the video game.
The real issue is whether Groucho is liable on the video game contract. If
Groucho dissociated on April 1, he would not be liable to Pacman on the contract because
Pacman had read the ad and therefore would have notice of Groucho’s dissociation. UPA
§ 703(b). Moreover, Groucho is entitled to the value of his share of the partnership as of
the date of dissociation, § 701(b), and that would not include the additional liability on
the video game contract.
However, Groucho does not appear to have properly dissociated until April 3.
Section 601(1) says a partner dissociates upon “the partnership’s having notice of the
express will to withdraw as a partner.” Although Groucho published the ad on April 1,
the partners didn’t actually receive any notice until April 3, when Pacman told Zeppo and
Zeppo notified Harpo. Therefore, the effective date of Groucho’s dissociation was April
3, and he is fully liable on the contract.
Allocating the Loss to the Partners
Subtracting the $1,500 due on the contract, the cash remaining after paying all
creditors is $11,000. The current balance in the partners’ accounts is a total of $20,000,
so this represents a $9,000 loss that must be allocated. However, Harpo’s purchase of the
video game contract violated the partnership agreement, making him liable to the
partnership for the $1,500 loss. UPA § 405(a). This must be charged against Harpo’s
account and treated as an addition to the partnership’s assets. After this $1,500 charge,
the net loss to be allocated among all the partners is only $7,500.
Since the agreement does not specify how to allocate losses, they must be
allocated in the same percentages as profits. § 401(b). ¶ 3 of the agreement provides the
appropriate percentages: Harpo 50% and 25% each to the other two partners. Thus,
$3750 of the loss is allocated to Harpo’s account and 1875 to each of the other partners.
After this allocation, the net amounts due to each partner are:
Harpo: $1,000 – 1,500 – 3750 = -4250
Groucho: 12,000 – 1875 = 10,125 (plus the $2,500 salary)
Zeppo: 7000 – 1875 = 5,125.
Harpo must pay $4,250. Groucho is entitled to $10,125, plus his $2,500 salary. Zeppo is
entitled to receive $5,125.